Since its founding in 1948, Israel has transformed itself from a small, Fledgling economy dependent largely on government spending to that of a powerhouse driven by private sector investments in areas as diverse as technological infrastructure to pharmaceuticals to financial services.
The Jerusalem Portfolio makes this process easy with professionally-managed stock portfolios of Israeli companies.
When Israel was still developing its economy in its first couple of decades of existence, the government had a significant stake in ensuring that both its public and private sector could have the resources to function well. In order to do so, the founding Prime Minister, David Ben Gurion, turned to the highly-developed Western economies, particularly the United States, to raise capital from investors willing to loan money to the Israeli government, which did so by issuing fixed-income investments known as Israel Bonds.
Over time, as the private sector grew and needed its own source of capital, Israeli companies began to seek their own funding sources independent from the government. With this independence, companies could engage potential public investors to own fractional stakes in their enterprises. Thus, a new asset class was born: Israel Equities, which are also known as Israel Stocks.
For much of Israel’s early decades, bonds were the only realistic method of investing in the Jewish state (short of approaching a company’s owner(s) personally to buy a piece of private ownership). While bonds have historically been the easiest and safest way to invest in Israel, with the modern maturity of the capital markets in the country, stock investing has become an increasingly more attractive method of investing in Israel.
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Israel stocks represent ownership interests in private-sector companies from various sectors, of which nearly ¾ of the country’s market capitalization comes from the Technological (49%), Financial Services (14%), and Healthcare (11%) sectors.
Israel stocks, like most equities around the world, are listed on an exchange which enable buyers and sellers to engage in a highly liquid process to ensure transactions are conducted fairly. Israel stocks that are listed in the country are traded exclusively on the Tel Aviv Stock Exchange.
While the Tel Aviv Stock Exchange is Israel’s only legal public stock exchange, that does not mean that owners of Israeli stocks can only transact in the country. In fact, nearly ¼ of Israeli stocks’ aggregate market value is traded outside Israel, with virtually all of that amount in the United States. Those Israeli companies traded in the United States can be listed either on the New York Stock Exchange or on NASDAQ.
There are many different ways to invest in Israeli stocks. An individual could buy a large number of shares in a single company. Alternatively, an individual could buy a small number of shares in many different companies. While these methods provide high degrees of customization, doing so requires being highly attuned to individual sectors or firms. Knowing which company or companies to select is a difficult balancing act which few investors are successful at doing over long periods of time.
Diversification is the only “free lunch” of investing. That approach is the one that The Jerusalem Portfolio uses because it minimizes risk and volatility. Allowing the investor to own fractional interests in large number of listed public companies in a variety of sectors.
Since Israel Bonds have historically been shown to be safe and secure investments, what are the downsides of such bonds?
Let us first state explicitly what bond issuance entails: Investor(s) loan cash, whose amount is known as the principal, or, face value amount, on a certain date, known as the origination date, to an entity (i.e., the Israeli government), who then promises to repay that principal at a certain date at the future, known as a maturity date. In addition, interest, or coupon, payments, which are usually expressed as a percentage of the principal, are typically paid at pre-determined intervals over the duration of that loan.
Ultimately, the goal for most individual, high-net-worth investors who invest in bonds is to recoup one’s principal at maturity while receiving the intermediate interest payments on time.
Thus, bond investments are mostly a defensive play. (Contrast this to stock investments, which are primarily an offensive play.) While one does generate secure income by holding bonds, that security comes at the expense of three downsides: (1) Lack of growth, (2) The effect of higher bond yields on bond values, and (3) Liquidity concerns.
Downside 1Bond investing does not provide growth.
At maturity, the best a bond investor can do is to get back 100% of the money loaned at origination. Unless the interest payments received can be invested in another bond that pays higher coupon payments, there is no potential to increase one’s potential future return on investment, which is ultimately what investing is about.
Downside 2Higher bond yields can be detrimental.
Now let’s suppose an investor could actually find another bond that pays a higher rate of interest than the one which that investor currently owns. While the income on that new bond might be higher, the value of the old bond will decrease. This is because as bond yields increase, bond values will decline. Ultimately, there is no free lunch with bonds:
- Higher yields will provide increased income but will come at the cost of lower values.
- Lower yields will result in higher bond values but will come at the cost of lower income.
Downside 3Bonds are not liquid.
For the typical high-net-worth individual investor, bond investments are very much a buy-and-hold strategy, not because one really wants to do so, but must do so. This is because the ability to sell a bond is not easy.
Consider the following :
- 1
To sell a bond, one first has to find a buyer who has some interest in the bond that the investor owns. That may not be possible if that bond holding is either too small a quantity or with a maturity that is not popular in the marketplace.
- 2
Even if that potential buyer has an interest, the price s/he is willing to pay might be well below its face value amount.
- 3
As mentioned in Downside Two above, if an investor is forced to sell a bond during a period of recent rising interest rates, the value of that bond will be at a depressed level and that investor will not be able to recover all of the principal had that bond been kept until the maturity date.
While bonds are usually safe if held to maturity, they are most definitely not safe if the money is needed at an earlier time, which defeats the purpose of owning bonds in the first place.
Bonds provide security, but with little growth opportunity.
Bonds can serve a purpose in a portfolio to control volatility, but at the cost of growth potential. This is particularly important in today’s environment with bond yields at historical lows.
One of the most important factors in long-term investing is ensuring the portfolio’s returns can exceed the detrimental effects of inflation. If a portfolio’s expected returns are lower than the long-term inflation rate, then the real purchasing power of the portfolio will decline over time.
As an example, consider the following U.S. Treasury bond yields and implied inflation percentages from equivalent-maturity inflation-protected bonds as of mid-November 2020.
As you can see, bonds lose to inflation over time:
As of 3/31/2022
| U.S. Treasury Security | Nominal Bond Yield | Implied Inflation Rate | “Real Yield” | Investing in the Treasury loses to inflation by about: |
|---|---|---|---|---|
| 5 Year Note | 2.42% | 3.34% | -0.92% | 0.9% |
| 10 Year Note | 2.32% | 2.84% | -0.52% | 0.5% |
| 20 Year Bond | 2.59% | 2.79% | -0.20% | 0.2% |
| 30 Year Bond | 2.44% | 2.47% | -0.03% | 0.0% |
Now consider the performance of U.S. Equities during the following time periods. Equities greatly exceed inflation over time:
As of 3/31/2022
| Time Period | Actual Annualized Return | Actual Annualized Inflation Rate | Real Growth Rate | Investing in Equities exceeds inflation by about: |
|---|---|---|---|---|
| 5 Year | 15.40% | 3.35% | 12.05% | 12% |
| 10 Year | 14.28% | 2.28% | 12.00% | 12% |
| 15 Year | 10.10% | 2.27% | 7.83% | 8% |
Investing in Equities ensures you are able to protect your capital against inflation (and then some). Bonds do not keep up with inflation, especially in a low interest rate world.
Equities are secure, when structured and perceived correctly. Let us explain.
Most investors are keenly aware of the swings in Equity markets, particularly during short periods of times. As a result, many of these same investors become afraid of such swings and decide that stocks are not for them. Having some fear of stock market volatility is entirely understandable. With that said, one should not fear volatility. Rather one should be cognizant of why stocks are volatile and whether one can reduce that volatility in a strategic way.
It is important to note that although the words risk and volatility are often used interchangeably, they are actually quite different. Volatility is caused by a risk or combination of risks. In addition, while both words are associated with price swings, volatility usually refers to swings on the downside and upside. Risks are usually more concerned with detrimental effects to a portfolio – in other words, just the downside, not the upside.
Put another way:
- Risk is defined as a factor which may contribute to a loss that becomes permanent.
- Volatility is defined as a fluctuation in value that lasts only temporarily.
There are typically 3 risks that are associated with the volatility of a portfolio:
Company-Specific Risk
Occurs when a firm has certain characteristics that make could cause its own stock price to decline independent of what happens to all other companies. For example, if a company’s CEO becomes ill, the risk of a lack of executive leadership is specific only to that company. Company-specific risk can and should be eliminated by employing diversification.
Sector-Specific Risk
Occurs when a group of firms participating in a certain part of the economy can be affected by broader events. For example, greater health care regulation could be a risk to stocks in the pharmaceutical sector. Sector-specific risk can and should be eliminated by employing diversification.
Overall market risk
Is generally driven by macroeconomic concerns. For Israel in particular, stocks as a whole that are listed on the Tel Aviv Stock Exchange could be affected by rising COVID-19 cases or threats of war from its neighbors in the Middle East. For example, if there is a threat of a war on a particular day of trading, an Israeli technology company’s stock might suffer just as much as an Israeli financial services stock does that day. Market risk cannot and should not be avoided. In fact, that risk is the only part of portfolio volatility that we embrace as that is the “price” one must pay to benefit from long-term performance.
Because Israel has such a dynamic and growing economy driven by global-leading technology and biotechnology firms, we are happy to embrace the market risk that Israeli stocks may present in the short-term because in the long-term Equities have continued to show themselves as a secure investment.
As managers of The Jerusalem Portfolio, we endeavor to eliminate Company-Specific Risk and Sector-Specific risk by employing a highly-diversified portfolio that invests in nearly 100 companies, leaving only risks to the Israeli economy overall to be the driver of performance.