Hub News #38

ISSUE 38

HUBNEWS SUMMER 2018

As global growth slows, and monetary policy shifts, has the decade-long party in equity and bond markets come to an end?

CONTENTS & WELCOME

CONTENTS 4. Brexit Vote Two Years On 6. The Portfolio Construction Files: Building Portfolios for Uncertain Times 10. Understand The 'Human' Element in Markets 14. Digging Deeper for Good Ideas 18. Picking Winners 20. Multi-Asset Outlook: Expect Surprises, Expect Volatility 23. Calm and Storms: A Plan for all Conditions 24. Commercial Property: The Benefits of Collaboration 28. Cairn Homes: From Unloved to Recovery 30. The Drawdown Problem: How Much Can You Safely Withdraw in Retirement?

34. Absolute Return Funds – A Largely Untested Panacea 36. A View from The Other Side 38. Distracted by The Dollar: Today’s Environment in Emerging Markets 40. Quantinomics: Equity Factor Investing 101

WELCOME Along with the weather, markets have been distinctly perkier in the second quarter. The S&P 500 may have had its ups and downs, but overall has seen a steady climb from its low in March.

Yet on the surface, many of the problems remain. Trump’s trade war is far from resolved. While it has been more rhetoric than action to date, it still looms over government and corporate spending plans. There remains the threat that it will escalate, hitting economically significant sectors such as technology.

At the same time, Donald Trump continues to take a casual approach to the structures that have supported liberal capitalism for decades, which is unsettling for financial markets.

There is better news from the global economy. It appears that the economic weakness at the start of the year may just have been a weather-related blip and, at the time of writing, indicators were improving.

However, there is little doubt that there is less absolute value in markets. The monetary policy environment is changing and removing a key support. In this

month’s issue, we look at where investors can still find value in this type of environment.

Baillie Gifford’s Torcail Stewart discusses how he uncovers value within the otherwise expensive corporate bond markets; Fidelity’s Alex Wright discusses the merits in a contrarian approach; while Square Mile discusses whether absolute return funds may be the answer.

Investec’s Alistair Mundy suggests that value investing can occasionally leave you on the naughty step.

We also tackle some of the big issues: Schroders takes on Brexit, Janus Henderson discusses the key risks in the global economy, while Aviva Investors looks at the equally big problem of how not to run out of money in retirement.

As ever, we welcome your comments and suggestions for Hub News and every other aspect of the Adviser Hub service. Please do not hesitate to get in touch at enquiries@adviser-hub.co.uk.

Cherry Reynard Editor www.adviser-hub.co.uk

ADVISER-HUB.CO.UK 0 3

POLITICS

BREXIT VOTE TWO YEARS ON On the anniversary of the UK's vote to leave the European Union, Schroders looks at the timeline to Brexit and what's happened in markets and the UK economy.

On 23 June 2016, the UK public voted on whether or not to stay in the European Union (EU).

Many expected the UK to remain in the EU, but by a majority of 52% to 48% the Leave campaign won. The UK is scheduled to leave the EU at 11pm UK time on 29 March 2019.

WHAT’S HAPPENED IN MARKETS SINCE BREXIT? Stockmarkets In the immediate aftermath of the referendum the FTSE 100 and the FTSE 250 fell 9% and 12%, respectively. But since the close of the market on 23 June 2016, UK shares, as measured by the FTSE All-Share, have risen 31.2% as of 15 June 2018.

The global economic backdrop has been helpful. Global investors have bought into the so-called Goldilocks scenario; a “not too hot, not too cold” combination of stable growth, benign inflation and low interest rates.

Support for the UK market and the economy came from the Bank of England (BoE), which has kept interest rates low and monetary policy loose, ensuring businesses and markets have access to funding.

However, the UK stockmarket has lagged the rest of the world.

Since the Brexit vote, Asian shares have returned 44.1%, according to Thomson Reuters data; US stocks returned 37.2%. Only European 0 4 ADVISER-HUB.CO.UK

shares, of the five main indices we looked at, made less than the UK, returning 19.5%. Global stock markets have returned 33.2%.

Sterling Sterling is down by 10% against the US dollar since Brexit, according to the Thomson Reuters data, although this masks a recovery from the near-20% fall immediately after the vote (see Fig.1).

The uncertainty over the outcome of Brexit negotiations, a slowing UK economy and a spike in inflation at the start of 2018, has forced the BoE to keep interest rates low so as not to slow the economy further.

Low interest rates, plus economic and political uncertainty aren’t good for a currency. But while a weak pound is bad for holidaymakers, it can be good for UK-listed companies that generate their profits overseas.

If the pound is weak, then the money companies make in foreign currency is worth more once converted back into sterling.

You can see the effect the fall in sterling has had on the FTSE All-Share index shown in the Fig.1 chart. The weakness in the pound has supported the index’s gains over the last two years. When the currency has strengthened, the stockmarket has weakened and vice versa.

In fact if you convert all the index returns into dollar terms

OCTOBER 2018 EU Summit

• Set out withdrawal agreement including divorce bill • A political declaration on the framework for the future relationship with the EU

AUTUMN 2018 The House of Commons needs to sign off a Brexit deal

JANUARY 2019 EU and UK parliaments must ratify withdrawal treaty before Brexit

29 MARCH 2019 UK is scheduled to leave the EU at 11pm UK time providing everything is agreed

30 MARCH 2019 31 DECEMBER 2020 Transition period ends. The UK can implement its own trade deals.

UK will begin transition period during which it will maintain the benefits of being in the EU but can also negotiate its own trade deals

POLITICS

Stockmarket sectors The Goldilocks economy has worked its magic on the sectors benefiting most from more benign global economics, among them basic resources and materials.

Sectors with lower cyclicality – those that produce goods and services for which demand is less affected by the health of the economy – have done less well. The weakest of these have suffered also from regulatory and competitive issues, including telecoms, utilities and tobacco.

Elsewhere, real estate and

View from a fund manager David Docherty, UK equities: “A big influence will be the ongoing tightening of US monetary policy.

This is bound to have implications for the world economy and markets as investors wonder how long Goldilocks will grace us with her presence. We think this will increase volatility with associated moves in bonds, commodities and currencies causing ripples in UK equities.

“In the meantime, there are other non-Brexit factors such as technological change, international trade, geopolitics and the current takeover (the merger and acquisition of companies) boom, while recent ructions in Italy show that the eurozone faces serious issues of its own.

“THE INEVITABLE TWISTS AND TURNS OF THE BREXIT PROCESS ARE SURE TO KEEP INVESTORS ON THEIR TOES, NOT LEAST BECAUSE OF THE IMPLICATIONS FOR UK PARTY POLITICS. SIGNIFICANT MARKET MOVES ARE EMINENTLY POSSIBLE AND MAKING THE MOST OF ANY VALUATION ANOMALIES THAT EMERGE WILL BE THE CHALLENGE FOR INVESTORS.”

the UK is house prices; since Brexit, house price growth has slowed consistently.

It may not be entirely due to Brexit, although it has been cited as a major factor by most providers of house price data. Buy-to-let investors have had to endure an increase in stamp duty and a tightening of mortgage tax relief.

Interest rates and inflation In August 2016 the BoE cut interest rates to an all-time low of 0.25% after a period of uncertainty following the Brexit vote. In the months that followed, inflation steadily rose higher, finally peaking at 2.8% in late 2017.

The BoE raised interest rates back to 0.50% in November 2017 as inflation rose and the economy

Fig 1

then UK stockmarket is the worst performing index of those we have highlighted. It is up 18.9% since Brexit, less than European shares which are up 21.8% in dollar terms.

appeared to be on a more stable footing. Investors were so confident of a further rate rise in May 2018 that they had priced in a 100% probability of it happening. It didn’t happen.

Since then the BoE has been unable to raise rates further. Inflation has eased back and the UK economy has slowed significantly. The market is now pricing in the most probable chance of a rate hike to 0.75% at the BoE meeting in November, as the table below shows. This now aligns with an earlier forecast from Schroders.

How sterling weakness has supported the UK stockmarket

150

130

110

90

“The inevitable twists and turns of the Brexit process are sure to keep investors on their toes, not least because of the implications for UK party politics.

“Significant market moves are eminently possible and making the most of any valuation anomalies which emerge will be the challenge for investors.

“In sector terms we are alert to opportunities in the unloved utilities and retailers, while experience has shown that periods of market turbulence can throw up exciting bottom-up stock ideas across the market as a whole.”

WHAT HAS HAPPENED TO THE UK ECONOMY? Growth (GDP) The UK has fallen to the bottom of the G7 growth league. This is a group of the world's seven most powerful industrialised countries – the US, Japan, Germany, the UK, France, Italy and Canada.

As Fig 2 illustrates, the slide down the rankings came after the UK’s vote to leave the EU. House prices One of the best barometers of the health of household finances in

70 23 Jun 2016

23 Nov 2016

23 Apr 2017

23 Sept 2017

23 Feb 2018

FTSE All-Share

Fig 2

general retailers have continued to underperform but structural concerns, epitomised by the ‘Amazon effect’ – the ongoing evolution of the retail sector brought about by online disruption – appear more significant than Brexit.

Valuations are lower in sectors which are more dominated by domestically-focused companies.

Telecoms, utilities, retail and banks all look cheap compared with the UK market average on a cyclicallyadjusted price to earnings (CAPE) multiple. A lower number suggests better value.

CAPE compares the price with average earnings over the past ten years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.

Valuation measures shouldn’t be considered in isolation.

Explaining what has happened in UK equities since the referendum is one thing. Predicting how the market will behave as Brexit negotiations play out is quite another. As the Amazon and regulatory examples show, Brexit will continue to be only one of a number of factors occupying UK equity investors.

GBP vs USD level

Real GDP growth % y/y

6 4 2 0 -2 -4 -6 -8 2008

2009

2010

2011

2012 G7 range

2013

2014

2015

2016

2017

UK

Fig 1: Source: Schroders. Thomson Reuters Datastream data as at 15 June 2018. FTSE All-Share used for UK shares.

Fig 2: Thomson Datastream, Schroders Economics Group, 22 February 2018, Thomson Reuters Datastream, Schroders Updated 7 June 2018.

Past Performance is not a guide to future performance and may not be repeated.

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PORTFOLIO CONSTRUCTION

THE PORTFOLIO CONSTRUCTION FILES: BUILDING PORTFOLIOS FOR UNCERTAIN TIMES Markets have been volatile since the start of 2018, bringing greater focus on the asset mix in client portfolios. Michael Gruener, Head of BlackRock EMEA Retail, discusses what clients have been telling him and how BlackRock is addressing the problem.

0 6 ADVISER-HUB.CO.UK

PORTFOLIO CONSTRUCTION

"AS INVESTORS INCREASINGLY FOCUS ON THE VALUE FOR MONEY THEY ARE RECEIVING, THE DESIRED OUTCOME WILL NEED TIGHTER DEFINITION AND MONITORING – THIS WILL CONTINUOUSLY ALIGN PORTFOLIOS TOWARDS THE MOST COST-EFFECTIVE WAY TO ACHIEVE IT." CHARTING NEW WATERS

Michael Gruener, Head of BlackRock EMEA Retail

One thing that’s coming through clearly from my conversations with clients over the past two months is that they are worried about future returns from markets. At a recent investor summit for a major client, the message could not have been clearer: volatility is back and the outlook is less certain than 2017. While investors – and BlackRock – remain relatively constructive over the state of the global economy over the next 12 months, the big question starting to arise is: what after that?

This client and others have told me they want ‘captains’ to steer them through these markets; to react and adapt to rapidly-changing conditions. They do not believe monodirectional, buy-and-hold solutions are as suitable for the next two years as they might have been during the past market rally – and that portfolios will need to be adjusted more often.

Client opinions and statements of intent are extremely useful, but I still like to look at data to identify emerging trends. Asset flows are painting a clear picture of strong investor momentum towards alpha-seeking strategies – particularly in fixed income. More than half of 2017 flows into alpha-seeking strategies went into bonds, while alpha-seeking equity – widely declared deceased – also staged a notable recovery last year.

A FUNDAMENTAL SHIFT? So, what now? Why do we see BlackRock institutional clients increasing their allocations to active management mandates? Why are clients using terms such as ‘steer’ and ‘navigate’ when talking about medium-term market conditions? There have been several attempts to call the end of the market rally since 2009.

Greece. Taper tantrums. The oil and commodity sell-off in 2014-15. Election shocks. Concerns about China’s swelling debt load. Stretched equity valuations. The Federal Reserve normalising policy. Yet none proved to be a trigger. So, is anything different now?

From my perspective, none of the current signals – US 10-year Treasury yields breaking

3%; broad money trends; slowing economic momentum – is a particular cause for alarm. But perhaps we are coming to the end of this long phase characterised by alternated ‘risk-on, risk-off’ periods . Maybe there will be more reward for bottom-up, fundamental stock picking, illiquidity premia and specialist markets.

HOW CAN WE ADAPT TO CHANGE? Investments are not binary. There are always nuances and different ways to tackle an investment challenge. As much as our clients are telling us they need captains, we reply that they require a toolkit which harnesses the power of data and modern technology and embraces a holistic set of portfolio construction capabilities.

Many investment objectives need a combination of investment strategies, and the conversation will increasingly turn to how best to blend a portfolio. Success in the future will involve looking across the investment spectrum to identify where indexing strategies are most appropriate, where factors can help drive additional returns and where an alpha-seeking approach is most apt. In fixed income, for example, yield curve strategies, duration management and access to markets can be a major differentiator for an alphaseeking manager.

As investors increasingly focus on the value for money they are receiving, the desired outcome will need tighter definition and monitoring. This will continuously align portfolios towards the most cost-effective way to achieve it. This will require more powerful tools and analytics to enable investors to have a deeper understanding of how the selected products interact with one another. Let’s remember that a portfolio composed of the best managers isn’t necessarily the best possible portfolio.

At BlackRock, we have been building for these times. We continue to develop innovative strategies across the spectrum of investment solutions. This helps investors build the core of their portfolios, get more value for money by moving away from benchmark huggers, and control the overall fee budget of their alpha sleeve. With an ever-growing set of investment strategies available, we are extending our portfolio construction capabilities, with dedicated teams and state-of-the-art technology to help clients gain deeper insights on the drivers of risk and returns in their portfolios.

This material is for distribution to Professional Clients (as defined by the Financial Conduct Authority or MiFID Rules) and Qualified Investors only and should not be relied upon by any other persons. Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: 020 7743 3000. Registered in England No. 2020394. For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. You may not get back the amount originally invested. The opinions expressed are as of May 2018 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy. This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer. © 2018 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES, BUILD ON BLACKROCK, SO WHAT DO I DO WITH MY MONEY and the stylized i logo are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. MKTG0518E-494487-1562281 ADVISER-HUB.CO.UK 0 7

Your weekly eye on the investment world Subscribe today at bnymellonmarketeye.com

For Professional Clients only. Any views and opinions are those of the investment manager, unless otherwise noted and is not investment advice. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and its subsidiaries. BNY Mellon Investment Management EMEA Limited and any other BNYÂ Mellon entity mentioned are all ultimately owned by The Bank of New York Mellon Corporation. Issued in UK by BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorised and regulated by the Financial Conduct Authority. AB00153, exp 28 Sept 2018. T6681 04/18

BEHAVIOURAL FINANCE

FOR PROFESSIONAL CLIENTS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

UNDERSTAND THE 'HUMAN' ELEMENT IN MARKETS Steven Andrew manages the M&G Episode Income and M&G (Lux) Income Allocation funds. He explains what differentiates M&G’s approach from other multi-asset managers.

There are a variety of ways in which fund managers can claim to have an edge, and advisers will have heard most of them. It might be their access to information, the way they use that information, or their ability to outwit the market with superior intelligence or insight.

None of these approaches, argues Steven Andrew, multi-asset fund manager at M&G, is likely to deliver good long-term sustainable outcomes for clients. He says: “Fund managers are all competing against everyone else – in New York, London, Amsterdam. They’re saying that this is not the right price for an asset.

Therefore, I would say that they know better than the market. To do this, we believe you need to be clear about what you are professing your skillset to be and you need great transparency and honesty about what you are trying to do.”

To his mind, the ‘superior information’ argument is tricky from a regulatory perspective.

No-one is supposed to have more information than anyone else. Anything else is to flout the rules on insider trading and it is certainly not a sustainable investment philosophy. Also, to suggest you are somehow smarter, or dedicate more shoe-leather to tackling a particular problem is on equally shaky ground, he says.

Andrew adds: “Everyone has access to the same information and no-one gets that information any quicker than anyone else.

Analytical processing power is widely available and collective wisdom is always reflected in this single price. Therefore, any new information 1 0 ADVISER-HUB.CO.UK

should change the market.”

At the heart of the M&G approach is the view that the efficient market hypothesis doesn’t work. It may hold in the long term, and it may work to exert a gravitational pull, but there are lengthy periods when it doesn’t work.

For him, a more productive approach is to look at what causes prices to deviate from fundamentals. Why is the market interested in what Donald Trump just said? Or why does it care about the level of the euro?

The reason is that everyone is looking at slightly different bits of information and interpreting them in slightly different ways. As such, market participants will make errors. Errors on one side are offset by the errors on the another and the errors aren’t correlated. It happens because people act like humans, not like machines as the efficient market hypothesis would suggest.

Andrew instead calls on the work of Nobel Prize winners Daniel Kahneman and Amos Tversky. These two academics did groundbreaking work looking at a cognitive basis for common human errors that arise from heuristics and biases. Although both were psychologists, their work was hugely influential in understanding investor behaviour. Andrew says: “Economists assume that we are rational decision-makers, but human beings are not rational decision-makers.”

For Andrew, this helped him understand what it was possible to achieve as an investor.

Specifically, he couldn’t out-analyse 200 Bank of England (BoE) economists who are carefully plotting inflation. He notes that the BoE with all its power found its forecasting power is no better than a moving average.

He sought instead to look at what is causing the price behaviour. Is it departing from the underlying value for good or bad reasons? Prices should reflect the degree of compensation an individual investor requires for taking risk. He says: “In a bond – as is happening in the German bund market today – the real yield is -1 –1.5%.

Is it rational behaviour to buy that bond? We don’t believe it is. The market wants to overpay for protection.”

In the equity markets today, for example, the US might be at one end in terms of safety, with Turkey at the other. Certainly, Turkey looks risky, but its stock market carries a sizeable equity risk premium. When does that become high enough to buy in? Andrew adds: “This is the context into which we can place facts.”

The wider M&G is important in this decision-making process, not because of the research capability this confers, but because it keeps everyone ‘intellectually honest’. Andrew believes it is not always easy to see your own biases and interrogating the reasons behind a decision is important.

He adds: “There is always a compelling narrative. Markets love a ‘what if’ scenario. We aim to invest with a margin of safety in the context of saying ‘what is the compensation for

BEHAVIOURAL FINANCE

this fundamental risk?’. It is contrarian, but we're only acting on price signals and trying to translate that into an actionable investment strategy. Where is the value? What are the facts?”.

More recently this has seen the team buy euro-area bank equities in the teeth of significant volatility in the asset class. Andrew points out that the stocks were already cheap and heavily discounted: “They are now seeing earnings growth and yet continue to be discounted. We continue to observe a set of supportive fundamentals. Here we are looking at the economic experience, the dynamic of growth and policy and where the market sees it. It is not forecasting, but taking a strong view on market beliefs.”

They have also taken a view on the impact of the Brexit vote. After the vote, the market ‘knew’ that Brexit was going to be bad.

However, Andrew argues, neither the market nor anyone else ‘knows’ that it will be bad – that won’t be clear for decades. He says:

“The only relevant question was whether the UK had changed its ideology regarding globalisation. We thought that there was a plausible answer that it hadn’t changed as much as people thought. We should put money on the other side of that. As such, we own a fair bit of UK domestic equity. This has performed very well over the past six months.”

It has also led them away from areas such as gilts, where they have had no weighting for three years. “They are simply too expensive.

We are thinking about risk as probable loss,” he says. There are always opportunities: “It is rare that bonds and equities are both expensive.

Within equities – not all are perceived in the same way at the same time. There is usually somewhere where you can get diversification and a better return over time.”

“FOCUS ON VALUATION IS THE OVER-RIDING PHILOSOPHY THAT INFORMS ALLOCATIONS. TO OUR MINDS OVER-PAYING FOR ANY ASSET, WHATEVER ITS QUALITY, IS TAKING ON ADDITIONAL RISK.”

ADVISER-HUB.CO.UK 1 1

M&G Multi-Asset

IM GINE

FEELING IN CONTROL OF YOUR CLIENTS’

FINANCIAL FUTURE

The reasons for investing for the long term can be different, but one thing is the same for all investors: taking a diversified approach can help manage risk, making you feel in control of your clients’ financial future.

The M&G Episode Income Fund could provide a multi-asset approach for income seekers. The Fund aims to generate capital growth of 2% to 4% over a three-year period and is ranked in the top quartile in the IA Mixed Investment 20-60% Shares sector over one year, three years, five years and the fund manager’s tenure.

Fund performance Year to Date M&G Episode Income I Acc (%)

+1.1

2017

2016

2015

2014

2013

Inception

+10.3

+14.9

-2.6

+13.7

+7.3

+8.1

Source: Morningstar, Inc., as at 30.04.18, price-to-price with income reinvested, based on Sterling Class I shares.

Past performance is not a guide to future performance. The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested. There is no guarantee the fund objective will be achieved.

The Fund allows for the extensive use of derivatives.

For financial advisers only. Not for onward distribution. No other persons should rely on any information contained within. This financial promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Conduct Authority in the UK and provides ISAs and other investment products. The company’s registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No. 90776. MAY 18 / 286506

SCOTTISH MORTGAGE STRATEGIC INVESTMENT BONDTRUST FUND

TOP QUARTILE PERFORMANCE WITH BOTTOM QUARTILE FEES OVER ONE, THREE, FIVE AND 10 YEARS.

SEEK AND YOU SHALL FIND. With our Baillie Gifford Strategic Bond Fund (formerly known as our Corporate Bond Fund) we aim to achieve a high level of monthly income for our clients by investing primarily in a diversified bond portfolio.

A defining characteristic is great bond selection that looks further than the usual one-year horizon. We go off the beaten track to find companies that are embracing change and those that are producing the products and services of the future, not the past.

You could say our portfolio comprises the ‘best ideas’ we can track down across the high yield and investment grade markets. You can see the results for yourself from the table below.

Performance to 31 March 2018* 5 years

10 years

Strategic Bond Fund

30.1%

105.8%

IA £ Strategic Bond Sector Average

19.8%

65.9%

As with any investment, your clients’ capital is at risk. Past performance is not a guide to future returns.

For financial advisers only, not retail investors.

For a fund that aims to achieve a high level of monthly income through a diversified portfolio, call 0800 917 4752 or visit www.bailliegifford.com/intermediaries

Long-term investment partners

*All data as at 31 March 2018. Source: FE, B Inc shares, single pricing basis, total return. Your call may be recorded for training or monitoring purposes. Baillie Gifford & Co Limited is the Authorised Corporate Director of the Baillie Gifford ICVCs. Baillie Gifford & Co Limited is wholly owned by Baillie Gifford & Co. Both companies are authorised and regulated by the Financial Conduct Authority.

CORPORATE BONDS

DIGGING DEEPER FOR GOOD IDEAS Corporate bond markets may hold less value, but there are opportunities for those willing to delve a little deeper, says Baillie Gifford’s Torcail Stewart.

At a time when there is less aggregate value in the corporate bond market, active managers need to dig deep to find good ideas.

For Torcail Stewart, manager of the Baillie Gifford Strategic Bond Fund, this means delving into unloved sectors such as retail, but also into mis-rated bonds to find opportunities. Through careful stock selection, he believes, it is possible to find much of interest in these sectors.

The Baillie Gifford Strategic Bond Fund is the renamed Baillie Gifford Corporate Bond Fund.

In a ‘Marathon to Snickers’ moment, the fund changed its name on concerns that it would be seen as a pure investment grade fund, rather than a blended, assetallocated corporate bond fund.

The successful process and investment philosophy remain unchanged, but the firm believes the new name better reflects the fund’s objectives. In Stewart’s view, the fund has always been a strategic bond fund in nature.

The fund combines bottom-up bond selection with asset allocation between investment grade and high yield bonds, plus the ability to vary exposure to corporate versus government bond risk.

The fund invests in global best ideas. It looks across the dollar, sterling and euro markets to get a flavour of where to go seek opportunities, then focuses on identifying companies with strong fundamentals. To provide a source of return, even when markets are tricky, Stewart finds there are some consistent areas of inefficiency, whatever the market conditions.

The first is in out-of-favour areas, where the bonds of strong companies are sold off alongside those of weaker companies simply because a sector is unloved. In 2016, for example, Stewart found opportunities in the oil and gas sector. The sector had a difficult period when the oil price was weak and good companies – even those with significant hedging in place – were sold off. Stewart adds: “Some companies had hedged oil prices until 2020, others had a significant proportion of variable costs which the market had clearly overlooked.

There were resilient businesses available on very attractive yields.”

Today, this approach sees him scouting in the widely disliked retail sector. As retail sales limp lower, corporate failures mount and 1 4 ADVISER-HUB.CO.UK

consumer sentiment deteriorates, the consumer sector has been sold down. However, this has seen good companies marked lower with the bad. Stewart says: “There are some businesses we like. For example, there is Sally Beauty, which has been resilient through a variety of market conditions. It sells hair colour to hairdressers.

This needs to be sourced locally and hasn’t been targeted by online giants such as Amazon. The bonds are yielding 6.6%” Liberty Interactive is another idea in the portfolio. One of its brands is QVC, the telesales shopping channel, which has been resilient in the US and globally. After a reorganisation of this business, its exchangeable bonds were swapped with assets of the QVC Group which generates higher levels of cash than Liberty.

Stewart says that the QVC business has benefited from being able to buy in bulk and offer good prices, a little like CostCo. The team have even delved into the difficult restaurant sector. They like the Wagamama chain, which has shown high growth, is well run and cash generative. Its food is also well-suited to home delivery through groups such as Deliveroo. He admits that the retail sector requires careful handling, but there are opportunities. Wagamama is offered on a 5% yield.

There are also opportunities among mis-rated bonds. These are bonds that have been assigned too weak a rating by the ratings providers. Stewart says: “The market is so focused on short-term quarterly numbers that it can’t see the wood for the trees. Netflix, for example, has been growing very rapidly, adding the equivalent of the population of Australia to its user base last year. Every time it grows, it lowers its costs. In Netflix Original, it is building its back-book and creating long-term value. The group’s pricing represents great value relative to the value of its content. On a single B+ rating, we believe the bonds are mis-rated.

“We see a similar phenomenon with unrated bonds. When the Pensions Insurance Corporation, a leader in bulk annuities, looked at coming to market, it was unlikely to get the rating it thought it merited because it hadn’t been to the bond market before. Therefore, it decided to go without a rating, though it had

to pay a high 6.5% coupon on its debt as a consequence. Three years later the business achieved a respectable BBB+ rating and the bonds jumped in price. The bonds had progressively hit our positive milestones and we increased the size of our position.”

In general, the team is looking for companies where balance sheets are improving and therefore there is capacity for growth.

Today’s environment presents its challenges.

Stewart says: “Spreads are lower than they have been in the past and that is influencing some of our investment choices. We are underweight emerging markets, for example. In terms of rate rises, a lot is priced in to the dollar market.

Whereas the Federal Reserve’s outlook chart – the so-called ‘dot plot’ which shows the expectations for future interest rate – was significantly above market expectations, the market has now caught up.

“We find it unusual that asset prices haven’t caught up with the new reality, and emerging markets may be the victim of this.”

Stewart believes inflation remains a risk, but sees spare capacity in the global system, even at this point in the cycle. There is hidden capacity in the form of part-time workers who want to move to full-time, for example. Certainly, if protectionism started to emerge more strongly, this would be an inflation risk, but this would have to extend beyond steel tariffs to other sectors and industries.

Stewart adds: “There are definitely structural deflationary headwinds out there such as automation, globalisation and corporate economies of scale. Such deflationary pressures are not going away. Furthermore, in response to trade tariffs, China may just depreciate its currency, which would be deflationary for everyone else.” As such, he believes, it is not clear that inflation will re-emerge.

He concludes with the gloomy thought that only three out of the last 13 rate hiking cycles didn’t result in recession. There is higher debt in the US and elsewhere than there has been historically. That may make the global economy more sensitive to a change in monetary policy conditions. The risks for inflation look evenly balanced and with them, the prospects for the corporate bond sector.

CORPORATE BONDS

"THERE ARE DEFINITELY STRUCTURAL DEFLATIONARY HEADWINDS OUT THERE SUCH AS AUTOMATION, GLOBALISATION AND CORPORATE ECONOMIES OF SCALE. SUCH DEFLATIONARY PRESSURES ARE NOT GOING AWAY."

Important Information and Risk Factors For financial advisers only, not retail investors. As with any investment, your clients’ capital is at risk. Past performance is not a guide to future returns. All data correct at June 2018 and source Baillie Gifford unless otherwise stated. The information contained within this article has been issued and approved by Baillie Gifford & Co Limited, which is authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is a unit trust management company and the OEICs’ Authorised Corporate Director. The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research. Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions.

ADVISER-HUB.CO.UK 1 5

We don’t just invest money for our clients – we invest the hours, months and years of hard work it has taken to earn it.

It’s not just about investing in one of our funds; it’s about investing in a belief that life is what you make it.

Each of us at Invesco Perpetual shares that belief and that’s what drives us – we are fully focused on delivering what truly matters to our clients – their objectives, their dreams.

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Mr Hayles Furniture maker for 27 years

This ad is for Professional Clients only and is not for consumer use. Invesco Perpetual is a business name of Invesco Asset Management Limited.

Authorised and regulated by the Financial Conduct Authority.

XXXX

G N I K C I P

S R E N N I W

Having a robust and proven investment process plays a crucial role in exploiting price anomalies and constructing long-term portfolios in emerging markets, says Douglas Turnbull, Senior Analyst, Emerging Market Equities at Invesco Perpetual.

1 8 ADVISER-HUB.CO.UK

EMERGING MARKETS

Investing in global emerging equity markets provides a diverse set of challenges – they tend to be more complex, heterogeneous and less efficient than developed markets.

As active fund managers with a long-term time horizon, it is thus important to have a robust investment process in place that allows us to exploit pricing anomalies across diverse regions.

Intrinsic to this is maintaining a strong valuation discipline as well as ensuring that our views are rooted in thorough analysis of company fundamentals.

This conceptual framework is a prerequisite for building a well-diversified portfolio of active stock positions without an inherent style bias, ensuring that our emerging market strategies are carefully balanced with an optimal risk/ return profile.

QUANTITATIVE AND QUALITATIVE From idea generation to portfolio construction, our investment process considers both qualitative and quantitative criteria. Our thesis will begin with identifying scope for mispricing, establishing points whereon we may disagree with the market’s consensus opinion, whether that’s on our understanding of an operating environment, business model and economics, or management prospects for a particular company.

We will then look to highlight the key drivers of that thesis and consider the direction, rate, and magnitude of change for them, moving to a quantitative understanding of the mispricing we see.

While there are many different ways to value stocks – price earnings and price-to-book ratios; discounted cash flow and Gordon growth models – we always look to choose the right tool for the job, consistently applying a pragmatic approach.

We believe that deep analysis of qualitative factors, set within a quantitative framework, plays a key role in separating us from the crowd and gives us greater scope to pick stocks that could be mispriced by the market.

PROCESS IN ACTION – FAB How this investment process works in practice is best shown by a stock example. Earlier this year we took a position in First Abu Dhabi Bank (FAB), which came into existence post the merger of the two major Abu Dhabi banks – NBAD and FGB. The consolidated entity (FAB) is now the largest bank in the UAE by total assets.

ECONOMIC/FINANCIAL CYCLES Banks are sensitive to economic and financial cycles, generally being healthier and more profitable when the economy is doing well, as opposed to recessionary periods when businesses are more at risk of defaulting on their loans.

In our view, Abu Dhabi’s economic recovery, in part due to being oil-priced linked, is at an earlier stage than other cycles in emerging markets.

We believe that improving economic conditions should support bank loan growth and better asset quality in the UAE. Furthermore, when the central bank of the UAE – in order to maintain their currency peg with the US dollar – raised interest rates in March following the hike in the US federal funds rate, we saw the move as positive for FAB on the grounds that it would support their profitability by increasing net interest incomes.

More idiosyncratically, FAB has been working through the integration of the two merged banks – we see that market expectations could further be beaten by their delivery above guidance on both cost and revenue synergies as they make faster progress on the former and are able to return to growth on the latter sooner than expected.

MISPRICING ANOMALY On the back of rising net interest margins and merger synergies – increased efficiency and higher fee income – we see accelerating earnings growth for FAB and an improving return on equity profile.

We capture these dynamics through our proprietary template bank valuation model, which allows us both to readily compare FAB to other banking opportunities and also to gauge the outputs from a range of consistently applied relevant valuation techniques.

Ultimately this led us to believe the company’s share price is not reflecting the improved outlook.

CONCLUSION Having an investment process that is robust in conception and depth of work – thus making it repeatable in how we apply it to individual stocks – has proven itself over many years of consistent application.

We believe it plays a crucial role in stock picking and construction of a balanced portfolio, allowing us to best capture the long-term opportunities offered by emerging market equities.

"WHILE THERE ARE MANY DIFFERENT WAYS TO VALUE STOCKS, WE ALWAYS LOOK TO CHOOSE THE RIGHT TOOL FOR THE JOB, CONSISTENTLY APPLYING A PRAGMATIC APPROACH."

Investment risks The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. As a large portion of the strategy is invested in less developed countries, you should be prepared to accept significantly large fluctuations in value. The strategy may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments, reduce the costs of investing and/or generate additional capital or income, although this may not be achieved. The use of such complex instruments may result in greater fluctuations of the value of a portfolio. The Manager, however, will ensure that the use of derivatives does not materially alter the overall risk profile of the strategy.

Important information This document is for Professional Clients only and is not for consumer use. Past performance is not a guide to future returns. This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities. Where Douglas Turnbull has expressed opinions, they are based on current market conditions, may differ from those of other investment professionals and are subject to change without notice.

Invesco Perpetual is a business name of Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.

ADVISER-HUB.CO.UK 1 9

MULTI-ASSET

For professional investors. For promotional purposes

MULTI-ASSET OUTLOOK: EXPECT SURPRISES, EXPECT VOLATILITY Paul O’Connor, Head of Janus Henderson’s UK-based multi-asset team, outlines his view on the events of 2018 to date and gives his outlook for different asset classes.

QUANTITATIVE EASING PEAKS, VOLATILITY TROUGHS We see 2018’s upshift in financial market volatility as a return to more normal market conditions, following one of the most tranquil years in market history. The unusually benign market environment of 2017 reflected a remarkably favourable macro backdrop. It was a year of sustained positive global growth surprises, yet with limited upward pressure on inflation and interest rate expectations. It was also a year in which global central banks poured $2,000bn into financial markets through their quantitative easing (QE) programmes – the biggest annual injection since 2008 (Fig 1).

This year, however, looks very different.

Markets are notably more turbulent. Investors have begun to realise that the near-perfect macro conditions of 2017 and early 2018 cannot last forever and are now adjusting expectations towards an environment that will be more complicated, more uncertain, and more ‘normal’.

SOLID MACRO FUNDAMENTALS We retain our constructive view on global macro fundamentals, believing that the global economic expansion has the potential to be unusually long by historical standards, underpinned by exceptionally low real interest rates in all the major economies. Even though the rate cycle is already on the turn, led by the US, the speed and scale of tightening that we anticipate from the major central banks looks unlikely to derail the global recovery.

It might seem incongruous to have a fairly cautious view on many of the major asset classes while holding a positive view on the macro outlook but this is where we find ourselves right now. We had been concerned that financial markets were fully pricing in the most optimistic macro outcomes and taking little account of a number of plausible risk scenarios, raising cash in our multi-asset funds.

Since then, investors have indeed begun to confront and price in a seemingly unending number of different concerns. This has included 2 0 ADVISER-HUB.CO.UK

the threat of higher US inflation and a more aggressive Fed rate-hiking cycle, regulatory risk in the technology sector, global trade tensions, and a range of country-specific troubles stretching from Korea to Argentina, Turkey, Italy and Spain.

A RATIONAL REPRICING OF RISK At this stage, we do not regard any of these issues as being big enough to affect global macro fundamentals meaningfully. However, they have been big enough to rattle financial markets. Theme by theme, investors have been reminded of the need to at least consider some threats to the highly positive consensus macro outlook that prevailed at the start of the year.

“MANY FEATURES OF THE GLOBAL MACRO ENVIRONMENT ARE UNPRECEDENTED, SUCH AS THE AMOUNT OF DEBT AND THE SIZE OF CENTRAL BANK INTERVENTION. ACCORDINGLY, THE IMPACT OF SHOCKS IS HARD TO CALIBRATE. WE HAVE TO STAY VIGILANT AND FLEXIBLE” In broad terms, we see what is happening here as being a rational repricing of risk – a healthy resetting of investor expectations from complacency to a more balanced evaluation of both upside and downside scenarios.

In most of the major asset classes, we believe that this repricing of risk is incomplete.

We expect markets to remain choppy in the months ahead as investors weigh up the various conflicting influences that are now in play. The volatility that we anticipate will at times be a source of discomfort for investors, but it will also be a source of opportunity for dynamic asset allocation. We are still well invested in financial markets in our multi-asset funds, but not fully.

We have some cash held back to give us scope to buy on dips if assets do become more attractively priced.

BUYING DIPS IN EQUITIES – STAYING PATIENT IN CREDIT Equities remain our strategically favoured asset class. Although the bull market is now well advanced by historical standards, the prospect of an unusually long economic expansion does provide fundamental support for further gains in stocks. Still, given the changing global monetary environment, and the various specific challenges discussed above, we see the volatile, lowish-return, equity market conditions of the year so far as a good guide to what the rest of the year holds.

Whereas, in most assets, the dips we have seen so far this year have not been big enough to tempt us, the one exception was the double-digit pullback in the FTSE 100 Index in Q1.

We continue to struggle to find value in fixed income. In government bonds, we expect real yields to keep trending higher, reflecting the ending of QE, the turn in the global rate cycle and the continued expansion of the global economy. We are happy to start reducing our underweight in government bonds by buying 10-year US Treasuries when yields exceed 3% but are not in a hurry right now, here or anywhere else in the government bond market.

Elsewhere in fixed income, our caution regarding investment grade corporate bonds this year has served us well. It has been the worst performing of all of the major asset classes so far in 2018. While the same factors behind our wariness on government bonds were key considerations, we also felt that the spreads of investment grade yields over sovereign bonds were just too low. Although spreads have now begun to widen – a good example of a much-needed risk repricing – valuations are not yet sufficiently attractive to encourage us to change our stance. We remain on the cautious side of neutral on high yield bonds as well.

WHAT COULD GO WRONG? As discussed above, there are of course a number of significant risks to our market outlook. While it is encouraging to note how resilient the global recovery has been to adverse shocks this year, any comfort on this front must be counterbalanced by the recognition of its structural frailties. Many features of the global macro environment are unprecedented, such as the amount of debt and the size of central bank intervention. Accordingly, the impact of shocks is hard to calibrate. We have to stay vigilant and flexible. At this stage, our attention is focused on the following three key risks: • Economics: the most credible macro threat to our continued long-cycle scenario would be if inflation expectations lifted so much as to compel central banks to normalise monetary policy more urgently. While recent data still support our view that the recovery in global inflation will be gradual, we continue to monitor developments on this front closely.

• Policy: the threat of a continued escalation in global trade tensions looms as a plausible risk to economic and market stability. Concern

MULTI-ASSET

focuses as much on the US-EU relations as those between the US and China. Our core view for now is that economic logic and corporate lobbying will ultimately guide leaders away from outcomes that damage the global expansion.

• Politics: Italy is the big worry here. The recently formed government is a fragile coalition of two parties that are not natural partners. It is hard to predict where they will take policy, but it is likely to be in a direction that puts Italy on a collision course with both the EU and financial markets. The constructive view is that the prospect of financial market turbulence will impose some discipline on policy and the new Italian government can find common ground with the EU in areas such as immigration and border control. However, more disorderly outcomes remain highly plausible.

Summing up, we still see the global backdrop as being in a transition phase, away from the exceptional macro conditions of 2017, towards a more complicated, uncertain and normal environment going forward. Investors will need to adjust to more frequent swings in sentiment and less stability in markets. However, even if things work out well, we still expect relatively modest returns from most asset classes over the course of this year. The era of easy buy-and-hold investing is over; we believe this is a time for active asset allocation. Expect surprises – expect volatility.

Fig1: central bank asset purchases (QE) 2,500

2,500

2,000

2,000

1,500

1,500

1,000

1,000 500

500

0

0

-500

-500 CHANGE IN G3 BALANCE SHEETS ($bn) -1,000

-1,000

2006 2008 2010 2012 2014 2016 2018 2020

Source: J.P. Morgan as at March 2018, 12-month changes in US dollars (billions). Red bars denote JPM forecasts.

Orange bar = 2017. G3 central banks = US Federal Reserve (Fed), European Central Bank, Bank of Japan. Chart is for illustrative purposes only.

These are the manager’s views at the time of writing (06/06/2018). They should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. No forecasts can be guaranteed. This document is intended solely for the use of professionals, defined as Eligible Counterparties or Professional Clients, and is not for general public distribution. Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially. Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment. Any investment application will be made solely on the basis of the information contained in the Prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the prospectus, and where relevant, the key investor information document before investing. We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes. Issued in the UK by Janus Henderson Investors.

Janus Henderson Investors is the name under which Janus Capital International Limited (reg no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (each incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3AE) are authorised and regulated by the Financial Conduct Authority to provide investment products and services. © 2018, Janus Henderson Investors. The name Janus Henderson Investors includes HGI Group Limited, Henderson Global Investors (Brand Management) Sarl and Janus International Holding LLC. ADVISER-HUB.CO.UK 2 1

EXPERTLY MIXED

For promotional purposes

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MAY 2018

Risk-targeted Lower cost Regular and attractive income Through a top-down, bottom-up, active investment approach, the funds are expertly mixed to provide investors with diversification across the full spectrum of asset classes.

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% Yield†

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†

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Source: Janus Henderson Investors as at 31 March 2018.

For professional advisers only. Investments can fall as well as rise. Past performance is not a guide to future performance. Nothing in this advert should be construed as advice. This is not a recommendation to sell or purchase any investment. Please read all scheme documents before investing. *Ongoing charges figure may vary over time. Yield may vary and is not guaranteed. The Janus Henderson Multi-Asset Core Income funds should be bought in conjunction with an attitude to risk tool as part of the financial advice process. These funds are, therefore, designed to be bought by advised clients only.

Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which Henderson Global Investors Limited (reg. no. 906355) and Henderson Investment Funds Limited (reg. no.

2678531) (each incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3AE) are authorised and regulated by the Financial Conduct Authority to provide investment products and services. © 2018, Janus Henderson Investors. The name Janus Henderson Investors includes HGI Group Limited, Henderson Global Investors (Brand Management) Sarl and Janus International Holding LLC.

DIVERSIFIED GROWTH

Andrew Harman First State Investments

CALM AND STORMS: A PLAN FOR ALL CONDITIONS

MARKETS ALWAYS HAVE THEIR CHALLENGES, BUT THE PAST THREE YEARS HAVE GIVEN MULTI-ASSET MANAGERS PLENTY TO NAVIGATE. ANDREW HARMAN, MANAGER OF THE FIRST STATE DIVERSIFIED GROWTH FUND, EXPLAINS HOW HE HAS STEERED THE SHIP. to be more objective. This matters today when the returns It is rare that financial markets are without turmoil of from financial markets promise to be distinctly different as one kind or another. However, the three years since the monetary policy direction shifts. launch of the First State Diversified Growth Fund have seen Harman says: “2017 was a Goldilocks market, ‘as good more drama than most. From the political upheaval over as it gets’. Financial markets were reasonably calm and Brexit in the UK, to the advent of the Trump era in the US, volatility was at all time lows. The UK was quite resilient, manager Andrew Harman has had some choppy waters to there was a broad-based recovery in Europe. Abe was navigate. However, the market climate today may present re-elected in Japan.” While monetary policy remained loose, a more complex challenge. investors could afford, to some extent, to ignore some of the The fund sets its stall out as flexible and dynamic. With geopolitical problems. a return target of RPI+ 4%, Harman cannot simply sit in Today, there has been a significant return of volatility cash and hope it all works out in the end. The fund has and credit risk. Harman adds: “Liquidity is being drained lots of tools available to deliver consistent returns – from from the system. It is very different to the loose financial conventional asset classes, such as bonds and equities, to conditions in previous years.” derivatives, such as swaps or futures, to alternatives and Some areas look exposed – emerging markets, short positions. There is no requirement for the fund for example. They have performed poorly as to invest in a specific asset type, so he can make the dollar and US interest rates have risen. judicious use of any asset that helps him fulfil However, Harman retains selective exposure the required outcome.

“Liquidity is being drained from the system. on valuation grounds.

The past three years have seen plenty It is very different to the Credit also looks exposed. Harman says: of geopolitical tension – notably since loose financial “As inflation increases yields should increase. the arrival of President Trump on the conditions in previous High yield is the most exposed and we don’t international diplomacy stage, but loose years.” believe it offers a good risk/return opportunity monetary policy has ensured that this has not in this environment. Equally, credit is likely to be been reflected in financial markets. Harman’s impacted by the reduction in liquidity.” view is that the outcome of political events Developed market bonds are experiencing the and elections are difficult to predict and even if the end of multi-decade bull market. However, very few offer correct outcome is predicted, the impact on financial assets a positive real (after inflation) yield so Harman needs to is not always clear. For Harman, it is not about adjusting to be selective. Emerging market bonds offer a positive aftera specific outcome, or working out where will benefit most, inflation return and these currently comprise up to 20% but to manage the associated risks. of the portfolio. Harman holds local and hard currency He says: “We want to manage the potential downside, emerging market bonds – with a larger exposure to and look at where the fund may be vulnerable. We look to US-denominated bonds. He also holds inflation-linked bonds, balance the fund’s return outcomes where there may be which offer some protection against inflation. negative consequences from a specific event.” In his view, The fund has a relatively low net exposure to equities at the ultimate hazard to an investor is that they do not have around 12%. However, it has a significant position in the UK, enough income and/or growth to meet their current and where valuations look attractive compared to the expensive future liabilities. The fund is managed with this in mind.

US market. The group is also positive on eurozone equities, The First State team's approach is thematic, rather than but negative on Japan. starting with a standard asset allocation mix and then moving Harman says: “If we don’t believe we receive sufficient under- or over-weight depending on market conditions. The reward for investing in an asset, we won’t hold it. Every six team may take a view on inflation, for example, and then months we go back to the drawing board: asking where we examine its impact on individual sectors. There may be a are in the economic cycle and what that means in terms of number of different asset classes that can be used to play valuations and portfolio positioning.” a specific theme. It will blend a combination of investments In spite of geopolitical tensions, financial markets have that have the highest likelihood of delivering the performance been relatively kind over the past three years. The new target and invests directly in assets to keep costs lower. monetary policy environment and the withdrawal of liquidity In Harman’s view, this thematic approach allows them presents new challenges. It is in this environment that a to be forward-looking rather than constructing the portfolio dynamic and flexible approach may come into its own. based on historic performance or volatility. It allows them ADVISER-HUB.CO.UK 2 3

COMMERCIAL PROPERTY

COMMERCIAL PROPERTY: THE BENEFITS OF COLLABORATION Landlords need to build strong, long-term relationships with their tenants to ensure stability for their investors, says Andrew Hook, Manager of the Aviva Investors UK Property Fund.

The relationship between commercial landlords and their tenants has sometimes been seen as a combative one, as each side tries to secure their best interests. However, the property team at Aviva Investors believe its collaborative model is far more effective in creating long-term stable tenancies that deliver the inflation-adjusted income and capital growth that investors expect.

The group is focused on a number of key locations that it has identified as having durable demand, coupled with structural growth potential. Andrew Hook, fund manager on the Aviva Investors UK Property fund, says: “Rather than having property in every market town across the UK, we focus on a small number of core locations outside of Central London. In a regional office context, these centres include Birmingham, Manchester and Cambridge, plus cross-rail hubs such as Ealing and Reading.”

This focused approach has a number of advantages. First, it is designed to make the strategy ‘future-proof’. Commercial property is always subject to the ebb and flow of business change. While the shift away from the high street as a result of ecommerce is perhaps the most obvious, all sectors are subject to the influence of technology, regulation or consumer preferences.

2 4 ADVISER-HUB.CO.UK

Hook says: “We always have an eye to the impact of technology. We are trying to ensure the longevity of the properties we hold by being strategic in the way we think.”

Service provider It also means the group can own meaningful clusters of property in certain areas. This brings greater expertise and influence, allowing the Aviva Investors team to get to know local planning teams and other stakeholders. Hook says that this helps them deliver a new model of landlord/tenant relationship. He adds: “It means we can offer a variety of solutions to our tenants, enabling us to be a services provider rather than operating on an outdated landlord/ tenant relationship.”

They will work with the tenant base to understand their specific needs. Companies increasingly recognise the productivity benefits of a happy and well-supported workforce.

They are scrutinising their occupancy needs more closely and looking at how the right building can help them win the war for talent.

This means better use of space to support the wellness agenda – with cycle racks, for example, showers and gyms – and flexible working.

Hook says: “It has never been more important for tenants to occupy quality space.

There are key structural changes in the economy.

Occupiers don’t look at one desk per employee any more, but instead need to accommodate flexible working as they push the ‘working from home’ agenda.” As a landlord, Aviva Investors needs to help these businesses adapt.

Promoting loyalty In a competitive market, this can help generate a loyal tenant base. The tenants feel they have a landlord that cares about their needs. Hook says this helps them build relationships for the longer term and ensure reliability of income and growth for investors in the fund.

Commercial property doesn’t lend itself to sharp changes in asset allocation, but within the fund’s core locations the team will shift to accommodate changing market conditions.

Hook says: “We are focused on building focus and scale in our core locations. Those locations are for the long term, so it’s not a strategy that’s likely to change. What can change is our allocation to different types of property within those target locations.”

The fund aims for a spread of sectors within the strategy – industrial, office and retail. It is benchmark agnostic, and Hook believes this is a key point of differentiation from its competitors.

They want instead to sustain diversity of

COMMERCIAL PROPERTY

demand from the occupier base. Until recently, for example, they had been looking to increase their weighting in industrial assets, but have since stepped back as the pricing no longer looks as attractive.

“WE ALWAYS HAVE AN EYE TO THE IMPACT OF TECHNOLOGY. WE ARE TRYING TO ENSURE THE LONGEVITY OF THE PROPERTIES WE HOLD BY BEING STRATEGIC IN THE WAY WE THINK.” The shadow of Brexit Brexit still looms large over the commercial property sector, but Hook says many occupiers remain happy to make decisions about space allocation. The one difficult area has been the high street. The wider group retains a number of retail holdings, but these tend to be in ‘destination’ shopping centres such as the Bentall Centre in Kingston or the Guildhall Shopping Centre in Exeter, blending highengagement retail with additional features,

including leisure and dining.

Hook agrees the supply of retail space is too great for retailers’ current demand. The need for floor space is diminishing over time, a trend that has accelerated in the first and second quarters of 2018. He believes Aviva Investors’ approach has helped the fund avoid major problems. He says: “We have been far less hit by CVAs than the industry as a whole. Within my fund, we’ve had only had two units that are part of a CVA process. They are being re-leased at the moment. This says a lot about the benefits of our strategy.”

Here, strong relationships matter. There have been persistent rumours about companies entering CVAs just to secure discounts on their floor space. Next recently complained that it was at a disadvantage as struggling high street peers had been able to secure rent cuts as part of the CVA process. A good landlord/tenant relationship can help prevent these problems escalating.

Hook continues to see a reasonable increase in valuations, which are now higher than their pre-Brexit levels. This, he says, is a mix of

market-level capital growth and a strong focus on asset management. He believes the fundamentals of the market remain strong with occupier demand robust and little over-supply.

“We have seen strong income growth on the fund. We believe in ensuring our assets work hard, because this should support investor returns over the long term.”

ADVISER-HUB.CO.UK 2 5

ENGINEERED TO GO THE DISTANCE Aviva Investors Multi-Asset Funds • Dynamic: targets optimal asset allocation • Precise: underpinned by robust risk management • Efficient: maps across a broad risk spectrum • Powerful: robust track record Aviva Investors Multi-Asset Funds (MAF) cumulative performance 1 year

3 year

5 year

MAF I

0.02%

5.14%

18.35%

MAF II

0.80%

10.13%

29.64%

MAF III

0.90%

14.83%

38.93%

MAF IV

1.00%

16.93%

45.00%

MAF V

1.59%

21.42%

48.51%

Past performance is not a guide to future performance.

Source: Lipper, a Thomson Reuters Company, as at 31 March 2018.

R3 share class, cumulative performance, mid to mid basis, net income reinvested, net of ongoing charges and fees.

Discover a range of funds engineered to align with your clients’ chosen risk and reward profiles, actively managed to target long-term capital growth.

The value of an investment and any income from it can go down as well as up and can fluctuate due to changes in currency and exchange rates. The funds invest in derivatives which may have the effect of magnifying investment gains or losses. Investors may not get back the original amount invested. avivainvestors.com/MAF

Sustainable Income | Capital Growth | Beating Inflation | Meeting Liabilities

For today’s investor

For professional clients and advisers only. Not to be distributed to or relied on by retail clients. Ratings are no guarantee of future performance and can change.

The Aviva Investors Multi-asset Fund range comprises the Aviva Investors Multi-asset Fund I (“MAF I”), the Aviva Investors Multi-asset Fund II (“MAF II”), the Aviva Investors Multi-asset Fund III (“MAF III”), the Aviva Investors Multi-asset Fund IV (“MAF IV”) and the Aviva Investors Multi-asset Fund V (“MAF V”) (together the “Funds”). The Funds are sub-funds of the Aviva Investors Portfolio Funds ICVC. For further information please read the latest Key Investor Information Document and Supplementary Information Document. Copies of these documents and the Prospectus are available in English free of charge on request or on our website. Issued by Aviva Investors UK Fund Services Limited, the Authorised Fund Manager. Registered in England 1973412. Authorised and regulated by the Financial Conduct Authority. Firm Reference 119310.

Registered address: St Helen’s, 1 Undershaft, London EC3P 3DQ. An Aviva company. www.avivainvestors.com RA18/0416/01082018

Make the most of potential others don’t see.

This advertisement is for investment professionals only

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FIDELITY SPECIAL SITUATIONS FUND No matter which way the market moves in the short term, the contrarian investment strategy of the Fidelity Special Situations Fund has added value to portfolios over the long term.

Managed by Alex Wright, FE Alpha Manager of the Year 2017, this fund is focused on harnessing unrecognised potential within UK equities.

Past performance is not a reliable indicator of future returns. The value of investments can go down as well as up and clients may get back less than they invest. The fund may invest in overseas markets and so the value of investments can be affected by changes in currency exchange rates. The fund may also use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger-than-average price fluctuations.

Make the most of this fund at professionals.fidelity.co.uk Copyright – © 2018 Morningstar, Inc. All Rights Reserved. Morningstar RatingTM as of 30.04.2018, in the UK Flex-Cap Equity Morningstar CategoryTM. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document and annual and semi-annual reports, free of charge on request by calling 0800 368 1732. Issued by Financial Administration Services Limited and FIL Pensions Management authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbols are trademarks of FIL Limited. UKM0618/21695/SSO/0818

CONTRARIAN INVESTING

CAIRN HOMES: FROM UNLOVED TO RECOVERY A typical contrarian investment in the Fidelity Special Situations Fund progresses through three distinct stages. Here, portfolio manager Alex Wright analyses the process in action with Cairn Homes, an Irish housebuilder that he has held since it listed in 2015.

Investing against the tide is a psychologically difficult thing to do, and unfortunately out-of-favour companies don’t often turn into stockmarket darlings overnight. In terms of my investment process, the stocks I own tend to move through three distinct stages: from unloved and out of favour in stage one, through a period of positive change in stage two, to recovery in stage three.

But how does this play out in practice? A good case study of this process is Cairn Homes, an Irish housebuilder that I’ve held in the Fidelity Special Situations Fund and Fidelity Special Values PLC since it listed on the London Stock Exchange in 2015.

Three years ago the Irish property sector was firmly out of favour and off the radar of many investors. It had been decimated during the global financial crisis. The number of houses built had fallen from around 90,000 completions pre-crisis to nearer 10,000 by 2012. House prices also corrected sharply.

However, after years of austerity, nascent signs were emerging that the Irish economy was starting to recover. Demand for housing was slowly recovering, but there was almost no one building new homes in Ireland. There was clearly an opportunity in the market.

As the only Irish housebuilder of scale left post-crisis, Cairn was uniquely positioned to capitalise on this improving backdrop. No other company had both the expertise to build houses and – via its plans to list – the capital to acquire and develop sites.

One of the advantages we have at Fidelity is we are generally made aware of upcoming initial public offerings (IPOs) at an early premarketing ‘pilot fishing’ stage.

With Cairn, this was around six months before its listing which enabled our analysts to start doing some early due diligence work to build conviction in the scale of the opportunity and Cairn’s ability to profit from it.

2 8 ADVISER-HUB.CO.UK

In this case, we couldn’t look at Cairn’s own annual reports as it wasn’t listed and was only founded in 2014. However, we could visit the company and its development sites to gain an insight into what land it had bought and most importantly, the management team’s commitment to executing its stated strategy.

We did a lot of work looking at listed peers in the UK in terms of the returns they were generating, and how they had performed across previous market cycles.

We also spent time analysing the Irish market – understanding not only where house prices were relative to history and indeed the UK, but also the health of domestic banks and whether they were in a position to start lending again.

As a result of this analysis and due diligence, we were able to build conviction. It became clear over time that the scale of the opportunity was not being fully recognised by others. This was relatively rare for an IPO as new listings tend to attract a lot of fanfare but in this case, the broader market was likely scarred by memories of the crisis. 2015 was also a busy period for new listings and there was a lot of attention on seemingly more exciting and fashionable stocks and sectors.

Market dynamics Notably, at the time of listing Cairn was initially valued in line with its UK-listed peers, yet the market dynamics it faced were substantially more attractive. For example, in 2014 there were just 10,500 housing completions in Ireland versus demand of around 25,000 units.

Housebuilders’ tendency to buy land at the bottom of the cycle means they can generally expect margins to reach the high teens (closer to mid-20s for Cairn given Irish housing market strength). Cairn had no serious competitors (as they had gone bust), and had the hallmarks of a

typical stage one stock for the portfolio.

Therefore it was a compelling opportunity and we moved to initiate a sizeable position at IPO. The stock didn’t move a great deal over the first 12 months of ownership. During this period, the company twice went back to the market to raise further equity via share placements in December 2015 and March 2016. The investment thesis hadn’t changed so we participated in both placements and increased our exposure to the stock.

Throughout this process our analyst team continued to meet company management and visit sites in order to assess whether it was actually building the number of houses it said it would and importantly gain comfort around the margins it was making on the houses built.

The impact of the Brexit vote actually hastened a sell-off mid-2016 to a point where the stock was trading below its IPO price despite it being in a much stronger fundamental position.

Since then, however, we have seen the stock aggressively re-rate over the last 18 months or so as sell-side coverage increased and the market became more comfortable in Cairn’s ability to deliver homes at scale. At the same time, Irish house prices have also accelerated at a double digit rate.

While the recent share price performance has seen the company move from stage one as an overlooked opportunity to stage two of my investment process where its earnings and market perception has improved, I believe there is still more to come from Cairn before it moves into stage three, where its share price gets closer to my upside target.

It is still in the early stages of delivering operationally – it built 420 houses in 2017 and is on track to deliver 1,200 by 2019. As it continues to scale up, we expect Cairn’s return on equity to increase while it should also continue to benefit from the broader recovery in Irish housing given its dominant position in the market.

“AS A RESULT OF ANALYSIS AND DUE DILIGENCE, WE WERE ABLE TO BUILD CONVICTION. IT BECAME CLEAR OVER TIME THAT THE SCALE OF THE OPPORTUNITY WAS NOT BEING FULLY RECOGNISED BY OTHERS.”

IRISH HOUSING MARKET NATIONAL

DUBLIN - ALL

0% -10% -20% -30% -40%

-38%

-38%

-50%

-51%

-60%

-57%

-70% PEAK TO TROUGH

PEAK TO CURRENT

Source: Fidelity International, CSO, June 2015.

CAIRN HOMES SHARE PRICE 220% 200% 180% 160% 140% 120% 100% 80% JUN-15

SEP-15

Cairn Homes

DEC-15

MAR-16

JUN-16

SEP-16

DEC-16

MAR-17

JUN-17

SEP-17

DEC-17

MAR-18

APR 13 – APR 14

APR 14 – APR 15

APR 15 – APR 16

APR 16 – APR 17

APR 17 – APR 18

N/A

N/A

15.4%

39.7%

14.8%

Source: Datastream, 30 April 2018. Based on total return in GBP terms.

Past performance is not a guide to the future. The value of investments and the income from them can go down as well as up, so you may not get back what you invest. Past performance is not a reliable indicator of future returns.

Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The Fidelity Special Situations Fund and Fidelity Special Values PLC use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. They also invest more than other funds in smaller companies, which can carry a higher risk because the share prices may be more volatile than those of larger companies. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.

ADVISER-HUB.CO.UK 2 9

RETIREMENT PLANNING

THE DRAWDOWN PROBLEM: HOW MUCH CAN YOU SAFELY WITHDRAW IN RETIREMENT? While many advisers use the 4% rule of thumb, a dynamic approach to drawdown is likely to be more sustainable.

John Southall, Head of Solutions Research at Legal & General Investment Management, discusses the potential alternative options available.

The answer is 4%. Or at least, this has been widely adopted as a convenient short-hand by investors and their advisers.

This was the answer ‘found’ by aeronautical engineer turned financial adviser William ‘Bill’ Bengen in the early 1990s and has formed the basis for drawdown withdrawal ever since. The problem is, its efficacy very much depends on when an individual retires.

Using Bengen’s original parameters, we revisited this assumption, assuming a static ‘naïve’ equal split between domestic equities and bonds. The research shows significantly different outcomes, depending on the retirement date. For the lucky retiree who began drawing down in 1993, their capital has gained 46% in real value by 2008. Drawdown has looked like a good choice for them.

Begin saving a few years later in 1996 or 1997 and the capital has remained static or depreciated only a little. This level of remaining capital should be enough to support another 15 years of income and may even leave a little to pass on to heirs.

However, retirees who start between 1998 and 2001 are far less fortunate. In the first half of their 30-year retirement journey, they’ve had to navigate the bursting of the technology bubble and the global financial crisis, both of which left a significant dent in their starting capital. While 4% drawdown seemed over-cautious for the 1993 intake, it looks reckless for later generations.

In particular, it has a nasty effect on retirement income. A 15-year real value decline of 41% is one thing on a portfolio statement, but the reality for retirees is stark. Imagine a 65 year-old retiree decides she wants to 3 0 ADVISER-HUB.CO.UK

purchase an annuity at age 80, following a 15-year period of 4% drawdown. If she started retirement in 1993, from 2008 onwards she could enjoy monthly payments of around £1900 for the rest of her life. However, if she were to invest from 2000-2015, an annuity would provide as little as £600 per month.

ALTERNATIVE OPTIONS However, if the 4% rule doesn’t always work, what is the option for retirees? Retire at the start of a bull market would be the easy answer, but that’s not very easy to predict, and many would have thought twice about stock market investment at the height of the global financial crisis (the most recent bull market began when the UK was still in recession in 2009).

When Bengen returned to his analysis, he added a couple of caveats: investors needed to embrace a more dynamic approach to two elements of their retirement journey: broader diversification and adjusting the level of income depending on the client requirements.

Certainly, spreading investments over different asset classes gives investors a better chance of preserving capital. Investors can in certain circumstances now pass on their pension pots to their children without incurring inheritance tax; therefore portfolios that are income-focused, but not income-obsessed, may be more appropriate. Unlike yield-targeting funds, growing clients’ capital as part of a total return aim alongside generating a sensible yield can be better aligned to their needs.

FLEXIBLE INCOME WITHDRAWAL Adjusting the level of income is also important.

We see three primary factors that should impact

“RETIREES WHO STARTED BETWEEN 1998 AND 2001 ARE FAR LESS FORTUNATE. IN THE FIRST HALF OF THEIR 30-YEAR RETIREMENT JOURNEY. THEY’VE HAD TO NAVIGATE THE BURSTING OF THE TECHNOLOGY BUBBLE AND THE GLOBAL FINANCIAL CRISIS, BOTH OF WHICH LEFT A SIGNIFICANT DENT IN THEIR STARTING CAPITAL.”

RETIREMENT PLANNING

Important Notice This is not a consumer advertisement. It is intended for professional financial advisers and should not be relied upon by private investors or any other persons. The views expressed within this document are those of Legal & General Investment Management, who may or may not have acted upon them.

Legal & General Investment Management is authorised and regulated by the Financial Conduct Authority and is the Investment Adviser to the UK Special Situations Trust, a UK authorised unit trust. Issued by Legal & General (Unit Trust Managers) Limited. This document should not be taken as an invitation to deal in Legal & General investments or any of the stated investments. Remember, the value of investments and any income may fall as well as rise and investors may get back less than they invest. Past performance is not a guide to future performance. Exchange rate changes may cause the value of any overseas investments to rise or fall Legal & General (Unit Trust Managers) Limited.

Registered in England and Wales No. 1009418. Registered office: One Coleman Street, London EC2R 5AA. Authorised and regulated by the Financial Conduct Authority.

the pace of drawdown, each of which is broadly in line with FCA guidance on suitability, namely that “recommendations to retail investors consider all relevant circumstances, including investment objectives, current and future income requirements and the investor’s attitude to risk.”

Any retirement fund withdrawal strategy should consider: asset drivers – the size of funds held and their risk and return characteristics; spending drivers – demands on the capital such as one-off lump sums (eg. once-ina-lifetime cruises or financial support for children or grandchildren trying to get on the housing ladder); and attitude to risk – how much risk an individual is prepared to take, both in terms of short-term volatility and the longer-term risk of the fund running dry.

The expected return from the chosen investment strategy over and above interest rates depends on both the asset allocation and views (there is no right answer). All else being

equal, a higher expected rate of return affords a higher income. However, we need to tread carefully, mindful of the various additional risks involved; for matters as important as a pension, investors generally should not base decisions purely on expected or ‘median’ outcomes – they are unlikely to sleep soundly if relying on a strategy with only a 50% chance of success. Any approach needs to be dynamic.

In terms of spending drivers, as retirees age, it becomes safer to withdraw a greater percentage of the remaining fund each year.

Perhaps counter-intuitively, however, the importance of longevity risk in terms of its influence on how much to withdraw each year actually increases with age. Different pension investors may have different needs, but most individuals are exposed to similar drivers. Some of these drivers act to increase spending over time, such as the need for inflation protection, and long-term care costs.

Retirees need to adapt their investment strategy and their withdrawal rates over time to handle longevity and investment risk. By assessing both investment and longevity risk we can define a 'sustainable' withdrawal rate for a chosen investment strategy – this is the maximum sum that an investor could withdraw each year Each investor’s situation differs along with their appetite for risk, their retirement spending goals or portfolio capital. Following a 4% withdrawal strategy blindly may lead to particularly volatile results. Indeed Bengen’s research did not suggest withdrawing this amount every year – just that it was safe to do so without running out of money.

A dynamic withdrawal strategy, more closely linked to the amount of spending necessary per year rather than a fixed portfolio percentage, may significantly improve the investment outcomes.

ADVISER-HUB.CO.UK 3 1

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Multi-Index Fund Range In today’s complex environment, it’s easy for portfolios to veer off-track, but our Multi-Index Funds are bolted to their risk profiles at all times. And because they are actively managed, they can take the best route towards your clients’ goals.

Our Multi-Index Funds are largely made up of our index funds so they remain simple and, more importantly, cost effective. We have over £2bn* under management in eight risk-targeted funds, each focused on either income or growth. All designed to get your clients where they want to be.

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This is not a consumer advertisement. It is intended for professional financial advisers and should not be relied upon by private investors or any other persons. The value of investments and any income from them may fall as well as rise, and investors may get back less than they invest. Exchange rate changes may cause the value of investments and the level of any income to rise and fall. Multi-Index funds are sensitive to interest rate changes. At times, especially over shorter timescales, lower risk rated funds may fall in value by more than higher risk rated funds. Details of the specific and general risks associated with the funds mentioned are contained within the Key Investor Information Documents. *As at 30 June 2017. **Call charges will vary. †Citywire source and copyright: L&G Multi-Index funds 3 & 4 awarded CityWire Gold Rated in the Mixed Assets – Conservative GBP sector. Square Mile rating applies to Legal & General Multi-Index Funds only. Legal & General (Unit Trust Managers) Limited. Registered in England and Wales No. 1009418. Registered office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority.

Free Independent Research and Insight • Fund opinion, ratings and factsheets • Video fund snapshots and talking factsheets • Adviser focussed educational papers Register for free at

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Why Square Mile?

• Square Mile is an independent investment research business that focuses first and foremost on in depth, qualitative fund research • We focus on identifying “best-in-class” funds and gaining the fullest possible knowledge and understanding of those funds • Rather than just explaining what a fund does and how it is constructed, we seek to understand how a fund behaves, whether it will consistently deliver on its objectives, and whether it represents good value for investors Important Information This advert is for the use of professional advisers and other regulated firms only. It is published by, and remains the copyright of, Square Mile Investment Consulting and Research Ltd (“SM”). SM makes no warranties or representations regarding the accuracy or completeness of the information contained herein. This information represents the views and forecasts of SM at the date of issue but may be subject to change without reference or notification to you. SM does not offer investment advice or make recommendations regarding investments and nothing in this presentation shall be deemed to constitute financial or investment advice in any way and shall not constitute a regulated activity for the purposes of the Financial Services and Markets Act 2000. This presentation shall not constitute or be deemed to constitute an invitation or inducement to any person to engage in investment activity.

Should you undertake any investment activity based on information contained herein, you do so entirely at your own risk and SM shall have no liability whatsoever for any loss, damage, costs or expenses incurred or suffered by you as a result. SM does not accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance is not a guide to future returns.

ABSOLUTE RETURN

ABSOLUTE RETURN FUNDS – A LARGELY UNTESTED PANACEA Absolute return funds have attracted huge levels of investment, but will they fulfil their objectives if markets head south?

3 4 ADVISER-HUB.CO.UK

The investment management industry has never been slow to spot an opportunity to create new products to sell. Alfred Winslow Jones may have been credited with forming the first hedge fund in 1949 but retail absolute return funds and the IA Targeted Absolute Return sector were born out of the rubble of the 2007-2009 financial crisis.

It is often said that stock markets go up on escalators but go down in elevators. In just 16 months between 31 October 2007 and 3 March 2009, the FTSE All-Share Index (including gross dividends) dropped by 45.6%, erasing all of the gains made since October 2003. It is a simple fact of compounding that if you lose 45.6% you then need to make 83.6% just to get back to where you started. It was not until July 2012, and with a lot of help from central banks, that the October 2007 peak was finally left behind.

So the attractions of an investment strategy which aims to avoid big drawdowns (and hence the need to recover steep losses) and provide steady, absolute returns are obvious. At the end of 2008, the IA Targeted Absolute Return sector comprised only 30 funds with an aggregate size of £2.6bn. By the end of April 2018, the sector had swelled to 118 funds with an aggregate value of £79.5bn.

Targeted Absolute Return is now the third

ABSOLUTE RETURN

largest IA sector.

Unlike most other IA sectors, Targeted Return is far from homogeneous and contains a wide spectrum of funds with different return objectives, performance profiles and investment strategies. Over the five years to 30 April 2018, cumulative returns ranged from -13% to +85% and annualised volatility (of weekly returns) from 0.8% to 13.0%. The main investment strategies we have categorised are: Global Macro, Long/Short Equities, Long-bias Multi-Asset and Unconstrained Bond. The sector also includes a range of more specialist strategies.

The challenge for investors who are attracted to the investment proposition of an absolute return fund, though, is that very few of them have been tested in a proper bear market.

Less than half the funds in the sector existed at the beginning of 2011 which, as noted earlier, was the last year in which equity markets posted a calendar year loss and in that year the FTSE World Total Return Index (“FTSE World”) fell by less than 6%. Just a handful of the funds in the sector, and not even the retail version of GARS existed at the beginning of the financial crisis in 2007. It has been difficult for absolute return funds not to meet their investment objectives in the benign investment conditions of recent years. However, the last two full-blown bear markets in 2007-2009 and 2000-2002 each lasted about 16 months peak-to-trough and we suspect that few funds in the sector will meet either their return or their capital preservation objectives in the next one.

In the last few years there have been only three setbacks of any magnitude in stock markets: August and September 2015, January and February 2016 and, most recently, February and March 2018. In each of those two-month periods, the FTSE World index fell by 9.6%, 6.5% and 5.5% respectively. The first two periods were only a few months apart and, tellingly, in its “Asset Management Market Study – Interim Report” published in November 2016 the FCA heaped criticism on the absolute return fund sector and commented that investors faced a ‘high likelihood of negative performance’.

Without claiming that what follows is definitive science, we have run a series of quantitative screens on the IA Targeted Return sector in order to identify which funds might be most likely to preserve investors’ capital when it really matters. Some of the funds which have screened well according to our criteria are already rated in Square Mile’s Academy of Funds.

In order to capture all three recent periods of stock market weakness, we have only considered the 86 funds which were launched prior to the start of 2015. With the first ‘correction’ not beginning until August 2015 we could have chosen a later starting date but we wanted to be certain that all funds in our screens were fully invested when the correction started as high cash balances and under-investment might have conveyed unfair advantage. We accept, however, that our choice of start-date necessarily excludes from our study a number of funds which might be strong candidates for inclusion in a portfolio of absolute return funds. The F&C Global Equity Market Neutral Fund (launched in August 2015) immediately springs to mind.

Fig 1: In our opinion, the most important feature of an absolute return fund is capital preservation and we ranked the funds first by their worst 12-month rolling returns since the beginning of 2015. Of the 86 funds in our screen, two of them have subjected their investors to a 12-month loss of more than 20% and another 12 have posted 12-month losses of 10% or more. Amazingly, just four funds have never sustained a loss over any 12-month period since the beginning of 2015. Remember, we do not even regard the stock market turbulence since the beginning of 2015 as particularly severe and it is nowhere near that experienced in 2011 or 2008. The top three funds ranked on this basis, together with their worst 12-month returns since launch, their launch dates and their annualised returns between January 2015 and April 2018 are shown in the tables below.

Fig 2: The second table shows the top three funds ranked by annualised return between January 2015 and April 2016, along with their worst rolling 12-month returns since January 2015 and launch. The relatively new Polar Capital fund apart, it is evident that higher returns are often accompanied by higher risk of loss.

two-month periods in which stock markets suffered significant setbacks. The aggregate decline in the FT World index in those six months was 21.6% and so this shows how funds might perform in a full-blown bear market. The top three are shown in the table below, again with their annualised returns between January 2015 and April 2018 and their worst 12-month returns since January 2015. The worst fund in the screen lost 14.4% This is clearly a rough-and ready quantitative study. However, it does show that investors need to think very carefully about what features they are seeking when investing in an absolute return fund. Higher returns are usually accompanied by higher drawdowns and the funds with the best records of capital preservation often have lower returns. Or investors can choose funds which are most likely to prosper when stock markets are weak and which will specifically complement other investments in a diversified portfolio.

For us, the holy grail is represented by a fund which generates mid single-digit returns, exhibits a low correlation to stock markets and which has an investment process that has proved it can protect capital when it really matters.

Fig 3: Finally, we ranked the funds on the basis of their aggregate returns in the three

Charles Hovenden, Portfolio Manager at Square Mile

Fig 1 Fund Name

Worst Rolling 12-Month Return Since Jan 2015 (%)

Worst Rolling 12-Month Return Since Launch (%)

Launch Date

Annualised Return (Jan 2015 – Apr 2018) (%)

Polar Capital UK Absolute Equity

+7.5

+7.5

Sep 2014

+27.3

Janus Henderson UK Absolute Return

+1.0

(3.3)

Apr 2009

+4.0

Old Mutual Global Equity Absolute Return

+0.3

(0.6)

Jun 2009

+4.9

Fund Name

Worst Rolling 12-month Return since Jan 2015 (%)

Worst Rolling 12-month Return since Launch (%)

Launch Date

Annualised Return (Jan 2015 – Apr 2018) (%)

Polar Capital UK Absolute Equity

+7.5

+7.5

Sep 2014

+27.3

FE Analytics

Fig 2

H2O MultiReturns

(8.4)

(8.4)

Oct 2013

+14.0

Schroder UK Dynamic Absolute Return

(11.1)

(11.1)

Sep 2009

+9.3

Fund Name

Aug/Sep 15+Jan/ Feb 16+Feb/Mar 18 (%)

Annualised Return (Jan 15 – Apr 18) (%)

Worst Rolling 12-month Return since Jan 2015 (%)

Annualised Return (Jan 2015 – Apr 2018) (%)

City Financial Absolute Equity

+20.2

+8.2

(19.3)

+27.3

FE Analytics

Fig 3

Jupiter Absolute Return

+11.3

+4.3

(4.3)

+4.0

GAM Multibond – Absolute Return Bond

+5.8

+4.5

(14.9)

+4.9

FE Analytics

ADVISER-HUB.CO.UK 3 5

VALUE INVESTING

A VIEW FROM THE OTHER SIDE Alastair Mundy, Head of Value at Investec, discusses why value investing is ‘simple, but not easy’ and can leave you sitting on the naughty step.

Investing, and particularly contrarian investing, is often described as being ‘simple, but not easy’. The simple part is straightforward.

One waits for a share price to fall, carries out some due diligence to check for any hidden nasties, checks the stock is cheap on some sensible assumptions and then buys the share.

And if everything goes to plan, the shares, as they recover, will attract the attention of other investors and reward the investor with a handsome profit.

The ‘not easy’ part is where the sweating begins. A stock only tends to fall if investors have some concerns about a company’s future.

There may be issues over a company’s indebtedness, accounting, industry exposure or some purely idiosyncratic issue and virtually all of the time it is perfectly rational to hold these concerns. And in many cases history tells us it is correct to have such concerns as worst-case scenarios can often play out (of which a recent example is Carillion).

But a more dispassionate assessment of history tells us that on the whole these worst-case scenarios are a fairly rare species.

They just tend to stick more in investors’ minds than those stocks that recover.

What can often be worse than the embarrassment of holding one stock that does very badly is holding a portfolio of stocks which, in general, are doing reasonably badly. This typically happens in markets that are influenced by a significant and prolonged theme – such as the technology, media and telecoms bubble in the late 90s and the mining bubble in the mid-noughties. At such times equity markets can become bifurcated with a group of stocks heavily in favour and the rest unloved.

We have been in one of these times over recent years. The belief that inflation will remain low for an extended period of time has seen interest rates fall to extraordinarily low levels, and this has created a number of market-wide effects that have worked against us. By reducing 3 6 ADVISER-HUB.CO.UK

the discount rates that are applied to equity earnings, lower interest rates have disproportionately favoured more highly rated quality/growth stocks which have a greater proportion of their value further out in the future.

I’ve been on the wrong side of things and am seated firmly on the naughty step. I’ve been sitting there for so long now, that I’m starting to leave an impression.

SO WHAT TO DO? There are three options. Option one is to simply capitulate – admit that the world has changed, that the old rules do not work and to embrace the dark side. Option two is to sit tight, accept one’s portfolio is significantly different from the market and trust that eventually themes (however strong the story) will reverse.

Option three is to break the first law of digging holes made famous by Dennis Healey, the Labour politician, who opined that, “if you find yourself in a hole, stop digging”. If the bifurcated market throws up increasingly attractive opportunities it is surely right to keep buying?

At this point, the career risk that Jeremy Grantham, founder of GMO, has often talked about becomes relevant. It stops being how long the fund manager can take the pain of underperformance and morphs into a discussion on how long the client is willing to take the pain of underperformance.

For a contrarian investor (and we are talking about a portfolio of stocks here rather than an individual stock) the typical response is somewhere between options 2 and 3. Continue to analyse the opportunity set and as it becomes ever more attractive to do so, skew the portfolio more towards the cheapest stocks.

However, it is probably best not to come over as too pig-headed, bloody-minded or unprepared to investigate alternative views. ‘The market is obviously wrong’ rarely wins plaudits with clients on the receiving end of one’s underperformance.

“WHAT CAN OFTEN BE WORSE THAN THE EMBARRASSMENT OF HOLDING ONE STOCK THAT DOES VERY BADLY IS HOLDING A PORTFOLIO OF STOCKS WHICH, IN GENERAL, ARE DOING REASONABLY BADLY.” Alastair Mundy, Head of Value, Investec Asset Managment

VALUE INVESTING

LOOKING IN THE TEA LEAVES The psychologist will tell you at these times that to remain rational, one should actively search for those whose views oppose your own.

Continually seeking solace from like-minded individuals can quickly encourage ‘confirmation bias’ – the belief that something must be right because someone else agrees with you. Clearly it is healthy to search for contrasting views, but at such times the opposition have the upper hand – they are both supported by a good narrative to which a trending share price brings further validation. The contrarian on the other hand appears to have just conjecture – ‘what if it the story reverses even though there is no sign of it in the tea leaves?’ – or history – ‘something typically turns up; the market’s just not always smart enough to see it’.

It’s not that the psychologists are wrong – it’s more that when markets or stocks are at extreme levels, there is probably not a great deal of rationality on either side. Someone who sold a stock a lot higher is busy patting themselves on the back and telling their war story rather than considering whether the price has gone too far or the facts have changed. Whereas someone who purchased a stock on the way down only to lose a reasonable amount of money is busy licking their wounds, reluctant to add to a position and worried that the market knows something they don’t. In these cases it is often good to return to analysis conducted in quieter, more rational times. The popular view may be well made, but at a lower price and valuation, what odds are being received for taking the contra view?

Underperformance is never nice, but for investors with high conviction portfolios and/or distinct investment styles it is unfortunately an almost inevitable price to pay for subsequently experiencing the good times.

Investments carry the risk of capital loss. This communication is for institutional investors and financial advisors only. It is not to be distributed to the public or within a country where such distribution would be contrary to applicable law or regulations. The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Investec Asset Management’s (‘Investec’) judgment as at the date

shown and are subject to change without notice. There is no guarantee that views and opinions expressed will be correct, and Investec’s intentions to buy or sell particular securities in the future may change. The investment views, analysis and market opinions expressed may not reflect those of Investec as a whole, and different views may be expressed based on different investment objectives. Investec has prepared this communication based on internally developed data, public and third party sources. Although we believe the information

obtained from public and third party sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Investec’s internal data may not be audited. Except as otherwise authorised, this information may not be shown, copied, transmitted, or otherwise given to any third party without Investec’s prior written consent. © 2018 Investec Asset Management. All rights reserved.

Issued July 2018.

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EMERGING MARKETS

Ewan Thompson, Neptune

DISTRACTED BY THE DOLLAR: TODAY’S ENVIRONMENT IN EMERGING MARKETS INVESTORS HAVE BECOME GLOOMY ON EMERGING MARKETS AS THE DOLLAR HAS RISEN. BUT, EWAN THOMPSON, MANAGER OF THE NEPTUNE EMERGING MARKETS FUND, ARGUES THEY SHOULD LOOK AT THE BIGGER PICTURE. wilderness prior to 2016, emerging markets were Emerging markets are prone to arouse getting their shop in order: “We are right at the competing emotions in investors. For the two start of the credit cycle. Dollar debt in emerging years to February 2018, investors were apt to see markets has risen, but it is concentrated in certain their good side, as economies improved, areas – China state-owned enterprises, for corporate earnings outpaced expectations and example. However, the Chinese government is governments enacted welcome reform. Since liquid and solvent and the China supply side has a February, a gloom has descended, with investors reform agenda. There is also a lot of dollar debt in fretting about the stronger dollar and rising US the Middle East and in the commodity sector, but interest rates. Neither is a completely balanced the latter has a natural hedge because they sell picture, argues Neptune’s co-head of emerging their products in dollars. Financial companies are market equities, Ewan Thompson. another area of concentration but are hedged The recent bout of volatility has seen by default.” emerging markets give up Valuations still trade at a some of their strong 25% discount to developed performance of the last two “HISTORICALLY, markets. They are not widely years. The rhetoric has grown EMERGING MARKETS owned or excessively popular. more excitable – emerging HAVE OUTPERFORMED While a dollar rise isn’t markets are vulnerable, it WHEN INTEREST RATES helpful, says Ewan, it is suggests, as the global growth ARE RISING ON EVERY unlikely to develop into an cycle rolls over and the OCCASION EXCEPT IN emerging market-wide crisis. monetary policy cycle turns.

2013. INTEREST RATES There are problems Thompson says: “Certainly ARE USUALLY RISING nevertheless, notably in there are a couple of BECAUSE GLOBAL Turkey and Argentina. While country-specific problems – GROWTH IS IMPROVING” the Neptune team are Turkey and Argentina have stock-pickers and do not try been knocked about. Some to allocate between countries, believe these are the canaries they will avoid countries where they see in the coal mine and there will be wider significant problems. In this, he believes Turkey is contagion. We don’t agree with that.” He argues the worst offender in terms of relying on foreign that the situation is very different to the ‘taper capital and remains vulnerable to a receding tide tantrum’ of 2013, the last time the interest rate of foreign direct investment in emerging markets. cycle looked likely to turn.

“Turkey used neither of its stronger periods to He adds: “Since then people have been very reform and Erdogen is a problematic figure. This is sensitive to the idea that higher interest rates are a classic case of what emerging markets used to bad for emerging markets. Historically, emerging look like.” markets have outperformed when interest rates Argentina, he believes, is a different story. are rising on every occasion except in 2013.

While it has dollar borrowings because it can’t Interest rates are usually rising because global borrow in local currency, a current account deficit growth is improving.” and high inflation, it is enacting a very aggressive In 2013, interest rates were rising because of programme of improvement. The Neptune funds the stresses in Europe, at the same time as China have some holdings in Argentina, believing Macri was slowing. At the end of 2015, however, China is pursuing a very sensible economy policy. returned to growth and since then, there has been Investors shouldn’t be giving up on emerging a recovery in global growth. The Federal Reserve markets just yet. There are problems, but they are has said it will factor global growth into its specific to certain countries and the contagion decision-making. For emerging markets, as long as effect is quite low. There is also much to like global growth is rising, the level of interest rate about emerging market fundamentals. Global rises in the US should not be a concern. growth is key, not the level of the dollar.

Thompson says that during their period in the

3 8 ADVISER-HUB.CO.UK

Quantinomics™

Quant investing doesn‘t have to be a black box.

Behind the algorithms and computers are people researching and testing fundamentally based, economically motivated signals that drive our investment strategies.

Quantinomics gives a behind-the-scenes look into how we leverage technology and apply human judgement to make data-driven investment decisions.

Visit GSAM.com/Quantinomics THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORIZED OR UNLAWFUL TO DO SO. Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change, they should not be construed as investment advice.

This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by GSAM and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes.

United Kingdom and European Economic Area (EEA): In the United Kingdom, this material is a financial promotion and has been approved by Goldman Sachs Asset Management International, which is authorized and regulated in the United Kingdom by the Financial Conduct Authority. © 2018 Goldman Sachs. All rights reserved.

QUANTINOMICS

QUANTINOMICS: EQUITY FACTOR INVESTING 101 Quantinomics is a behind-the-scenes look at insights and factors that shape the investment strategies run by GSAM's quant team. This Q&A looks at how it works in practice.

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QUANTINOMICS

IN EQUITY FACTOR INVESTING 101, WE EXPLORE EQUITY FACTOR INVESTING AND HOW IT’S USEFUL. What are factors? A factor is an attribute of a security that is identified as a potential driver of return. Factors form the basis of performance. Just as an interviewer might consider “work experience” or “technical abilities” factors in a job interview, an investor might consider “value” and “momentum” as factors in a security or a portfolio.

What are Equity Alpha strategies? These typically seek to generate an informational advantage by interrogating various datasets to help identify securities that are priced too low or too high, and then buy or sell based on that information. For instance, quantitative investors seeking equity alpha could incorporate credit card data to potentially better predict sales growth before the market can price it in.

H IG H Q U AL

ENTU M OM

LO W V O L A

T IL IT Y

STRONG M

A LUE DV

ITY

G OO

How are equity factors identified? Equity factors begin with a thesis describing how a company attribute may affect forward returns. A thesis starts off What is equity factor "FACTOR INVESTING with an idea, such as “Stocks investing? Equity factor REQUIRES MORE THAN that have recently increased investing is a systematic DATA AND RESEARCH. IT in price will continue to approach to evaluating TAKES A TEAM OF INVESTMENT increase in price due to the companies. Companies are PROFESSIONALS TO bandwagon effect.” Researchers assessed on how attractive DEVISE THESES, MAKE will then aggregate relevant they are based on one or DECISIONS AND datasets – both traditional more factors, and then ranked IMPLEMENT FACTOR INVESTING (eg., stock prices, valuation against other firms. HigherSTRATEGIES." metrics) and alternative (eg., ranked companies may indicate a analyst reports, credit card data) – greater opportunity for alpha.1 and analyse the raw data to form an investment view. The performance of the factor Is all equity factor investing the same? No. In is evaluated for potential usefulness fact, GSAM’s Quantitative Investment and significance.

Strategies team (QIS) is focused on two main forms of equity factor investing: Smart Beta2 How do we put it all together? Factor strategies and alpha generation. investing requires more than data and research.

It takes a team of investment professionals to What is Smart Beta? Smart beta investing devise theses, make decisions and implement seeks to derive return from risk premia3 in the factor investing strategies. From the advanced market; smart beta factors tend to be well statistical analysis to the optimisation of known and easier to implement4 (see below). portfolios, to the understanding of clients’ For example, the “momentum” factor is well needs, factor investing requires expertise. known and is based on the belief that stocks that have recently increased in price may Explore GSAM.com/Quantinomics to learn continue to increase in price due to the more about how GSAM uses factor investing to bandwagon effect. help pursue clients’ investment objectives.

Disclosures: 1 Alpha is the portion of the total return on the portfolio not attributable to the portfolio’s exposure to its benchmark or index.

2 Smart Beta refers to quantitative index-based strategies.

3 Risk Premia refers to the excess return demanded by investors to compensate them for a specific risk of holding an asset.

4 Smart Beta factors tend to be well known in academic literature and are well-documented.

The factors tend to be easier to implement since they can be created with readily available data and simple, rules-based frameworks. Source: GSAM. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. Although certain information has been obtained from public sources believed to be reliable, without independent verification, we do not guarantee its accuracy, completeness or fairness.

The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. They are based on proprietary models and there can be no assurance that the forecasts will be achieved. There is no guarantee this signal can or will help enhance returns. Please see additional disclosures at the end of this presentation.

Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments can go down as well as up. Future returns are not guaranteed, and a loss of principal may occur. All investing involves risks, including possible loss of principal. This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any client’s account should or would be handled, as appropriate investment strategies depend upon the client’s investment objectives.

Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

United Kingdom and European Economic Area (EEA): In the United Kingdom, this material is a financial promotion and has been approved by Goldman Sachs Asset Management International, which is authorized and regulated in the United Kingdom by the Financial Conduct Authority.

Goldman Sachs & Co. LLC, member FINRA © 2018 Goldman Sachs. All rights reserved.

Compliance code: 118000-OTU-731938

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