LEADING EDGE RLAM’S REGULAR REVIEW OF INVESTMENT MARKETS • november 2017
Holding cash and waiting for the sales?
Head of Short Rates and Cash, Craig Inches looks at more efficient solutions for cash management in an environment where many are maintaining large cash positions.
Anticipating the twist in the tale
Head of Multi Asset, Trevor Greetham examines the current equity market cycle and considers how long the present rally can continue.
Keeping up with the Sustainable Team
Members of our Sustainable Team update on some key Environmental, Social and Governance (ESG) themes from sustainable agriculture to the decarbonisation of transport.
Hungry for income? An international take on a favourite recipe The RL Global Bond Opportunities Fund blends together RLAM’s existing philosophy with some new ingredients. We take a closer look at this Fund.
What has survived Gordon Brown, the financial crisis and the Brexit referendum? Senior Fund Manager, Henry Lowson looks back over the past 10 years investing in UK smaller companies, and how the sector has fared against its large cap counterparts. For professional investors only, not suitable for retail investors
Head of Distribution
Welcome Welcome to this edition of Leading Edge. Since our last issue, we have seen a continuation of the political uncertainty that has dominated for some time now. In June, the UK experienced one of the biggest electoral shocks since the 1970s, with Theresa May’s Conservative party losing their majority in Parliament and having to forge an agreement with Northern Ireland’s DUP. The outcome has exacerbated ambiguity around Brexit negotiations and the outlook for the UK economy generally.
Against this backdrop, Senior Fund Manager Henry Lowson looks back over the past 10 years investing in the UK small cap market, which has delivered outperformance versus its large cap counterparts despite various political upheavals. Henry’s process focuses on identifying companies with strong fundamentals that are outside of the mainstream, with the aim of delivering value, irrespective of the conditions impacting the broader UK market.
Get in touch We welcome your thoughts on the e-zine and our communications with you in general, so please do give us your feedback by emailing: email@example.com Tel: 020 7506 6500 Fax: 020 7506 6796 Web: www.rlam.co.uk For professional customers only. The views expressed are the authors’ own and do not constitute investment advice. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information concerning the risks of investing, please refer to the Prospectus and Key Investor Information Document (KIID). All rights in the FTSE 100, FTSE All Share and Small Cap Ex Investment Trust Indices (the “Indices”) vest in FTSE International Limited (“FTSE”). “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE under licence. The RL UK Smaller Companies Fund (the “Fund”) has been developed solely by Royal London Asset Management. The Index is calculated by FTSE or its agent. FTSE and its licensors are not connected to and do not sponsor, advise, recommend, endorse or promote the Fund and do not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Fund. FTSE makes no claim, prediction, warranty or representation either as to the results to be obtained from the Fund or the suitability of the Index for the purpose to which it is being put by Royal London Asset Management.
Head of Multi Asset, Trevor Greetham, also looks towards geopolitics and the resilience of equity markets in the face of escalating tension with North Korea and European elections. He asks ‘can bull markets die of old age?’ examining the investment models guiding his asset allocation. Equity investing remains a core focus for RLAM and one area in which we are seeing renewed interest is our award-winning range of Sustainable Funds. Mike Fox and his team have been marrying analysis of both financial and Environmental Social and Governance (ESG) factors to identify those companies creating a net benefit to society, and have achieved an impressive track record in doing so. Looking towards fixed income, we catch up with RLAM’s Credit Team, examining corporate bond markets from both a UK and international perspective. We also hear from Craig Inches, looking at solutions for those investors maintaining cash positions in the face of historically expensive asset markets. As we move towards the end of the year, thoughts start to turn towards 2018. Regulatory change, in the form of MIFID II implementation, remains a focus for us and we endeavour to keep you informed of what this means for you as clients as we approach the end of the year. As always, we will also keep you updated with the views of our investment specialists on our Income Activists, Bonds and Beyond and Investment Clock blogs. As ever, we’d love to hear your thoughts on the e-zine, so if you have any comments, feedback, or suggestions for future articles, please share them by emailing firstname.lastname@example.org I hope you enjoy the issue. Rob Williams Head of Distribution
NOVEMBER 2017 | LEADING EDGE | 3
Also in this issue P.10 Taking the weight: how our integrated insurance solutions could lighten the load of investment
Institutional Business Development Manager, Emmanuel Archampong and Head of Investment Solutions, Nick Woodward outline RLAM’s flexible partnership approach to solutions for insurers.
What has survived Gordon Brown, the financial crisis and the Brexit referendum?
Hungry for income? An international take on a favourite recipe
eeping up with K the Sustainable Team
Senior Fund Manager, Henry Lowson looks back over the past 10 years investing in UK smaller companies, and how the sector has fared against its large cap counterparts.
The RL Global Bond Opportunities Fund blends together RLAM’s existing philosophy with some new ingredients. We take a closer look at this recipe.
Holding cash and waiting for the sales?
Spot the difference: under the bonnet of the Royal London Corporate Bond Fund
Anticipating the twist in the tale
Head of Short Rates and Cash, Craig Inches looks at more efficient solutions for cash management in an environment where many are maintaining large cash positions.
Head of Fixed Income, Jonathan Platt and Fund Manager, Shalin Shah give an update on RLAM’s flagship credit fund, looking at how a focus on security has influenced the portfolio.
Members of our Sustainable Team update on some key ESG themes from sustainable agriculture to the decarbonisation of transport.
Head of Multi Asset, Trevor Greetham examines the current equity market cycle and considers how long the present rally can continue.
4 | LEADING EDGE | NOVEMBER 2017
What has survived Gordon Brown, the financial crisis and the Brexit referendum? Answer: UK small cap
For some, this outperformance might come as a surprise; in this article we look in further detail at the reasons why UK smaller companies have generated strong long-term performance, and why we believe that UK small cap should be considered as part of longterm asset allocation. Small companies, large universe The UK small cap universe totals over 1,250 companies and is spread across a variety of industries and sectors. Unlike the FTSE 100, the FTSE Small Cap ex-IT Index has a lower concentration in the mining, oil & gas and financials sectors, and a greater concentration in industrials and information technology, and so is arguably better diversified than the larger index. Indeed, there is less concentration risk, as the largest stock in the FTSE Small Cap Index is typically less than 2% of the index. By comparison, the largest stock in the FTSE 100, HSBC, is 7.9% of the index*.
Senior Fund Manager
Relative performance of FTSE indices 180
FTSE SMALL CAP FTSE 100
FTSE ALL SHARE to 100
From Gordon Brown to Theresa May, from the credit crisis to Brexit, and from Leona Lewis to Taylor Swift, the world in 2017 is dominated by different challenges, concerns and celebrities than 10 years ago. The past decade has not been a smooth ride for investors, but looking back at the performance of UK smaller companies, it is clear that this asset class has outperformed its large cap counterparts in the UK equity universe.
Source: Thomson Reuters Datastream as at August 2017.
FTSE Small Cap (ex investment trusts) index 0
Real Estate Telecommunication Services
Health Care 24.86
FTSE 100 index
Health Care Industrials Information Technology
Materials Real Estate
Telecommunication Services Utilities
Source: Bloomberg, August 2017.
With a large investment universe and a spread of differentiated business models, there is significant potential for active small cap managers to diversify their portfolios and find undiscovered gems.
A common misconception regarding UK smaller companies is that they offer only exposure to the UK domestic market. InÂ fact, nearly half of the FTSE UK Small Cap index company sales are exposed to
NOVEMBER 2017 | LEADING EDGE NOVEMBER 2017 | LEADING EDGE | 5| 5
UK small cap – performance vs AUM 15
UK Smaller Companies (AUM) £bn (LHS) AUM w/ performance stripped out (index – RHS)
20 20 10
Source: Liberium Investment Authority as at May 2017.
overseas markets**. Although the small cap index suffered in the immediate aftermath of the Brexit referendum as investors flocked towards the large-caps in the FTSE100 (with a greater weighting towards overseas earnings), UK small cap stocks recovered strongly as they continued to report positive earnings results and upgrades. In particular, industrials, healthcare and technology sectors performed well. An inefficient market The inefficiency of markets, particularly in smaller companies, has been compounded by the structural decline in analyst research and resources, as regulatory pressures have resulted in shrinking commission pots for investment banks. As a consequence, it is now often uncommercial to dedicate the necessary analyst resource to the smaller end of the market, where share volumes and liquidity are traditionally lower than in the large cap area. This can mean that some stocks are undervalued not because they are bad companies, but because they are relatively unknown. As bottom-up active stock pickers, the challenge for us is to uncover these attractive opportunities. There has also been a structural shift out of UK small cap, which has meant that despite
its performance, the asset class is still relatively under-owned. This is illustrated in the chart above, which highlights that if one strips out the positive performance, assets under management (AUM) in the smaller companies sector have declined over the last 10 years. With less research, fewer funds dedicated to smaller companies, and investors focusing increasingly on benchmark-driven strategies, our skill lies in our ability to identify and analyse areas of the market that are perhaps off the mainstream radar. We seek high quality companies that can grow their earnings and cash sustainably over the long term. We combine top-down sector and thematic analysis with bottom-up fundamental analysis of companies to find these investment opportunities at attractive valuations. We typically meet around 500 companies per year, and use these meetings, together with our market experience and a wide network of analyst research, to source potential ideas. We aim to identify companies where not all the good news has been reflected in the share price and where positive optionality exists for company earnings and their respective valuations to be substantially higher on a 3-5 year view.
0.8 0.6 0.4
14 Ja n-
12 Ja n-
08 Ja n-
6 -0 Ja n
4 n0 Ja
02 Ja n-
Not everything changes in the space of 10 years: Roger Federer won the Wimbledon men’s singles title in 2007 and in 2017 and remains at the top of his game. Smaller companies tend to be younger and at an earlier stage of their growth trajectory. In addition to having the potential to grow further, financial physics means that is easier for these firms to grow faster in comparison to larger behemoths. Critical to their success, however, is innovation, in terms of the product or service they supply. This allows them to compete effectively with incumbents, taking market share and growing in less supportive economic backdrops. It is also what makes smaller companies attractive targets for merger and acquisition (M&A) activity. Indeed, the weakness of sterling since the Brexit referendum has meant that UK assets and companies have become more attractive to overseas firms. There has been a flurry of such activity and it looks set to continue. Recent examples include work-wear rental supplier Berendsen (target of a bid by French rival Elis) and Zegona Communications (whose asset Telecable was bid for by Spanish company Euskaltel). Brexit and other geopolitical events will continue to cause uncertainty for UK investors. It is impossible to predict the likely trajectory of the market, but we believe we can pick good companies, and this is the focus of our efforts. Our stock-picking strategy results in a portfolio that typically holds 70- 90 stocks, whose diversity aims to generate superior riskadjusted returns. As can be seen in the chart below, over the last 12 months the correlation between stocks has fallen significantly, creating a fertile environment for stock pickers. We continue to focus on high quality companies, with robust cashflows and strong balance sheets, that are able to weather short-term volatility far more successfully than their weaker peers.
Will small cap still be hitting winners in 10 years’ time? We think so.
FTSE 250 – Constituent correlation with Index
Source: Datastream and Liberum, as at 31 May 2017
Where next for UK small cap?
*Source: FTSE as at August 2017. **Source: RLAM as at September 2017. Past performance is not a guide to the future. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the manager’s own and do not constitute investment advice. Investment in smaller companies may be riskier and less liquid than larger companies, which could mean that their share prices and therefore fund performance is more volatile.
6 | LEADING EDGE | NOVEMBER 2017
Hungry for income? Try our international twist on a favourite recipe Launched in December 2015, the RL Global Bond Opportunities Fund has already proved a welcome addition to RLAM’s bond fund menu, aiming to provide a high level of income with the opportunity for capital growth. With an income yield of 5.66%, the Fund has delivered a return of 8.29% year to date and 16.11% since inception*. As a relatively new Fund, what are the secret ingredients of its successful performance so far? An established method with global appeal One reason for the Fund’s rapid success is undoubtedly that it shares the same investment philosophy with the RL Sterling Extra Yield Bond Fund. Launched in 2003, the RL Sterling Extra Yield Bond Fund has a well-established track record of delivering to its high income objective as well as providing strong returns over the long term. The RL Global Bond Opportunities Fund adopts the same unconstrained investment approach as the RL Sterling Extra Yield Bond Fund and benefits from access to the same wide universe
Eric Holt Head of Credit
Rachid Semaoune Fund Manager
of eligible assets. But whereas the RL Sterling Extra Yield Bond Fund must maintain at least 75% of the Fund’s currency exposure in sterling, the RL Global Bond Opportunities Fund is not subject to currency exposure limits, meaning it has greater scope to exploit global opportunities. The Fund’s core markets are Europe, the UK, the Nordic countries and North America, but the Managers can also invest in new issues within emerging markets (hard currency only), as well as in developed Asian countries.
such as the fundamentals of the issuing company, the bond’s structure, the regulatory environment in which the issuer operates and any additional security features like protective covenants, RLAM’s in house research team can identify untapped opportunities for superior income generation. This allows Fund holders to take advantage of the incremental yield which arises from perceived illiquidity, a lack of rating or exclusion from a benchmark in a risk-efficient manner.
Sourcing the right ingredients
For an example of what this unconstrained, global, stock-specific approach means in practice, we can look at a bond issued by Norwegian property company ML 33. Issued in Norwegian Krone with no equivalent sterling issue, these unrated but secured bonds are outside of the scope of benchmark- and rating-constrained investors, but offer an attractive yield of 5.5%, along with enhanced security for bondholders**. The bonds are secured against prime office space in Oslo, meaning investors have a claim against this asset in the event of the bond defaulting. There is a very low risk of the tenant defaulting on the property, as the current tenant is A+ rated oil and gas company Statoil, and the bonds mature well within the term of the Statoil’s lease. Bondholders enjoy the further protection of a covenant
The Fund’s investment philosophy reflects its high-income objective. Using a reference yield of LIBOR +3%, the Fund does not use a benchmark but adopts a fully unconstrained and opportunistic investment approach in order to target a high level of income. Unrestricted by ratings and able to invest at all levels across the capital structure of the issuer, the RL Global Bond Opportunities Fund seeks to avoid market inefficiencies such as an over-reliance on ratings and focus on liquidity, taking instead a stock-specific, bottom-up approach. In line with RLAM’s overall credit investment philosophy, the Fund benefits from the in-depth analysis carried out by RLAM’s investment grade and high yield research teams. By understanding the individual characteristics of each bond,
NOVEMBER 2017 | LEADING EDGE | 7
which prevents dividend payments being made should the loan to value (LTV) rise above 80%. A rise in the LTV above 85% constitutes an event of default, whereby the bondholders can exercise their claim on the underlying asset. Another example of how in-depth credit research across a global universe of eligible assets can identify opportunities – in this case, owing to changes in banking regulations, is our holding in Lloyds 6.413% perpetual bonds. These high-coupon, US dollardenominated bonds are old-style capital instruments, otherwise known as Tier 1 bonds. As high-coupon bonds, it would be uneconomical for the issuer to leave the bonds outstanding past the Basel III January 2022 deadline, after which Tier 1 bonds will cease to qualify as capital. However, there is no early redemption clause allowing the bonds to be redeemed ahead of the call date, in October 2035. By holding these bonds within the Fund, we benefit not only from the higher yield, but also stand to benefit from the potential tendering of the outstanding bonds at an attractive premium before January 2022 – as has previously occurred.
Seeking the perfect blend Another important driver of the Fund’s success to date is its positioning. It is well diversified to mitigate credit risk, and duration is maintained short, at around 4.7 years*, in order to minimise the impact of potential rate rises, as we believe that yields will gradually trend higher. There is no specific sector allocation within the Fund; sector positioning is determined by where value lies at the security level. However, Fund positioning is currently biased towards financials, as we see value in the sector as banks continue to shrink their balance sheets and build capital buffers to comply with banking regulations. Looking ahead, we will continue to focus on value opportunities which are often overlooked by benchmark investors, maintaining significant exposures to high yield and unrated bonds, as well as secured bonds that offer protective covenants alongside attractive income generation, supported by RLAM’s in-house Credit Research Team.
To find out more about RLAM’s credit philosophy, watch our video: www.rlam.co.uk
*Source: RLAM and FE as at 30.09.2017. Total return, based on Z share class net of fees. Inception date 08.12.2015. **Source: RLAM as at September 2017. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Capital invested in the Fund is at risk and there is no guarantee that yield target will be achieved. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market. Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk.
8 | LEADING EDGE | NOVEMBER 2017
Keeping up with the Sustainable Team Ashley Hamilton Claxton
Victoria McArdle Investment Analyst
Head of Sustainable Investments
Corporate Governance Manager
Sustainability doesn’t stand still: greater scrutiny of environmental, social and governance (ESG) issues, public scandals and rapid advances in technology have forced companies to move quickly to meet the demands of an increasingly diverse and complex range of challenges. Our Sustainable Team analyse these issues on a case-by-case basis when selecting investments for our Sustainable Funds range, and engage proactively with companies to advise them how best to tackle their most pressing sustainability concerns.
Governance – Ashley Hamilton Claxton Corporate governance is an essential component of companies’ long-term growth and success. There are increasing numbers of studies that demonstrate the effects of good or bad corporate governance practices upon profitability, and scandals related to poor governance, such as JD Sports and the BP Macondo Well disaster, have resulted in significant losses for investors, along with widespread negative publicity. In 2011, we reviewed Volkswagen for investment on the basis that it was making significant progress on reducing the emissions of its vehicles. At the time, it was viewed as having a very positive environmental story and would have passed our environmental screen. However, we ultimately failed it on corporate governance grounds, and did not invest due to the undue influence of the founding family, lack of independent board oversight, and dual class share structure. In light of the emissions scandal engulfing the company, our emphasis on good governance paid off, and we were able to avoid making losses.
In this article, our Sustainable Team provides stock examples to show how sustainability affects our investment decisions, and to explain some of our current investment themes where we are identifying companies with significant potential to have a positive impact upon society. We have been a long-term shareholder in Unilever, which is one of our top stocks as an environmental, social and governance (ESG) leader. It has very strong governance and a well-respected board, which was recently put to the test by the Kraft Heinz bid. The board
provided a sensible and proportionate response in rejecting the bid, and putting in place a cost-cutting programme that will improve returns for shareholders while still respecting the firm’s ethos and sustainability commitments. We believe good governance at Unilever has helped protect our interests as shareholders. Agriculture – Victoria McArdle By 2050, the global population is expected to rise by a third, and the UN Food and Agriculture Organisation warns that we will need to produce 70% more food by 2050 than we did in 2009. Demographic trends such as the rise of the middle class and increased urbanisation mean that demand for protein, particularly for meat and fish, is rising and fewer people are working the land. Raising animals to be eaten has a huge environmental cost already: a quarter of the world’s land is used for grazing these animals, who consume 30% of the world’s crops. When you consider climate change and the degradation of land used for farming, it is clear just how vital advances in agriculture are to ensuring food security for generations to come, and how companies that are addressing this concern have the potential to provide a significant net benefit to society. To this end, we have invested in the following companies:
NOVEMBER 2017 | LEADING EDGE | 9
Performance Fund Size
Royal London Sustainable Leaders Trust UK All companies
Royal London Sustainable Diversified Trust Mixed Investment 20-65% Shares
Royal London Sustainable World Trust UK All companies
Royal London Sustainable Managed Growth Trust Mixed Investment 0-35% Shares
Royal London Sustainable Managed Income Trust 1 Fund income vs target in PPU*
4.7 v 3.8
14.8 v 12.3
Source: RLAM and FE as at 30 September 2017. 1Fund Performance shown is based on the C Acc share classes. Quartile rankings versus sector averages indicated. *Pence per unit. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.
• Deere is the premier name in farm equipment. Precision agriculture will facilitate more efficient production by combining equipment, technology and services to improve management of farm information, optimise harvest logistics, and inform better agronomic decisions. • Higher productivity is key to meeting growing demand for animal protein. Genus is a global leader in animal genetics: through genomic selection and gene editing, they allow farmers to produce higher yields of milk and meat. • Novozymes provides innovative biological solutions to improve the efficiency of industrial processes. They offer products with a range of exciting agricultural applications, from boosting grain yields to reducing farmers’ reliance on antibiotics. Decarbonisation of transport – Gail Counihan Decarbonisation of transport is hugely topical at the moment - it is strategically important to reducing global emissions and reducing the impact of climate change. Currently, transport accounts for over half of the world’s use of oil, which is why we are hearing more about emissions regulation, electric vehicles, and whether or not diesel will have a place in the transport fleet of the future. ‘Real Driving Emissions’ testing means that car manufacturers are facing additional scrutiny outside the test lab, which means they need to make tangible progress on their emissions or face hefty fines for non-compliance.
Electric vehicle manufacturers are not the only companies investing heavily in this space –manufacturers of auto components are improving the energy efficiency of their products, which are then used in electric vehicles or traditional combustion engine vehicles. We have recently invested in Valeo, a company that we believe is delivering decarbonisation on many levels, through its products and services, as well as through its own emissions. They are a clear ESG leader from an operational perspective, and are delivering products and services that provide an indisputable net benefit to society. Valeo is perfectly positioned to benefit from the exciting upswing in new energy vehicles, be it through strategic acquisitions or through geographical presence in China, which aspires to be a world leader in electric vehicles. Innovation and artificial intelligence – Mike Fox The pace of innovation in the global economy is rapidly increasing. Whether it be Amazon, Uber, Airbnb or Google, companies who consistently innovate are transforming the way we live. Innovation is accelerating due to three main reasons. The first is the increase in computing power: we all carry powerful computers in our pockets now in the form of smartphones. The second is data: the amount of data in existence is growing exponentially, and data is the raw material for computers and can be converted into insight. So the rise in computing power combined with exponential increases in data is a powerful force. The third factor is cash: major technology companies are spending
huge sums on research and development. Computing power, data and cash are the three reasons for accelerating innovation. Investors should look out for artificial intelligence, virtual reality and self-driving cars in the coming years as consequences of this. We think these technologies will be socially positive, as well as profitable for those companies who create them, which is ultimately the aim of sustainable investing. The long-term returns of our sustainable funds and the number of industry awards they have won are testament to the success of our investment approach in generating sustainable returns. We are patient investors: we recognise that there will be times when markets are unfavourable for some of our securities, but our conviction in their sustainability and growth potential means we’re prepared to weather some short-term dips to reach our long-term goals. We invest in this way not only because of the ‘sustainable’ mandate, but because we believe this is the best way to build portfolios to generate long-term returns. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Capital invested in the Fund is at risk and there is no guarantee that yield target will be achieved. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market. Subinvestment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk.
10 | LEADING EDGE | NOVEMBER 2017
Taking the weight:
How our integrated insurance solution could lighten the load of investment As part of the Royal London Mutual Insurance Society, we understand that insurers have very specific requirements when it comes to their investments. We have developed a flexible partnership approach, which enables us to provide an integrated, holistic and bespoke solution to insurers’ investment requirements. In this article, Emmanuel Archampong and Nick Woodward explain the three pillars of our integrated insurance solution: i) governance ii) service iii) investment expertise. Governance Good governance is a central cog in the wheel of managing an investment portfolio. Effective decision making, clear principles and beliefs, and a comprehensive understanding of the investment goals and how they should be met are the foundation of a successful investment solution. For many organisations, however, there are a number of reasons why good governance might be a challenge. Sitting on an investment committee requires a significant time commitment, and a high level of investment knowledge and understanding. For some companies, where the appropriate time and resources might not be easily available, delegating the investment decision-making function can be an optimum solution in terms of both efficiency and risk management
to ensure the highest level of governance and accountability. In many organisations, managing assets can easily become separated from overall balance sheet considerations, often simply through different teams being responsible for different functions. Our flexible partnership approach places us as a core partner between the actuary and the board. By being able to understand the balance sheet and the specifics of the assets, liabilities and capital requirements, our expertise enables us to interact directly and efficiently with all sides, and to provide appropriate and comprehensive investment views. Each insurer is different, and has its own aims and objectives. By working directly with our clients and improving the efficiency and risk management perspective of decision-making, we can help each to better achieve their investment goals. Service In addition to improving efficiency of dialogue, we are able to offer a much higher level of service by working closely with your business, and speaking your language. This means that we will understand specific reporting requirements and make best use of the investment information available at RLAM. Managing the insurance assets of the UK’s largest mutual life, pensions and investment company means we have dedicated insurance professionals and relationship managers, which means we are able to support insurance clients who require non-standard reporting, for example unique security classifications and ‘look-through’ reports on assets. We are also able to provide ‘Quantitative Reporting
Institutional Business Development Manager
Head of Investment Solutions
NOVEMBER 2017 | LEADING EDGE | 11
Templates’ and solvency capital reporting to meet Solvency II requirements. To outperform liabilities in a capital-efficient way is a goal for all insurers, and we use our investment expertise to construct, manage and monitor a bespoke portfolio which is designed to suit these objectives. This means that the funds we select for the portfolio will be the funds with the most appropriate characteristics to help you achieve your investment aims, both in terms of returns, and risk budget. At RLAM, we have a broad range of investment capabilities and are able to undertake the analysis required to build a combination of investments that is best suited to your goals. We also recognise that not all strategies will be suitable for our insurance clients’ specific requirements.
Buy & Maintain
Global High Yield
Buy & Maintain Credit
Short Duration Global High Yield*
Global High Yield*
UK Equity Income
UK All Share
Sustainable Managed Growth
UK Real Estate Fund
Short Term Money Market
Short Duration Gilts
Short Duration Credit
Short Duration Global Index Linked
Duration Hedged Credit
Enhanced Cash Plus
Sustainable Managed Income
UK Index Linked
UK Mid Cap
Asia Pacific ex Japan
Global Index Linked
European Corporate Bond
UK Smaller Companies
Europe ex UK
Sterling Extra Yield Bond*
Investment Grade Short Dated Credit
Global Bond Opportunities* Multi Asset Credit
*Dublin domiciled funds
Source: RLAM as at 28.02.2017
Creating a cashflow matching portfolio Growth Portfolio Cash
• Two main components: 1. Matching portfolio: made up of two constituent parts: i.
Core matching whose primary focus is the matching of the liability duration and
ii. Matching Plus which will contribute to the Core Matching portfolio but also enhancing risk-adjusted return 2. Growth portfolio: embracing a multiasset approach
One example of how we manage our clients’ portfolios is by separating the overall portfolio into a ‘matching’ segment and a ‘growth’ segment. The former consists of assets designed to ‘match’ the clients’ liabilities using a mix of bond funds, while the ‘growth’ segment is constructed of returnseeking assets to grow the capital value of the portfolio, aiming to achieve ‘equity-like’ returns, but in a more capital efficient way and with much lower risk than a pure equities investment. We also conduct our own inhouse asset and liability modelling, which
provides a quantitative risk framework for decision-making and monitoring, and enables our clients to set specific risk limits and targets. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the authors’ own and do not constitute investment advice.
12 | LEADING EDGE | NOVEMBER 2017
Holding cash and waiting for the sales? Craig Inches looks at how to improve security and returns from your cash holdings.
Craig Inches Head of Short Rates and Cash
NOVEMBER 2017 | LEADING EDGE | 13
It’s hard to convince yourself to buy something that you know is expensive. With furniture, kitchens and clothes, you know you can always wait for the next Bank Holiday sale. But for investors who are holding cash while waiting for asset prices to climb down from their high levels, there is no convenient calendar date on which mark-downs in price will be advertised. Many high-profile managers, including Warren Buffett, have openly declared the large cash positions they are maintaining while they wait for better opportunities to invest. Efficient cash management is an important part of running a balanced portfolio. Holding large amounts of cash for a long period, either un-invested or in overnight instruments means investors could be missing out on the opportunity to earn a better return while improving the security of their investments, without compromising on liquidity or risk.
Asset allocation RL Short Term Money Market Fund Corporate Bonds 3.2%
Supranationals & Agencies 0.7%
RL Cash Plus Fund Corporate Bonds 9.6%
Supranationals & Agencies 1.0%
Covered Bonds 19.2%
Treasury Bills 25.5%
RL Enhanced Cash Plus Fund Mortgage backed Securities 10.2%
Corporate Bonds 42.4%
Cash & Cash Instruments 51.4%
Covered Bonds 29.9%
Cash & Cash Instruments 59.4%
Supranationals & Agencies 0.1% Cash & Cash Instruments 27.7%
Covered Bonds 19.6%
Price versus quality
One of the first questions when shopping around is whether the item you want to buy is high enough quality to justify the price?
If you decide to buy a new TV, you will probably look at whether it comes with a guarantee, and take into consideration whether the manufacturer or the particular product is known for either quality or for frequent faults.
There is a temptation to think that because you are paying a high price for something, it must be the highest quality, the best option. This is not always the case, as we have discussed in this article. It is important to delve deeper into the underlying characteristics of each fund to ensure the manager has carefully considered price, security and an appropriate level of diversification to construct a liquid, high quality portfolio. Cash is an important part of running a balanced portfolio, and with increasing amounts entering the asset class, potentially for a longer time period than intended, we think it’s crucial that investors attain the highest level of security for an appropriate level of yield.
While equity markets have hit successive new highs over the past year boosted by encouraging economic data, both from the UK and globally, bond yields have continued to remain low due to loose monetary policy and asset purchases by central banks. As a consequence, in the search for yield, investors are paying a premium for riskier assets, without necessarily receiving a higher return. In our cash funds, we invest in high quality, liquid instruments. We look carefully at whether the yield on the instrument is appropriate compensation for the risk undertaken in purchasing it. In the current low-yielding environment, we feel that longer dated cash instruments are not offering a good balance between risk and reward. We therefore diversify our portfolios to invest in a range of short-dated instruments, including certificates of deposit, covered bonds and floating-rate notes (FRNs), which offer more attractive returns for the appropriate level of risk.
For efficient cash management, focusing on quality is crucial, as we aim to maintain a high level of security in addition to providing incremental returns. We carefully analyse the issuer and the asset itself to determine whether the level of security reciprocates the expected return. Although it may be tempting to view pure cash as the ‘most secure’ option, the decreasing number of banks who are willing to take overnight deposits, particularly around important accounting dates such as year-end, means that investors are paying more for such instruments, without receiving an increase in security. By diversifying portfolios to invest in liquid, short-dated securities, we find that we are not forced to buy expensive cash instruments, and are able instead to purchase assets that offer equivalent levels of security, but at a more attractive price.
The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The level of income (yield) from a bond fund is not fixed and may go up and down.
14 | LEADING EDGE | NOVEMBER 2017
Spot the difference! Under the bonnet of the Royal London Corporate Bond Fund Jonathan Platt
Head of Fixed Income
Senior Fund Manager
The RL Corporate Bond Fund was launched in 1999 and is managed by Head of Fixed Income, Jonathan Platt and Senior Fund Manager Shalin Shah. In October 2017 Shalin was appointed as Co-Manager of the Fund, having worked closely with Jonathan on the Fund since 2014.
Jonathan Platt, together with Eric Holt, Head of Credit at RLAM, and Martin Foden, Head of Credit Research has been instrumental in developing and shaping RLAM’s credit investment philosophy over the last 15 years. Central to this philosophy is the belief that credit bond markets are inefficient. Other funds in the peer group increasingly focus on big, liquid, benchmark constituents when defining their universe of potential bond investments. This may be a pragmatic response to the sheer size of some funds, or a behavioural bias, with managers taking comfort in the external validation of a particular bond through a credit rating. However, the sterling corporate bond universe is much more than just bonds that have an investment grade credit rating and an issue size of £250m or above (the criteria for benchmark inclusion). In managing the RL Corporate Bond Fund, Jonathan and Shalin’s approach is unconstrained, looking across the whole sterling credit market and exploiting opportunities that market inefficiencies lead many investors to overlook, with a focus on bonds that the managers deem to be investment grade.
Contrary to expectations, the sterling credit market offers a great deal of international exposure, especially to North America and continental Europe, owing to the earnings profile of large blue chip companies that have a listing in the UK. However, the Co-Managers also continually monitor the spread differential for existing sterling issuers against their US dollar or euro counterparts, and will take advantage of opportunities to exploit attractive relative value in non sterling-denominated bonds. An individual approach to collaborative working RLAM’s credit team’s collegiate working style is another key differentiator of the Fund. By striking an optimal balance between individual Fund Manager responsibility and a collective approach to sector and stock analysis, investors in the Fund benefit not only from the experience and knowledge of Jonathan and Shalin, but from that of RLAM’s wider Credit Team, one of the most experienced credit bond teams in the UK. Our in-house Credit Research Team are vital to the Fund’s success, providing the essential in depth analysis needed to uncover overlooked or unusual opportunities within the Fund’s investment universe, irrespective of benchmarks or ratings. The stability of the team and its
NOVEMBER 2017 | LEADING EDGE | 15
ability to attract new talent is supported by its remuneration structure, which rewards the whole Credit Team based on the collective performance of our credit funds. Security matters The Fund’s bias towards secured bonds has proved fruitful. With most bonds within benchmarks issued as senior and unsecured obligations of the issuer, holders of these bonds face the same risk of loss as the company’s many other unsecured creditors in the event of a default. Yet it is possible to find bonds that provide additional protection to bondholders, giving them priority over unsecured creditors in the event of a default, usually through a claim on certain assets of the issuer. According to financial theory, these secured bonds should offer a lower yield than unsecured debt, as investors will demand less compensation (yield) where there is greater protection. But this is not always the case. The ability to buy a diverse range of secured bonds at yields that compare favourably with unsecured debt is a key inefficiency in the sterling credit market that Jonathan and Shalin seek to exploit within the Fund.
Covenants The Fund also benefits from exposure to secured bonds with covenants: covenants are constraints on what the issuer can do, designed to protect bondholders. When covenants prove to be too restrictive from the issuer’s perspective, the issuer may ‘call’ or buy back the secured bonds, usually at an attractive price, which can be beneficial for the Fund. This protection is particularly important in an environment of very low yields, where mergers and acquisitions risk for bond holders remains elevated. The Fund’s very low holding in Annington Finance is a recent example of how strong covenants can both protect and, in some circumstances, materially enhance returns. In 1996, Annington issued secured bonds with protective covenants. These covenants restrict its ability to access any excess cashflow as well its portfolio of residential properties, which are leased on a long-term basis to the Ministry of Defence. Given the ongoing low interest rate environment, in 2017 Annington decided to restructure its debt, resulting in the secured bonds held by the Fund being redeemed for
a significant uplift in price, boosting Fund returns. Annington then issued a number of new unsecured investment grade bonds across a range of maturities, with yields of 1.7% to 2.05% over the relevant reference gilt, which the Fund purchased. These new bonds, while unsecured, still feature a number of covenants that protect our position as creditors, including limiting the amount of unsecured and secured debt Annington can issue. Consistent long-term performance The Fund’s consistent outperformance versus its benchmark is driven by the same factors that differentiate it from its peer group: the focus on secured and asset-backed bonds, exposure to non-rated bonds, a willingness to diverge from benchmark weightings and the ability to look for opportunities across the whole of the sterling credit market, all supported by RLAM’s collegiate approach to credit bond analysis. With many corporate bond funds offering similar exposure to the same large issuers, these key differentiators play an increasingly important role in our ability to offer an alternative set of cashflows from which to generate income and returns.
Fund performance Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Capital invested in the Fund is at risk and there is no guarantee that yield target will be achieved. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market. Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk.
8% 7% 6% 5% Return
4% 3% 2% 1% 0%
-1% RLAM Index
YTD 5.34% 2.44%
1 Yr 3.01% -0.20%
3 Yr Ann 7.44% 5.93%
5 Yr Ann 7.80% 5.64%
SI Ann 6.79% 5.61%
Source: RLAM, gross of fees and gross of tax of the Z share class, as at 30 September 2017. Index for RL Corporate Bond Fund is iBoxx Sterling non Gilts All Maturities Index; inception date for Z share class is 30 April 2010.
16 | LEADING EDGE | NOVEMBER 2017
Anticipating the twist in the tale Despite being fraught with geopolitical risk, 2017 has so far been a good news story for equity markets. Stocks have continued to climb as global growth has remained positive, interest rates have stayed low and inflationary pressures have fallen. While certain events have given markets pause, including elections in Europe and, more recently, escalating tension with North Korea, none has led to a sustained fall. With investors becoming increasingly nervous as the equity rally continues, we consider four potential areas that could provide a ‘twist’ to markets. Will cash ever be king again? Although most investors keep a proportion of their portfolios in cash to service short-term liquidity requirements, as a medium- to longterm investment, cash has underperformed other asset classes. Interest rates have remained below the rate of inflation since the financial crisis and the situation has worsened since the EU referendum, with the weak pound pushing inflation higher. As a result, cash returns have been negative in real terms every year since 2008, and the purchasing power of cash has fallen by 20% over this period. An investment of £1,000 put into a deposit account 10 years ago would be worth about £800 in today’s money. The same amount invested in a typical multi asset fund would be worth £1,700*.
Sterling based returns by calendar year Year 1
UK Stocks Commodities +30.1%
EM Stocks Global Stocks
Multi Asset Multi Asset -10.4%
Global Stocks Commodities Global Stocks +4.4%
UK Stocks Global Stocks Inflation (RPI) Multi Asset
Global Stocks Multi Asset Global Stocks UK Stocks +12.2%
Multi Asset Multi Asset Multi Asset EM Stocks Inflation (RPI) UK Stocks
Multi Asset Commodities Commodities UK Stocks +5.5%
Global Stocks Inflation (RPI) Global Stocks Global Stocks Inflation (RPI) Global Stocks +11.2%
Inflation (RPI) Inflation (RPI) Multi Asset
+1.2% UK Stocks
+8.2% Property +6.5%
Multi Asset Multi Asset
Inflation (RPI) +2.8%
Inflation (RPI) UK Stocks
Inflation (RPI) Commodities
EM Stocks Inflation (RPI) -10.3%
EM Stocks Commodities Commodities Commodities Commodities -18.4%
Source: RLAM, DataStream as at 31.08.2017. Figures show total returns in GBP terms ranked from highest to lowest each year.
We expect interest rates to stay below inflation. While the Bank of England is expected to reverse the emergency rate cut made following the referendum by the end of this year, we do not believe this will signal the start of a sustained tightening cycle. The Bank has highlighted the need to exercise caution when considering raising rates in light of the high levels of unsecured consumer debt in the UK and this, combined with ongoing Brexit uncertainty, should prevent rates from rising significantly in the near term. Cash will continue to burn a hole in your pocket. Can bull markets die of old age? With the current equity market cycle already into its eighth year and stocks continuing to grind higher, many investors
are turning bearish. However, it is important to remember that it is the nature of stock markets to rise over time, and the length of the current rally does not, alone, imply an impending correction. As shown in the chart to the right, there is a strong correlation between a rise in the unemployment rate and recessions. But this is the opposite of the current strong positive trends we are seeing in employment and labour market data. There is also little evidence of the kind of phenomena that triggered the last three recessions: the excessive growth that led to rate rises in the case of the 1980s bull market, the excessive bullishness and speculative sell-off of the 1990s dot com bubble, or the excessive financial leverage that
NOVEMBER 2017 | LEADING EDGE | 17
Trevor Greetham Head of Multi Asset
triggered the banking crisis in 2008. Growth is steady, and there is no sign of the late-cycle surge in wages that leads central banks to raise interest rates meaningfully. Banks have significantly increased their capital buffers to satisfy tighter regulation since the financial crisis and, if anything, markets are tending towards excessive bearishness.
could drop again. On the other hand, a soft Brexit could be positive for the economy and for property markets, but the resulting sterling strength may limit returns in a partial reverse of the 2016 dynamics. We believe investors with a low risk appetite should avoid taking a view on the negotiations and hold most of their assets in sterling.
What does Brexit mean for investment returns?
What about geopolitics?
Despite expectations that portfolios would fall in value post the EU referendum, 2016 was the best year for multi asset investors since 2009, as a 15% drop in the value of sterling boosted the value of overseas investments and the UK equity market, which sources 70% of its earnings overseas. From where we are today, we see significant two way risk for the pound. A ‘hard’ Brexit or a ‘no deal’ outcome would be negative for the UK’s economy, and the pound
We believe that investors remain sensitive to geopolitical risk and that it is likely that we will continue to see bouts of risk aversion, with hawkish central bank rhetoric, North Korean tensions and concerns over Chinese growth probable sources of volatility. However, each pause in the current equity rally has been followed swiftly by a new upward trend, as macroeconomic fundamentals, which are the real drivers of markets, remain supportive.
Global stocks vs. bonds and US unemployment rate (inverted) 2.2
Investor sentiment and stock prices Our investment models enable us to adopt a high-conviction view on economic fundamentals, while our sentiment indicator (above) guides our shorter-term positioning: significant falls in investor sentiment, generally caused by geopolitical risk events, trigger ‘buy’ signals. We added to our overweight position in equities in the summer as sentiment fell sharply following the heightened tensions between the US and North Korea. A positive fundamental view makes us more likely to buy dips than sell rallies. Don’t get it twisted We believe the current economic cycle has some way to go. With inflation low and growth steady, the outlook for equities remains constructive, particularly while central banks opt for incremental tightening. There will be bumps along the way but with cash losing its purchasing power on a daily basis, it pays to stay invested.
Watch our latest monthly video from Trevor: www.investmentclock.co.uk
Global stocks vs. bonds
0 20 1
5 19 9
US Unemployment rate, (RH Scale, inverted)
Source: Thomson Reuters Datastream as at 19/09/2017
*Source: Source: RLAM as at 31.08.2017. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Simulated returns calculated using total return data for the underlying asset classes, taking a 1% fee into account. The composite weight is made up of 50% global stocks and 50% UK government bonds.
26 AP RI L
A date for your diary Once again, we will be holding our annual Investment Conference, giving you the opportunity to hear from our investment experts in a series of panel discussions and self-selected sessions. The Conference will be held on Thursday 26 April at etc. venues, County Hall. For more information about the day and to secure your place, please email email@example.com
RLAM Academy We have developed a series of CISI accredited webinars to help advisers and trustees develop their knowledge and meet their CPD requirements. The RLAM Academy features succinct educational presentations across various topics and asset classes including cash, fixed income, equities, property and corporate governance. Visit our website for more information We’ll be adding to the Academy throughout the year so look out for our updates on new topics and webinars.
Responsibility Matters If you enjoyed the articles from our Sustainable Team, you may be interested in Responsibility Matters, our quarterly newsletter focusing on the environmental, social and governance (ESG) issues impacting investors. As a responsible investor, we are committed to exploring the issues and news items are most prominent within the sector. Read the latest issue
Get in touch As always, if there’s anything you’d like to hear more from us on, please do get in touch using the email below: firstname.lastname@example.org
For professional customers only. Financial promotion issued by Royal London Asset Management October 2017. Information correct at that date unless otherwise stated. Royal London Asset Management Limited, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, registered in England and Wales number 2372439. RLUM Limited, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office:55 Gracechurch Street, London, EC3V 0RL. The marketing brand also includes Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259, and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland. Our ref: N RLAM W 0006.
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