LEADING EDGE RLAM’S REGULAR REVIEW OF INVESTMENT MARKETS • APRIL 2017
UK equities: Keep calm and carry on compounding
There is little doubt that 2017 will be a year of political risk and economic uncertainty. Members of RLAM’s UK Equities Team explain why attempting to predict the macroeconomic environment is a dangerous bet.
For professional investors only, not suitable for retail clients
New thinking in global equities
RLAM’s newly appointed Head of Global Equities, Peter Rutter, introduces the Life Cycle approach to building global equity portfolios.
Quality not convenience: corporate bond investing
Head of Credit Research, Martin Foden and Senior Fund Manager, Rachid Semaoune highlight how RLAM has responded to the challenges that have characterised credit markets in recent months.
The artificial intelligence revolution – the rise of the machines
Head of Sustainable Investments, Mike Fox looks at what we mean by Artificial Intelligence, its implications for society and the case for its inclusion within a sustainable investment strategy.
Rob Williams
Head of Distribution
Welcome Welcome to this edition of Leading Edge. On 28 March, RLAM hosted its third annual Investment Conference, and our articles in this issue bring you the highlights of our presentations from the day. Touching on the full spectrum of asset classes, our managers review how markets have been shaped by the many surprising economic and political events of recent months, and share their macroeconomic insights and investment strategies for the coming year, which promises to be just as eventful as the last. In our final article, futurist and author Mark Stevenson introduces yet more disruption, as he explores how the accelerating pace of technological advancement will reinvent the concept of ‘wealth’, meaning traditional business models must adapt or face extinction.
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: leadingedge@rlam.co.uk Tel: 020 7506 6678 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 Small Cap Ex Investment Trust Index (the “Index”) 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.
In the months since the last edition of Leading Edge, we have seen a pronounced upturn in global growth and inflation expectations, yet politics has continued to dominate. Trump’s election victory in November led the dollar index higher and sparked a rally in equities which has endured into 2017, with many indices registering new record highs in recent months. Fears of an economic downturn were dispelled as UK growth remained robust in 2016, while sterling continued to be weak, with talk of a potential ‘hard’ Brexit resurfacing as the UK government triggered Article 50. Against this backdrop, RLAM’s UK Equities Team offers their thoughts on prospective domestic opportunities. Henry Lowson argues that the outof-favour small cap market remains compelling, while Martin Cholwill and Richard Marwood explain how they seek to avoid investing in line with shortterm trends and economic predictions. Meanwhile, with elections taking place in the UK, Netherlands, France and Germany during 2017, concerns about the spread of populism caused risk aversion and divergence in government bond yields in Europe. As Brexit negotiations finally get underway and Trump’s presidency suffers its first defeats, political risk and high levels of uncertainty are here to stay. Trevor Greetham considers how these and other factors have impacted the Investment Clock, highlighting the importance of a robust investment process in uncertain times. I hope you enjoy the issue. Rob Williams Head of Distribution
APRIL 2017 | LEADING EDGE | 3
Contents
Also in this issue 5 Storms ahead? Don’t forget your MAC Head of Global High Yield, Azhar Hussain and Fund Manager, Khuram Sharih outline how RLAM’s Multi Asset Credit (MAC) strategy fared during stormy weather.
10 Small cap investing – the hunt for undiscovered gems
04
08
11
New thinking in global equities
UK equities: keep calm and carry on compounding
The artificial intelligence revolution – the rise of the machines
RLAM’s newly appointed Head of Global Equities, Peter Rutter, introduces the Life Cycle approach to building global equity portfolios.
There is little doubt that 2017 will be a year of political risk and economic uncertainty. Members of RLAM’s UK Equities Team explain why attempting to predict the macroeconomic environment is a dangerous bet.
UK Small Cap Fund Manager Henry Lowson argues that the UK small-cap market remains a compelling proposition in the post-Brexit world, and reveals RLAM’s approach to identifying the best value and growth opportunities from this broad opportunity set.
14 Bond in 2017- stick or twist? Head of Short Rates and Cash, Craig Inches and Senior Credit Fund Manager, Paola Binns look at the case for corporate bonds for income generation and why investors seeking to protect capital should now ‘twist’ into short duration funds.
Head of Sustainable Investments, Mike Fox looks at what we mean by Artificial Intelligence, its implications for society and the case for its inclusion within a sustainable investment strategy. postBrexit overview of UK equity markets.
12
16
18
Quality not convenience: corporate bond investing
Green lights all the way:
Head of Credit Research, Martin Foden and Senior Fund Manager, Rachid Semaoune highlight how RLAM has responded to the challenges that have characterised credit markets in recent months.
Head of Multi Asset Trevor Greetham outlines the importance of diversification and a robust investment process to multi asset portfolios.
Mind the gap – a better approach to liability aware investing
GMAP your way to better outcomes
Head of Liability Driven Investments, Nick Woodward explains how an active approach to building liability aware portfolios could offer an efficient solution to schemes seeking to de-risk.
4 | LEADING EDGE | APRIL 2017
New thinking in global equities
Peter Rutter Head of Global Equities
RLAM’s newly appointed Head of Global Equities, Peter Rutter, introduces the Life Cycle approach to building global equity portfolios, explaining how it gives the advantage of generating new insight by providing an efficient and repeatable method of sifting through the extensive global equity investment universe. The Life Cycle As companies evolve, they progress through successive stages of growth and return generation. A relatively new company with original, disruptive products and strong momentum will have contrasting priorities to an established household name that has diversified into many markets and regions, and expectations for these companies will likewise be different. The Life Cycle approach shows that it is possible to find return-generative companies at every stage of their evolution. The key, however, is that at each stage of the Life Cycle, investors need to look for appropriate qualities and characteristics, and to ask pertinent questions, in order to judge a company’s strength, potential and intrinsic value. Using the same criteria to measure both newly accelerating companies and bellwether mature conglomerates will not give a true picture of a company’s strengths and weaknesses. Chart 1 shows where we place competitor companies within the same sectors in our Life Cycle scheme.
Chart 1: Corporate Life Cycle
Accelerating
Compounding
Slowing & Maturing
Mature
Turnaround
Source: RLAM as at 28.02.2017. For illustrative purposes only.
In addition to applying the Corporate Life Cycle approach to companies, we also use it as a lens through which to view regional markets and global economic themes. Managing complexity Global equities present a vast opportunity set, and for investment managers, filtering the spectrum of investment opportunities for inclusion within a portfolio is the first challenge. There are many ways in which to break down the global investment universe, and common methods include market cap size, industry or geography. Our approach to managing global equities is distinctive and efficient: we use specially designed algorithms to slot all companies into the various stages of our Life Cycle framework. Rather than adopt more broadly used and, to an extent, indexinfluenced systems, as a basis for our global equity strategies, we have devised what we
believe to be a more insightful, more logical and ultimately, more successful, approach. Our aim is to identify the strongest companies at every stage. It is not just about looking for those companies in the early ‘accelerating’ stages of development, or about avoiding mature companies that are seeking a turnaround. We look for specific attributes in every segment, and our Life Cycle framework seeks to enable us to ask the right questions at the right time. It is a universal and enduring concept, and applies to every company as it progresses through cycles of innovation, growth, competition and maturity. Stocks: this time it’s different We can demonstrate Life Cycle analysis at a stock level by charting Nokia’s progress from a company that produced a diverse range of products, from paper to cables and industrial equipment, to one that took the market by
APRIL 2017 | LEADING EDGE | 5
Chart 2: Stock level analysis 35 30
‘Slowing & Maturing’
25 CFROI %
20 15 10 5 0 -5 10
YEAR 1
3
5
Nokia
7
Apple
17
19
21
23
Source: RLAM as at March 2017.
storm with its mobile phones, starting with the classic Cityman900. Dominating the mobile phone market for over a decade, Nokia was finally thrown from its seat of power by Apple’s launch of the iPhone, and after a number of years in decline, was bought by Microsoft. What is even more interesting is that when the corresponding chart for Apple is superimposed, as shown in chart 2, the similarities between the two trajectories are
very clear. It is important to remember that the point of the Life Cycle framework is not to avoid investing in companies that have reached more mature stages and are being threatened by competition, but to look for appropriate qualities in these companies. The market: what are you buying? The Life Cycle method can also be applied in order to acquire insights into regional
Chart 3: Life Cycle by region Accelerating
US
Compounding
Slowing & Maturing
Mature
Turnaround
18%
27%
29%
14%
12%
Japan
4%
8%
9%
19%
60%
UK
5%
17%
24%
15%
39%
Emerging
15%
15%
28%
21%
21%
MSCI World
14%
23%
25%
17%
20%
Source: RLAM, March 2017. Developed is MSCI World Index weighted.
Chart 4: Domestic vs multinational 14.0
CFROI % (aggregate)
Thematic: you’ve been Trumped? Applying the Life Cycle concept at a higher, thematic level, it is clear that global multinational companies have been experiencing noticeably higher returns over the past 20 years than their domestically focussed counterparts. The majority of these multinationals are US companies, and the question now is whether the protectionist policies touted by the new US president will become reality, and threaten the driving forces of these companies’ success. These conglomerate firms have benefitted from increased sales from broader markets, lower costs from outsourcing overseas and lower taxes through efficient management. These forces have the potential to alter the direction of this Life Cycle theme, turning its current upward trajectory into a downturn. As global equity investors, we will be watching closely and adjusting our portfolio for signs of structural change. With the flexibility to invest across all markets, we are able to position our Fund to reflect long-term trends. Global equity investing encompasses a huge and complex opportunity set, and our solution for managing these intricacies, driving insight and constructing coherent portfolios is our Life Cycle framework. This differentiated approach seeks to drive performance and set us apart from competitors, and is a complete and enduring principle that underpins our approach.
12.0 10.0 8.0 6.0 4.0 2.0 0.0
markets. When used as a lens through which to view the core global markets, it is clear from the analysis below that different regions have different exposures to the Life Cycle. For example, the US has a strong bias towards earlier stages of innovation and development while surprisingly, emerging markets have heavy weightings to later stages of the Life Cycle. As with the stock level analysis, this framework is not designed to avoid investment in particular regions, but what it shows clearly is that by restricting your portfolio geographically, you will be bound to the Life Cycle profile of your selected markets, which means that the characteristics that you look for when investing should also reflect this backdrop. As global investors, we have access to the broadest investment universe.
1996
1998
2000
2002
2004
Local Source: RLAM as at March 2017.
2006
2008
Global
2010
2012
2014
2016
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.
6 | LEADING EDGE | APRIL 2017
Storms ahead?
Azhar Hussain
Don’t forget your MAC
Khuram Sharih Senior Fund Manager
One year cumulative return 15%
10%
5%
0%
c1 6 De
v1 6 No
t1 6 Oc
p1 6 Se
Au
g1 6
l1 6 Ju
n1 6 Ju
Ma
Ap
r1 6
r1 6 Ma
b1 6 Fe
n1 6 Ja
De
v1 5
-10
c1 5
-5%
y1 6
RLAM Model Portfolio MAC ML BB-B Non-Financial High Yield Index BAMLIG Global broad market Corp. excluding Sub Fins
No
2016 was a volatile year for fixed income. Ahead of the imminent launch of our MAC Fund, RLAM bolstered our team and put in place a model portfolio, which against this backdrop has been put to the test. In this article Azhar Hussain and Khuram Sharih provide an update on RLAM’s MAC model portfolio, discussing performance, composition and their approach to building a fund designed with the aim of generating consistent returns with low volatility through the credit cycle.
Head of Global High Yield
Source: RLAM, JP Morgan and Bank of America as at 31 December 2016. Inception date 1 December 2015. Figures refer to model portfolio performance and do not include impact of fees. Past performance is not a guide to future performance.
Different types of rain As shown in the table opposite our ‘alternative’ credit approach for MAC seeks to target attractive returns without compromising liquidity or significantly increasing volatility, as is commonly the case at the riskier end of the credit spectrum. Our model portfolio invests in assets across the global credit universe, including loans, high yield and asset-backed securities. The strategy is also not constrained by following the allocation of a particular benchmark index.
Characteristics
Traditional
Alternative
Illiquid
Return (LIBOR)
+2%
+4%-6%
+8%-10%
Duration
5 to 10 years
1 to 4 years
N/A
Volatility
✔
✔✔
✔✔✔
Liquidity
✔✔
✔
✘✘
Secured High Yield Credit markets
Global Sovereign Investment Grade
US HY European HY US Leveraged loans European Leveraged loans Security Credit
Rising rates environment
APRIL 2017 | LEADING EDGE | 7
Since the inception of the RL MAC model portfolio in December 2015, the Fund has exhibited lower volatility than traditional investment grade and high yield portfolios*. This is a direct result of the mix of assets held, and the focus on high quality security selection and volatility management. As shown in the chart, fundamental credit selection in combination with diversification across asset classes dampens volatility while increasing certainty of returns.
Spread vs Volatility by Asset Class Spread vs Volatility by Asset Class
500
EM HY
450 USD Loans
400
MAC Fund
350
US HY
300 250 200 Eur IG
150
US IG
100 50 0
3.0%
2.0%
4.0%
5.0%
6.0%
7.0%
8.0%
Source: RLAM at 28.02.2017 Source: RLAM as atas28.02.2017
7.5
Klöckner Pentaplast TL 1L Eur (secured) Klöckner Pentaplast 7. 125% 2020 (unsecured)
7.0 6.5 6.0 5.5 5.0 4.5
t1 6 Oc
p1 6 Se
g1 6 Au
l1 6 Ju
n1 6 Ju
16 Ma y
r1 6 Ap
r1 6 Ma
16 Fe b
De
n1 6
4.0 c1 5
The expertise of our Credit Research Analysts enables us to look carefully at the different options for investing in each company seeking to select the one that best suits our portfolio’s goals.
8.0
Ja
While it is important to generate returns, we do not chase yield, and aim to keep volatility low. An example is Kloeckner Pentaplast, where the company’s secured loan, held in the MAC model portfolio, generated a far more stable trajectory of returns than its higher yielding unsecured bond.
Loans Market provides opportunities
YIELD (%)
Minimising volatility: checking the weather forecast
Source: RLAM and Bloomberg as at 14 March 2017
Our investment philosophy underpinning the MAC portfolio is consistent with RLAM’s overall credit investment approach, which aims to exploit inefficiencies in the market by using our expert research to uncover mispriced opportunities. In our MAC portfolio, we combine our core bottom-up fundamental stock selection process with a top-down strategic allocation view, to construct a portfolio of our best ideas. This stock selection process seeks to add value in well-known names, as well as in less explored parts of the market; for example, analysis of the covenants of two nearly identical bonds issued by telecommunications operator Sprint enabled us to
detect a higher level of security and protection in one of the bonds. As a result, our investment was less affected by a subsequent bout of volatility, and therefore generated a more attractive risk adjusted return. MAC: the all-weather solution By constructing a portfolio across the credit spectrum, our MAC model shows how our approach seeks to generate consistent returns with low volatility. For all long-term investors, stability is a key factor in compounding returns, and we believe that our MAC strategy is wellplaced to weather the storms ahead.
Fund launch subject to approvals. *Source: RLAM, JP Morgan and Bank of America as at 31 December 2016. Inception date 1 December 2015. Figures refer to model portfolio performance and do not include impact of fees. Past performance is not a guide to future 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. The views expressed are the manager’s own and do not constitute investment advice. Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk. 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.
8 | LEADING EDGE | APRIL 2017
UK equities: Keep calm and carry on compounding
Martin Cholwill
Richard Marwood
Senior Fund Manager
Senior Fund Manager
There is little doubt that 2017 will be a year of political risk and economic uncertainty. Martin Cholwill and Richard Marwood, managers of the RL UK Equity Income and RL UK Growth Funds, are firmly of the opinion that attempting to predict the macroeconomic environment is a dangerous bet. Instead, they focus on selecting companies with strong business models that have the potential for long-term compounding of dividends and growth.
10
5
0
-5
-10
1920s
1930s
1940s
1950s
1960s
1970s
1980s
1990s
2010s
2000s
Source: Citigroup as at 31.12.2015.
UK Dividend Growth by Yield Group Since 1990 24.0% 20.0% 16.0% 12.0% 8.0% 8+
%
4.0%
Starting dividend yield
-16.0% -20.0% -24.0%
Source: SG Cross Asset Research/Equity Quant FactSet
8% 7-
7% 6-
6% 5-
5% 4-
% -4 3.5
% 33.5
% -3 2.5
2.5 2-
-8.0% -12.0%
%
0.0% -4.0%
2%
Our research shows that the lower the starting yield, the greater the potential for growth. Crucially, companies with a very high dividend yield are more likely to cut dividends than to increase them, creating a ‘value trap’.
Dividend Growth in Div Re-rating
1-
Yields: look for growth, not value traps
15
1%
Growth in dividends protects against inflation – when inflation increases, dividend growth also tends to increase. The most uncertain element of returns is re-rating (sometimes referred to as ‘multiple expansion’ or a willingness of equity investors to pay more for company earnings), which tends to be driven by macroeconomic events; we therefore concentrate on the compounding effect of dividends and dividend growth when seeking long-term returns.
Components of UK equity returns
0-
In order to pay and grow dividends, a company must have strong, predictable cashflows; this is one of the most important factors to consider when comparing investment opportunities, particularly given the number of firms that have survived the post-financial crisis world on a diet of cheap leverage. When breaking down equity returns into their component parts of dividends, dividend growth and re-rating, the importance of dividends and dividend growth is clear, as shown in the chart opposite.
Dividend growth over following 12 months
Dividends are key to returns
APRIL 2017 | LEADING EDGE | 9
Our funds: complementary approaches
Clear distinctions: retail sector stocks
The RL UK Growth Fund can be thought of as a UK ‘dividend growth’ fund. Rather than expand our dividend offering with a ‘high income’ fund, we see better potential for long-term returns by looking for dividend growth and the wider universe of stocks that this opens up. Our UK Growth Fund invests in companies with a lower starting dividend yield, which we expect to increase faster than the market. There is some overlap with the UK Equity Income Fund, but the latter generally invests in companies with higher starting yields, but which remain well-placed to pay sustainable and growing dividends.
To clarify the different styles of the two funds, we highlight examples of a company held in one fund but not the other, a company held in both funds and a company held in neither. B&M: this discount home retail store is held in the UK Growth Fund. It is in a strong position to benefit from the structural change favouring the ‘value’ end of the market, supported by its strong retail proposition, and with a lower starting dividend yield, it exhibits clear potential for premium growth. WHSmith: this stock has performed extremely well, driven by its Travel segment and high street stores. The company has paid a number of special dividends, and as a
Getting the right mix RL UK Growth
RL UK Equity Income
consequence of its higher yield, is held in the Income Fund. Dunelm: With a dividend yield of 4%, this homeware stock is held in both Funds, as it still exhibits strong capability for dividend growth. The company has a strong position on account of its low-cost property portfolio, and is wellplaced for the shift towards online shopping. Tesco: this company is not held in either fund. We believe it continues to face strategic challenges, being part of the ‘squeezed middle’ between value and high-quality. It has lost market share in recent years and has structurally low profit margins. Conclusion Focussing on dividends and dividend growth, and their role in compounding returns, is crucial. Despite macroeconomic uncertainties, there are still strong companies to be found, and active stock selection and analysis therefore underpins both our Equity Income and Growth funds in their aims to generate sustainable, 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. The views expressed are the manager’s own and do not constitute investment advice.
10 | LEADING EDGE | APRIL 2017
Small Cap Investing The hunt for undiscovered gems
Henry Lowson Senior Fund manager
Henry Lowson, lead manager of the RL UK Smaller Companies Fund, argues that the UK smallcap market remains a compelling proposition in the post-Brexit world, and reveals RLAM’s approach to identifying the best value and growth opportunities from this broad opportunity set.
Graphite or diamond? With Brexit uncertainty abounding, 2016 was perceived to be a tough year for UK small caps. Although the much-anticipated slowdown in UK growth never materialised, the impact of sterling weakness following the ‘Leave’ vote had a mixed impact on UK equity market indices. Companies with overseas exposure benefitted significantly from the effect of weaker sterling, while domestically focused counterparts lagged by comparison. With 45% of sales outside of the UK, small caps were not left out in the cold, and 2016 was ultimately a positive year for the smallcap sector, despite its relative lack of exposure to large pharmaceuticals and oil-price sensitive commodity stocks which performed well over the year. The FTSE Small Cap ex-Investment Trust Index ended the year roughly 12% higher*. Crystallisation of growth The UK small-cap sector has consistently outperformed the broader market over the longer term, but is out of favour with investors, having experienced significant outflows in recent years as global mandates have grown in popularity. We believe companies in an early stage of development offer significant earnings growth potential in comparison with much of the wider market; the best examples have motivated, incentivised management teams and a more entrepreneurial approach. Valuations continue to be attractive in both absolute and relative terms, due to investors’ current preference for other mandates. The sector has also benefitted
from increased merger and acquisition activity in light of higher UK growth and ongoing low interest rates. As firms seek to control costs by cutting back on analyst coverage of small caps, it is increasingly likely that we will see more mispricing in the market and, with a potential universe of 1,200 stocks, there remain plenty of opportunities to discover potential hidden gems within the UK small cap sector. Hunting for gems: Accesso Take Accesso for example, a software solutions provider for attractions and entertainment venues with a broad and distinctive product offering, including commission free e ticketing and queuejumping solutions. This company exhibits many of the qualities and drivers of growth that we look for in small-cap companies. It has a strong position through long term contracts with some of the world’s top attractions. It also has a clear innovative edge: using patented technology. This company is held in the Fund because we believe it to be well-placed to generate both organic growth and to undertake acquisitions, having expanded into the global market. Further, the company’s new management has renewed its focus on sales. A sparkling small-cap future We invest, rather than trade: each stock in our Fund is generally held for three to five years, enabling the Fund to benefit from compound earnings growth, rather than chasing shortterm gains. Instead of attempting to predict
the market, we take a stock-specific approach, using a qualitative and quantitative approach to identify companies with characteristics that add value. We look at a combination of top down thematic factors (e.g. regulation, economic and industrial trends), and bottomup fundamentals (e.g. balance sheet strength, cashflow and management quality) in order to assess whether current valuations reflect a company’s true potential. We also place a high importance on meeting with company management. Our specialist analysis, commitment to quality and focus on longterm drivers of growth enable us to take advantage of the mispricing opportunities that result from the small-cap sector’s low analyst coverage and current unfashionable status with investors.
*Source: FE, total return in GBP as at 31.12.2016. 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. 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.
APRIL 2017 | LEADING EDGE | 11
The artificial intelligence revolution
ines
mach e h t f o e s i The r
Head of Sustainable Investments, Mike Fox, looks at what we mean by Artificial Intelligence, its implications for society and the case for its inclusion within a sustainable investment strategy.
Hal and the Hoff Many of us will have first come across Artificial Intelligence (AI) in science fiction: the eerie, calm voice of Hal, the spaceship’s rogue computer from 2001: A Space Odyssey, or the friendlier car-based supercomputer, KITT, from Knight Rider. Having made the leap from our books and screens into our lives, ‘voice’ remains a common feature of AI, tapping into childhood dreams of owning our very own KITT, as shown by the popularity of Amazon Echo’s voice-controlled personal assistant, Alexa. Learning intuition To date, the greatest strides in AI have been made by building computer algorithms capable of analysing vast amounts of data and identifying patterns that a human brain could not, and then learning from these. Many hedge funds use this type of AI to analyse market data.
Mike Fox Head of Sustainable Investments
But increasingly, AI is also replicating human behaviours and thinking: Google’s ‘AlphaGo’ beat top human players at the board game Go, while Carnegie Mellon University’s ‘Liberatus’ system trounced four of the world’s poker champions. These victories mark a new milestone in AI as neither game can be won using computation alone – there are more possible moves in Go than atoms in the universe, and rationality is of limited use in poker. In order to win, the systems had to use intuition and learn how to bluff. Faster, faster Rapid advancements in AI have been driven by the same improvements in computing power that mean we can all now carry a supercomputer in our pocket. The dramatic increase in smartphone usage has contributed to another driver of AI: the data explosion. By 2020 there will be eight times more data in existence than in 2015. With private sector technology companies spending more than ever
before on research and development, the pace of development in AI looks set to accelerate. Kill or cure? Prominent figures such as Stephen Hawking, Bill Gates and Elon Musk, CEO of Tesla, have all publicly voiced concerns that AI poses an existential threat to mankind - if not now, then at some time in the future. RLAM’s view is that technology is, on the whole, a socially positive force and that AI development is beneficial insofar as it is undertaken in pursuit of specific societal improvements. There is clear evidence of this in healthcare where, as well as improving patient care, AI is being used to develop systems that monitor data from the human body to diagnose illnesses before symptoms are manifest, improving treatment outcomes. Elsewhere, use of AI in the industrial sector has helped firms to increase efficiency of their assets within plants, and to reduce waste, bringing environmental benefits. AI and sustainable investment Owing to predominantly negative depictions within popular culture, AI is still viewed with distrust and fear by many. However, to date the societal benefits of AI have been considerable, and we believe the benefits will be even greater in the future. Despite its early stage of development, AI is a highly investable theme, well suited to Royal London’s Sustainable Funds. Amazon, Google, Microsoft, IBM and SAP are held in the Funds as they are excellent examples of the type of companies we like to invest in: stable, well-managed yet innovative companies, whose products and services contribute to society, and which offer long-term value and growth potential. 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.
12 | LEADING EDGE | APRIL 2017
Quality not convenience
Martin Foden Head of Credit Research
Rachid Semaoune Senior Fund Manager
Corporate bond investing
While monetary policy support and record-low government bond yields grabbed the headlines over the past year, the real impact upon corporate bond investors has largely been overlooked. Fund Manager, Rachid Semaoune and Head of Credit Research, Martin Foden, discuss the challenges that have characterised credit markets over the last 12 months, and how RLAM’s investment process enables them to take advantage of the opportunities that have arisen in order to continue to generate income across portfolios. The income challenge Credit spread compression was a significant feature of 2016: the difference in yield (the spread) between corporate and government bonds narrowed markedly, and remained very low, even once government bond yields began to rise. Credit investors have therefore faced lower yields on corporate bonds, and have therefore been compensated less for the additional risk taken for investing in corporate, as opposed to government, bonds.
Average credit spreads
180
Euro spread Sterling spread
170 160 150 140 120 110 100 90 80 70
Source: RLAM as at 28.02.2017
b1 7 Fe
n1 7 Ja
c1 6 De
16 No v
t1 6 Oc
p1 6 Se
g1 6 Au
l1 6 Ju
n1 6 Ju
y1 6 Ma
r1 6 Ap
r1 6 Ma
Fe
b1 6
60
APRIL 2017 | LEADING EDGE | 13
Blurring the boundaries
Convenience creates inefficiencies
Quality across all portfolios
The primary driver of this spread compression has been the corporate bond purchase programmes undertaken by the European Central Bank and Bank of England. This broad-based buying has artificially compressed yields on affected corporate bonds, regardless of the bonds’ characteristics. This has led to a ‘convenience’ market, where investors can buy bonds in the knowledge that they are supported by central bank purchasing programmes.
The more inefficient the market, the more opportunities we can find as active investors. There are many sources of market inefficiency in addition to central bank actions, such as credit ratings, regulation and market preferences for benchmark indices. Investors will often look for a ‘convenient’ solution, but we believe that buying into market trends leaves investors exposed to unrewarded risk, and the danger of a sudden reversal.
We adopt the same approach to credit analysis and active management in all our credit funds, and this is just one example of the many opportunities that we aim to uncover as active investors. As market inefficiencies increase, we believe the best way to generate long-term returns in our portfolios across the credit spectrum is by leaving ‘convenient’ investment solutions behind and instead looking for opportunities in more specialist areas, where we have a high level of research experience.
Consequently, pricing has ceased to reflect the fundamentals of bonds, and has instead been skewed by monetary policy. The differentiation between bonds that should be reflected in their yields has been removed by exogenous factors. For active investors, this indiscriminate approach to investing creates clear inefficiencies, of which we are able to take advantage, using our stock-specific approach to analysis.
We employ a stock-specific approach across all our portfolios to identify opportunities that are off the broad market radar. As an example, the table below shows three different bonds from the university sector, ranging from a high-rated, unsecured bond to the more complex amortising issue, secured on university accommodation. These examples show that the ability to analyse more complex bond issues and the flexibility to look for off-benchmark opportunities, including unrated bonds, means it is possible to find higher yielding investments without compromising on quality.
A higher yield from higher education Issuer
Structure
Rating
Credit Spread
A
Unsecured
AA
0.7%
B
Unsecured
N/A
+1.2%
C
Secured/Amortising
A2
+5.4%
Source: RLAM as at 28.02.2017
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.
1. 2%
1.2%
%
%
1.2
1.2% 1.2
% 1.2
1.2%
Bonds in 2017 Stick or twist?
1. 2%
1. 2%
14 | LEADING EDGE | APRIL 2017
Head of Short Rates and Cash, Craig Inches and Senior Credit Fund Manager, Paola Binns look at the case for corporate bonds for income generation and why investors seeking to protect capital should now ‘twist’ into short duration funds.
Counting cards Following an extended period of deflation and low growth, strong economic data has brought optimism back to markets, along with expectations of higher inflation. Against this backdrop, bond yields have begun to rise and curves have generally steepened. However, as Brexit looms large over the UK, concerns about a slowdown in domestic growth have offset the broader upturn in sentiment, and the UK bond market has bucked the trend, with yields lower and the yield curve flatter compared with 12 months ago. Given the upturn in global growth and inflation, we expect yields to rise in 2017. As shorter duration bonds are less sensitive to yield movements than longer duration bonds, the best way to protect against capital losses in this environment is to adopt a short duration position. But with short-dated government bonds currently yielding very little and inflation expected to rise to around
2.7% this year, how can investors protect their capital and continue to generate income? Holding your nerve Offering 1.2% additional yield over equivalent government bonds at the time of writing*, corporate bonds are a natural choice for investors seeking to diversify and maximise income. Default risk is often cited as a primary concern of prospective investors, but even during the worst period of the 2009 financial crisis the default rate in investment grade bonds was only 0.63%**. Our approach to corporate bond investing prioritises value and security, aiming to exploit market inefficiencies to maximise income in a risk controlled way. One example of inefficiency is the fact that investors often pay a premium to invest in a more liquid bond. However, during periods of market stress it may actually be as difficult to sell an apparently liquid bond as to sell a less liquid
one. Other market inefficiencies include an overreliance on benchmarks, and an emphasis on credit ratings, which only look at the default risk of a bond, which we consider to be an incomplete assessment of overall risk. By selecting bonds that offer protection through their structure or specific covenants, we seek to enhance income security by improving the chances of recovery in the event of a default. A favourable hand Delamare Finance’s secured 2029 bond, held in the RL Short Duration Credit Fund, exemplifies this approach. Delamare Finance is a special purpose vehicle (SPV) whose cashflows are derived from properties leased by Tesco. The bond carries similar credit risk to an unsecured Tesco bond. However, compared to the Tesco unsecured 2023 issue, the Delamare Finance bond benefits from the additional security of a first claim on tangible property assets and a yield almost 2% higher.
Craig Inches
Paola Binns
Head of Short Rates and Cash
Senior Credit Fund manager
APRIL 2017 | LEADING EDGE | 15
1.2%
1.2% 1.2% Don’t be a high roller
BB+
BB+
Security
Unsecured
First fixed charge on property
Spread
2.4%
4.1%
Yield
3.3%
5.2%
Source: RLAM as at 24.01.2017
Market favours familiarity over credit enhancements
1.2%
Credit Rating
*Source: RLAM as at 31.03.2017. **Source: Moody’s annual default study 2016. 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. The views expressed are the manager’s own and do not constitute investment advice. Sub-investment grade bonds have characteristics which may result in a higher probability of default than investment grade bonds and therefore a higher risk.
1.2%
1.2%
1.2%
£369m
1.2%
£389m
1.2%
Size
1.2 %
Delamare Finance PLC 5.5457% 2029
Investors who have chosen to ‘stick’ in longer dated bonds have enjoyed exceptionally strong capital returns over the last three years, but against a backdrop of potentially rising yields, and ongoing political risk, we think it’s time to ‘twist’ into shorter duration assets. Offering the highest level of total returns per unit of risk of all our Funds, the RL Short Duration Credit, Short Duration High Yield and Enhanced Cash Funds help to protect capital gains while continuing to maximise total returns in a risk-efficient way*. Their short duration shields against rising rates and volatility, while the Funds benefit from the enhanced protection afforded by our focus on value and security.
1 . 2 %
Tesco 5% 2023
1.2 %
Market inefficiencies – Security and rating
16 | LEADING EDGE | APRIL 2017
Green lights all the way?
Trevor Greetham Head of Multi Asset
GMAPs: Your route to investor outcomes As the RL Global Multi Asset Portfolios (GMAPs) celebrate their one year anniversary, Head of Multi Asset, Trevor Greetham, outlines the importance of diversification and a robust investment process to building multi asset portfolios.
A smoother ride Multi asset investing seeks to offer less volatile returns through diversification. As can be seen in the table below, asset class returns have varied greatly over the last 10 years, and there is no discernible pattern.
To maximise returns, it is necessary to take a forward-looking approach in order to identify which asset classes are likely to do well or badly, and when, and to use the principles of diversification to combine these to achieve better risk/return ratios.
A smoother journey
Source: DataStream, Total returns in sterling terms. YTD return as of 31 December 2016
APRIL 2017 | LEADING EDGE | 17
Industrial Metals
RECOVERY
OVERHEAT
UMER DIS ONS CR &C ET IO
REFLATION
COMMODITIES
BONDS
CASH
O
M
,S
S IE
TA P
IT
Government Bonds
STOCKS
CE N
Softs
FIN A
Corporate Bonds
▼
GROWTH MOVES ABOVE TREND
▼
LOGY & INDUSTR NO IAL CH S TE Y AR N
▼
However, it is important to note that while we believe that our models and templates are a good guide, we do not stick to them
INFLATION RISES
C
Respecting other drivers
The Investment Clock
LE
The next stage of the TAA process consists of fundamental analysis: establishing the current stage of the business cycle, based on monetary policy and other macroeconomic and political factors. From our reading of the tactical models and fundamental analysis, we create an implementation template, which sets out asset and geographic allocation.
For example, despite the business cycle having been in ‘overheat’, for a number of
TE
Our active TAA process consists of a systematic, research-led framework overlaid with experience and judgement. Based on quantitative models that simulate the added value that different asset allocation strategies have achieved since 1992, our Investment Clock model shows which asset classes tend to perform well, and which are likely to struggle, during the various stages of the economic cycle, which is driven by growth and inflation. For example, according to the Investment Clock, stocks tend to perform best during periods of ‘Recovery’, when inflation is weak but growth is improving, while commodities tend to perform well in the ‘Overheat’ stage, when growth is strong and inflation is rising. Back-testing of the investment clock over a 40-year period shows that the theory is been borne out in real-life.
From a multi asset perspective, we believe there are three main drivers of global markets in 2017. Firstly, growth and inflation pressures are building, while central banks are maintaining low interest rates. This is an environment which favours stocks over bonds. The second driver is the ‘lone hiker’ scenario: the Federal Reserve is the only central bank
IALS & ENE TER RG MA Y
Mirror, signal, manoeuvre
Current driving conditions
slavishly. Perhaps the most important part of the process is relying on our team’s collective expertise and experience to identify and take action where there are market or economic factors that may impact our models in an unexpected way.
LES
, H E A LT
R HCA
Precious Metals
E&
UT
IL
High Yield Bonds
▼
Energy
InflationLinked Bonds
GROWTH MOVES BELOW TREND
Our multi asset investment process combines strategic and tactical methods. Using strategic asset allocation (SAA), assets are allocated with the aim of maximising long-term returns according to a Fund’s return goals and risk tolerance parameters. SAA ensures the Funds are diversified across an efficient mix of return-seeking assets such as equities and property, and assets that are resilient to shocks such as gilts, while avoiding exotic or expensive investments. We then use active tactical asset allocation (TAA) to add value over the short to medium term by moving money towards assets that we consider currently to be attractive in relative terms. Using this combination of SAA and TAA, our GMAP funds seek to offer equity-like returns for a fraction of equity volatility over the long term.
STAGFLATION
INFLATION FALLS
As at 31.03.2017
months, we have only just recently moved to an overweight position in commodities as, despite strong ‘buy’ indicators from our models, significant US dollar strength is a headwind for commodities. However, commodities have proved resilient in the face of continued dollar strength, and supply and demand fundamentals are improving. We are overweight stocks versus bonds. European stocks tend to do well when the world economy is strong but we have held an underweight position in Europe since Brexit, owing to political risk. However, we continue to monitor the political outlook in Europe, and may close our underweight if an intensification of political nervousness causes a dip in the market. We are overweight Japan and we are underweight US and Europe. We are positive on the US and commoditysensitive Australian dollar versus sterling, the euro and yen.
to be raising rates. This is good for the US dollar and strong dollar beneficiaries, such as Japan. Finally, political risk will create opportunities to buy during this extended equity rally. Despite some recent cooling, while global monetary policy stays generally loose, we believe stocks still have further to climb. Arriving safely at your destination The GMAPs benefit from the actuarial rigour that comes with Royal London’s multi asset heritage and Trevor Greetham’s strong performance record and could be well suited to investors seeking smoother returns across a number of economic scenarios. The range aims to maximise real returns within an appropriate risk level. By combining robust SAA with research-led TAA and judgment, we aim to map a smooth journey towards improved outcomes for investors.
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. The views expressed are the manager’s own and do not constitute investment advice.
18 | LEADING EDGE | APRIL 2017
Mind the gap Liability aware investing Credit Fund Manager, Shalin Shah, and Head of Liability Driven Investment, Nick Woodward, consider the liability matching challenge facing UK pension schemes today and explain RLAM’s intelligent approach to liability aware investing, which focusses on the long-term sustainability of cashflows.
Reduced service UK defined benefit pension schemes are facing an income problem. In an environment of ultra-low yields, deficits have swollen at a point when many schemes are cashflow negative, with retirees now constituting around 40% of the membership of a typical UK scheme. With most defined benefit schemes over 50% invested in bonds, pension trustees need to consider new ways to generate income if they are to avoid being forced to sell assets at potentially lower prices to meet income needs. An automated, onesize-fits all approach to long-term liability matching is clearly no longer optimal. Buckled tracks
Shalin Shah
Credit Fund Manager
Nick Woodward Head of Liability Driven Investments
At RLAM, we believe credit cashflow matching offers a solution. Our credit investment philosophy is based on the premise that there are fundamental, longterm inefficiencies in credit markets, such as overreliance on bond indices and risk ratings, the emphasis on liquidity and an undervaluing of security. Solvency II, the proliferation of smart beta and exchange traded products (ETFs) and, more recently, central bank monetary easing, have introduced distortions into
bond markets, increasing demand for lower-risk assets and assets that lie within benchmarks. The robotic approach taken by some managers to liability matching has contributed to these distortions, driving demand for bonds of specific maturities (particularly long-dated index linked gilts), resulting in identikit portfolios that are skewed towards a small basket of assets and are poorly diversified. Our approach seeks to match cashflows and to take advantage of, rather than contribute to, these market distortions and inefficiencies in order to generate sustainable income. Safety matters We start our process by considering the characteristics of each bond and selecting those that offer the highest level of cashflow security, whether in the form of covenants or through their place in the capital structure. We look beyond credit ratings, which reflect only the likelihood of default; our active credit research considers a much broader range of factors, including the level of recovery of a bond in the event of default. This flexible, unconstrained process gives us access to a broader opportunity set, allowing us to seek higher income without compromising on quality or incurring a significant increase in risk.
APRIL 2017 | LEADING EDGE | 19
“
RLAM’s liability-aware portfolios offer a diverse, predictable solution for pension funds seeking to generate higher income with long-term cashflow security.
”
In motion The AA’s callable 2025 (2043 maturity) bond is a good example of the benefits of analysis and flexibility. AA is dominant in its sector, with a bias towards debt reduction, and this bond features attractive covenants. Under these covenants, the company cannot pay dividends if its debt to earnings ratio exceeds a specified level; it is also not allowed to pay a dividend during the 12-month period prior to maturity. The bond is highly likely to be called in 2025, as, if it is not, bondholders gain control of the cashflows. However, the bond remains out of scope for buyers constrained by Solvency II, as its final maturity is 2043. Whilst offering numerous protective covenants, the bond has a spread of 2.2%, 100 basis points wider than a typical investment grade credit bond*. Planning the route In building a cashflow aware fund, RLAM’s process considers the defined period of cashflow liabilities (for example 10). We draw from our pre-screened universe to select bonds that provide coupons and capital repayments over the defined period, beginning by matching the longestdated maturity and plotting
how the cashflows during the lifetime of the bonds contribute to the cashflow liabilities over the defined period as a whole. We then repeat this exercise for the penultimate maturity bucket, and so forth, until we have matched all the cashflow liabilities for the defined period. Developing a cashflow matching strategy 8 7
>150 bonds
6 5 MILLIONS
We believe credit benchmarks are the wrong starting point when seeking to build a secure bond portfolio, as they are essentially a list of the most indebted companies. As active managers, we analyse a broad range of off benchmark bonds and buy these where they satisfy our mandate requirements and thorough analytical screening.
>40% Secured
4 3 2
<30% BBB
1 0
2017
2018
2019
2020
Telecommunications Banks & Financial Services Supranationals & Agencies Consumer Services
2021
2022
2023
Real Estate Structured General Industrials Social Housing
2024
2025
2026
Insurance Utility Covered Liability Cashflow
<10% financials
Source: RLAM, for illustrative purposes only
Flexible ticket RLAM’s liability-aware portfolios offer a diverse, predictable solution for pension funds seeking to generate higher income with long-term cashflow security. For investors looking for exposure to a broader range of assets, our approach to cashflow matching can be expanded to include government bonds, derivatives and unrated bonds, while retaining the same pre-screening method and focus on long-term sustainability of cashflows.
*Source: RLAM as at 31.03.2017. 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. 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.
The Future and what to do about it Mark Stevenson, Futurologist and guest speaker at RLAM Investment Conference Mark Stevenson talks about the future. This is not as a series of predictions - so called ‘futurologists’ are often wrong. Instead Mark and his network of thinkers focus on becoming ‘future literate’, which is about asking the right questions, and preparing for developments which we can see happening today that are likely to reshape, if not completely redesign, our future. From driverless cars to petrol created literally out of the air, technology is not only all around us, but doing what would have less than a decade ago been thought impossible. For industry leaders, looking at how disruptive technology will affect their business, and planning how to adapt to embrace these developments rather than be subsumed by them, is vital. In the same way that the internet ripped apart the Yellow Pages and digital technology unwound video cassettes of Blockbuster, firms today that are built on materials or technology that are already being challenged by newer, cleaner, more efficient versions, need to ask how they are going to change in order to survive. It is not only companies that need to be future literate: countries have to ask these questions, too. While the US and Russia are propping up the rusty scaffolding of their petro-state structures, Saudi Arabia, sitting on top of some of the world’s most plentiful oilfields, is making a transition over 20 years to reduce its dependence on the black gold. As former oil minister Sheikh Ahmed Zaki Yamani stated, “the stone age did not end for the lack of stone.” The economic map of the future is already being redesigned. Mark also discussed the new definition of wealth: it’s not just the assets under control, but the power, influence and ability to make things happen that come as a consequence. For many who work in large firms that, often unwittingly, are on the precipice of extinction by new, powerful technologies, it is difficult to ‘understand’ when your salary and position depends on ‘not understanding’. Change requires action and the innovations we are witnessing now are not just going to go away – they will make the industrial revolution look like a storm in a teacup. For everyone, not just as investors, but as human beings, taking the future seriously is critical. While arguably many of our economic and social institutions are no longer fit for purpose, we have the tools, technology and talent to remake the world. It will get messy, but preparing for, enjoying and benefitting from positive changes requires us to be brave, rather than burying our heads in the sand. It’s time to write the new music, not to dance to the old tunes.
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: leadingedge@rlam.co.uk
Financial promotion issued by Royal London Asset Management November 2016. 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 subfunds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland. Ref: N RLAM ON 0005