Question the Committee – Edition 5

Chairman’s Note

I’d like to start by thanking you all for your questions and engagement. With the last six months encompassing some of the best and worst periods for investment markets in over a decade, this year’s edition comes at an extremely interesting time. As such we have tried to select questions which cover a broad base of content. From geopolitics to new idea generation, we hope this has a bit of something for everyone.

Winning Question:

How much do you expect your strategy to change if we leave without a deal?

Good question and very topical at present. After the second extension on 12^th April, our view on the UK changed considerably as it became apparent that Parliament was now so divided that the chance of achieving an appropriate compromise (even in the next 6 months) had fallen significantly.

We therefore reduced our UK exposure in favour of opportunities overseas, and as the portfolios sit today, they would perform strongly should the UK economy deteriorate or a no-deal outcome be achieved (mainly due to the likely currency weakness, therefore boosting the returns on overseas holdings).

However, whilst the outcome itself doesn’t concern us with respect to short-term performance, it would no doubt create significant opportunities in certain areas. We would look to be extremely active around such an event, and therefore over the following six months you would no doubt see our strategy change, but the exact changes would depend on how markets react.

A Selection of Others:

Are you concerned that a recession could come sooner rather than later and how do you prepare for such an event?

We pride ourselves on our ability to protect clients’ capital in challenging markets. As such, the risk of an economic recession is always high on our agenda.

The two parts to our investment process are top-down (macroeconomic analysis) and bottom-up (idea generation). The former involves ongoing in-depth analysis of economic growth prospects and the risks to that. We combine both quantitative (monitoring various data points for trends) and qualitative (views from who we consider are the top-economists in our industry) inputs, to produce a macroeconomic view of the world, the key challenges to that and a set of criteria to watch to identify when it is changing.

Moreover, our bottom-up process has resulted in a winners list of best-ideas, many of which are only applicable in certain market environments. We spend a lot of time discussing what we would do in certain scenarios, such as the next recession, and are pleased to note that we have a variety of ideas that should benefit in such an environment.

In summary, we have a diligent top-down process to identify and pre-empt risks such as this, and have a bank of ideas we would implement to ensure clients’ capital is well protected. However, it is important to note that we do not believe a global recession is imminent, with our central case being that growth remains low but positive over the short to medium term.

What mistakes did you make in 2018?

It is always good to review both your good and bad decisions. In fact, it is something we integrate diligently within our investment process in order to improve the way we operate and reduce the chance of similar mistakes being made in future. In 2018, two are worth noting…

Firstly, we over-allocated to Emerging Market Bonds in quarter one. Fundamentally the decision was correct, but the timing could have been improved and it caused unwanted volatility in February and March. Secondly, in Q4, we added to equities too early, with markets continuing to move lower before subsequently rebounding. In both cases the ideas ultimately added-value, but we didn’t maximise the benefit of the decisions due to timing.

Consequently, we have reviewed and altered our execution policy in 2019, hopefully demonstrating our commitment to consistently improve our processes.

Why is Trump fuelling a trade war, and how do you think the current negotiations with the Chinese will end?

There are two main reasons why Trump is pursuing such a policy. For those who followed his election campaign back in 2016, you will remember his slogan “America First”. Despite being the largest economy in the world and at the forefront of globalisation, he was elected on promises such as these. By showing the world how tough he can be on China, he is pleasing those who voted for him, in what is ultimately an attempt to be re-elected in 2020.

Secondly, Peter Navarro is currently the Director of Trade & Manufacturing Policy for the US administration and is also Trump’s advisor on trade. Navarro is perhaps most well-known for his book “Death by China” and subsequent film of the same name where he outlines the need to stop Chinese trade. With this kind of ideology heading up the National Trade Council, it is clear to see why Trump is taking such a hard stance on trade with China.

With regards to the negotiations, the events of the recent weeks, where China were found to have removed key segments of the trade deal document, was viewed as a reversal on key agreements in the talks, causing Trump’s reaction to increase tariffs on Chinese goods. While in the short-term this has created some volatility and uncertainty, we still believe that in the long-term a deal will be struck between the US and China.

There are two reasons why our view hasn’t changed. Firstly, Trump needs a trade deal if he stands any chance of being re-elected. Without one he will be viewed as a failure on trade policy (one of the key elements of his election campaign) but also this will have a negative effect on the US stock market, which the US electorate is very sensitive to. Secondly, China also needs a deal to succeed in their objective for their economy to be the largest and most powerful in the world. So in both cases, with the uncertainty created by a trade war, puts a severe roadblock in the way of them achieving their goals.

Which holding has performed the strongest since the start of the year?

It has been a really buoyant start for equity markets, with our holding in Fundsmith Equity producing the strongest performance so far. At the time of writing it has produced a return of 19.78% in 2019, vs its benchmark the MSCI World at 12.90%.

Pleasingly, this is a core position that is held across the portfolio range at a good weighting, and you are always looking for your highest conviction ideas to provide the greatest impact.

What contingency is being considered due to, and what are the implications of, a Labour government?

A labour government in our view would cause a market environment that is extremely unusual, with UK equities and UK government bonds (opposite ends of the risk spectrum) both losing value at the same time, as investors become concerned about unsustainable debt levels and therefore lower long term growth.

In accordance to the discussion around our investment process above, this is another risk that is heavily on our radar. One way to ensure we are not overly exposed is to diversify globally. As an example, 66% of our Medium Risk Portfolios equity allocation is invested overseas, and we hold a near zero weight in UK government bonds. Moreover, the level of diversification we have across the portfolio range gives us confidence that they will perform strongly whatever party is in power.  

However,  despite these structural protections, we have still debated this outcome at length, and noted how we would change the portfolios should it occur; reducing specific positions that would be impacted to a greater extent, and further titling the overall mix tin favour of overseas opportunities.

Should investors pay fees when negative returns are produced?

Investment fees should be related to:

– the production of long term risk-adjusted performance above or in line with objectives, and;

– ensuring your portfolio remains invested in line with your risk profile

Within any market cycle there will always be years where returns are strong, and years where returns are poor. In both environments it is possible to add significant value, either by losing less when things fall, or by gaining more when they rise. Moreover, we generally work harder when things are tough in order to take advantage of the opportunities created. Last year was a great example of that, where a lot of the work we did in Q4 has caused the strong performance since the turn of the year. Taking a longer term horizon to assess the value added is therefore extremely important.

The second point is also underestimated though. Risks change frequently, and having the expertise to diversify and seek out alternative sources of risk and return is a rare commodity. Even in years where markets are challenging, ensuring your portfolio remains invested appropriately should mean that your objectives can still be met, which is the reason we invest in the first place.

Finally, under the alternative scenario where fees are only paid in positive years, the incentives to produce performance become very short-term (as we would be focussed on each year in isolation), potentially leading to an elevated level of risk taking. Therefore, providing both the above statements are consistently achieved over the long term, annual fee structures are the best way to align incentives and ensure we are working extremely hard for you (and have the chance to add value) whatever the market environment.

How do you go about finding new ideas and can you give an example of a recent one?

Predominately new ideas are generated through our quarterly investment process. Prior to every quarterly investment meeting, our proprietary quant screen is run for every sector in the Investment Association universe to assess our current holdings, winners list options, and new potential opportunities. Once a new fund has been identified a meeting will be organised with the fund manager to run through the qualitative aspect of our research process. Then a research note is written up on the prospective funds with a recommendation as to whether the fund is a potential new holding or not investable.

A recent example would be the M&G Listed Infrastructure fund which was introduced to the portfolios in April 2019. This fund was found through some quant research on the infrastructure sector in late 2018. Further digging identified a USP in this mandate and it was subsequently added to the portfolio once our due diligence was complete. In the short time since it has been in the models, the fund has performed strongly, which is pleasing.