The Investment Committee

24th February, 2017

IC Insights

Question the Committee: Edition 3

Chairman’s opening remarks:

I would first like to say thank you again to all those who submitted their questions for this edition. We received more than ever, making it a tough task to filter them down to a final 10. The current world around us is practicing short-termism on an increasing scale, and in our industry that revolves around performance numbers. Whilst these are absolutely vital, it is important to remember how and why we got there, and hence the winning question on this occasion nicely reflected the dynamic between investment process and outputs.

A process is only as good as the team behind it, and our team continue to grow from strength to strength. Just recently we added a new member to the IC in Declan Gamble (hired for his surname of course, which more aptly reflects our higher risk mandates); an economics graduate with a real flair for understanding how asset classes correlate together. This is one of many skills which are required to run risk-focussed portfolios where downside protection is paramount… and with that, I hope you enjoy Question the Committee.

Winning Question:

Whilst currently living in Europe we may look at the UK, Europe and the world somewhat differently to UK inhabitants. I can see we use Standard Life as our overall umbrella investment vehicle. What is the criteria that the IC uses in looking at new funds that come to market? How do the IC account for UK growth forecasts when the “prescribed Wisdom” post Brexit was that the UK would be a disaster? And how does this effect the investment criteria?

Great question. A successful investment mandate is built around a combination of process and judgement. To that end, it is an art as well as a science. In this example, our criteria are the process, and our adjustment for UK growth forecasts is the judgement.

With respect to new funds coming to market, the IC utilise a proprietary fund matrix (a very large spreadsheet) that allow us to evaluate funds across more than 30 criteria. By running set filters (which vary depending on the objective of the funds we are looking at) we can reduce the universe down to a shortlist that are of interest. Before we invest in any fund we require at least one meeting with the fund manager and over time we have developed a library of research notes covering more than 200 funds, of which 60 we believe to be “best-in-class”.

Concentrating on a certain sector, say UK equities, we then aim to identify funds that will perform strongly in different environments e.g. those that protect capital better when markets sell off, and those that will shoot the lights out if the economy is very strong.

Now we have to integrate our judgement about the UK growth forecasts you elude to… do we think they will be higher than market expectations or lower? Depending on the answer, this will direct us to decide which fund to implement.

If you had £100k in the bank what would you do… Pay off mortgage or invest?

The mathematical answer is rather simple; which number is bigger… the return you expect on your investments or the interest on your mortgage? Therefore, in a world where you have no preference over paying down debt and attitude-to-risk doesn’t matter, we would normally say invest because our return targets will be higher than most people’s interest rate.

However, in reality there are a lot of important factors to consider and the answer will highly depend on your circumstances and objectives. For example, people who are relatively risk averse should prefer to reduce risk by paying down debt, rather than increasing it by investing further. The emotional points are important as well – would you feel more secure if your debt was lower? How would you feel if the investment didn’t work out? How does this affect your position further down the line? In summary, to make the most informed decision, your preferences should be considered alongside your wider financial plan.

Obviously no guarantees are made but there is an expectation that a certain fund will provide a particular return when averaged out over a period of time. With lower risk funds there is usually a higher amount invested in bonds and savings but a lesser amount in equities (relative to higher risk funds). Does this mean that the rate of return on lower risk funds is likely to be significantly influenced by interest rates particularly when long-term trends kick in? For instance, rates for the last 5 years or more have been exceptionally low by historical standards. In contrast there was a period in the 1970’s when rates were very high for some years. So would a fund that ‘traditionally’ returns 5% historically be expected to return less in current conditions and more if exceptionally high conditions occur again? Or does the balancing of investment assets mean that there is little effect on the long term average? 

This is a very good question. If interest rates rise back towards long term trends, then the more defensive assets such as bonds will struggle. In contrast, a rising interest rate environment usually means the economy is doing better and therefore aggressive assets such as equities do better. On this basis, to answer your question, a defensive bond fund that historically returned 5% should return less if interest rates rose substantially. A very good example of this has been the performance of US government bonds in the last six months of 2016; they offered a negative return as US interest rates rose.

However, it is important to note that there are defensive assets that can mitigate this risk. Certain bonds completely protect you from rising interest rates, so finding these ideas at the right time is important (this is where we come in). In addition, using a “portfolio” approach allows you to hold different things that do well at different times. If we believe interest rates are a risk to some lower risk assets, we can tilt our approach to stay away from these areas and allocate elsewhere.

To that end, having a diligent process whereby you identify the key global risks and adjust your allocations accordingly is vital over the short, medium and longer term. Irrespective of our outlook for interest rates then, we still maintain the same 3%-5% return target for our Low Risk Portfolio over every rolling five-year investment horizon.

For several years, the journalists and ‘’guest columnists’’ in the financial and your money sections of the popular press, have been advising readers ‘’switch and fix your mortgage now, before interest rates rocket’’. This has been an almost constant theme on a regular basis. Could the committee provide their opinion on a theory of mine: These journo’s and guest writers have a vested interest, directly or indirectly, in trying to obtain business, commission or fee, by attempting to persuade the public to fix/switch. There has been no factual, historical ,empirical or any other data to support their interest rate hike theory. Inflation ,wage increases and global growth have been steady and controlled by monetary policy. The journo’s appear to be deliberately trying to drum up business.

Why are we bombarded with scaremongering advice, which is unfounded? Does the committee concur? Oh, by the way, can you advise when interest  rates will rise?

Whilst we can’t comment on whether journalists have a specific agreement to drum up business on fixing/switching mortgage rates, we do agree that there exists an awful lot of “noise” in the media that is counterintuitive and/or poorly supported. You are right… many columns have told people to fix because interest rates are going up and they have been wrong.

Taking your point further and considering media incentives in general, we live in a world where the objective is to be “first”, not “right”. People want to sell stories and talk about things that will be read, less concerned about the validity of the view. If the FTSE is falling heavily, news shows often highlight this in detail, despite the fact that only a very small portion of the population are invested directly in the FTSE. Unfortunately, this prays on many people’s emotions and often causes the wrong decision to be made.

Going back to interest rates, offering an impartial view backed up by evidence and judgement, we have been talking about “lower for longer” for many years. Now of course, your decision “to fix or not to fix” should be based on more than a view on interest rates. How important for example is the consistency of repayment? Knowing how much is going out each month has value in itself, allowing you to plan other expenditure and removing the chance it could increase if interest rates do rise.

Focussing on the current outlook, we do not expect interest rates to increase in the UK for some time, and when they do it will be an extremely gradual move. Our central scenario is for Brexit uncertainty to loom through 2017 and 2018, with the economy growing slowly but steadily, and whilst we may be wrong, this would suggest a benign environment for interest rates. Looking further out than that and it becomes hard to predict, but look for the success of Brexit negotiations alongside UK economic growth as the key triggers.

Is the proposed Kraft-Heinz takeover bid of Unilever the forerunner in a series of approaches towards larger London listed companies which could now be perceived as relatively ‘easy pickings’, given the ongoing weakness of Sterling, after the dust has settled on the US presidential election – if indeed it actually has?

Quite possibly. The devaluation of sterling certainly gives overseas investors a discount on UK assets, although only a relatively small proportion of Unilever’s income and asset base is denominated in sterling, and therefore this would only have had a marginal effect on the value of their business for takeover purposes.

More likely this is “end of cycle” type behaviour, whereby financial officers are cautious about the economic outlook; probably due to political uncertainty; and are therefore reluctant to invest their cash in long term projects. Instead, cash is usually deployed to increase owner equity through share buybacks or to generate growth through merger and acquisition behaviour. Therefore, this type of behaviour will likely continue until we get a clearer economic picture, although I am sure the competition commission will have something to say about transactions of this magnitude.

I think you stated in the past that Neil Woodford has been used as a consultant. I note he is setting up a new fund with the aim of returning 5% income in the first 12 months. My low risk investments with yourselves have returned a very disappointing average over the last 2 years. While I understand times have been difficult, my perhaps naïve understanding of funds is that those based on income are the lower risk funds, in which case can we take Neil Woodfords advice and hope to return a more satisfying 5% at low risk over the next 12 months?

Thank you for the question – it’s always important to get feedback regarding client’s views on past returns and expectations. On your point about Neil’s new fund, whilst it true that often “income” funds are lower risk than non-income funds, the asset class that the fund manager uses to generate income is more important to risk. Neil is an equity manager, and therefore only buys and sells equities which are considered highly volatile.

The second thing we would point out is that generating 5% income does not necessarily mean you will achieve a 5% return. If you generate 5% income but your capital drops 5%, then you end up at 0%. Having said that, because income is generally seen as attractive, providing it is sustainable moving forwards (which Neil will ensure) it can be a great investment option. This is a key reason we hold the Woodford Equity Income fund (Neil’s flagship vehicle) across the model portfolio range. But it is not held at 100% in the Low Risk portfolio, because the risk to equities losing money if the UK falls into recession or France votes in Marine Le Pen for example, is high. Therefore, we blend this with lots of other exposures to generate a truly low risk profile. It would be more appropriate to compare our High Risk Portfolio to Neil’s fund, although there are still large differences.

Overriding, our central objective is to maximise the chance that clients hit their financial planning goals. To achieve this, we must invest in a range of assets that are appropriate to each risk level and can perform in various market environments. The key to this is not losing money in the difficult times, and benefiting from this protection when things improve.

A five-year cycle is the more appropriate timescale to measure performance over. Over the last five years, our Low Risk Portfolio (in which you are invested) has participated in 62% of the upside of the FTSE 100, and only took 31% of the risk. This type of trade-off allows us to achieve the target for this portfolio of 3%-5% net of all charges across any cycle, and historically we have never missed this.

The Sunday Times recently showed the performance of leading Equity Income funds over the last five years and I was wondering how the DB Wood Funds performed in comparison to these?

Unfortunately, there isn’t really a fair comparison here – our portfolios are all lower risk than the funds your article refers to. Their mandate is to hold 100% in equities, in comparison to our High Risk Portfolio which only holds 72% (and is blended with other assets, both aggressive and defensive).

What we can say is that our top fund pick in this sector has returned 83.44% over the last five years, putting it in the top 10% of all UK equity funds over that period.

Would DB Wood advise investing in Gold, Gold Coins such as MS65 Saint-Gaudens , or Platinum at this time?

We can’t advise you either way on this I’m afraid. Whilst we have held a small position in Gold within the portfolios for some time, it is used as an insurance policy against other markets struggling. Therefore, whilst clearly it is not our long term view that Gold will lose money, it must be seen within the wider context of a whole investment portfolio.

Present footsie high – should I be getting some cash from the portfolio to finance the new bathroom my wife would like?

Loved this question. Providing it is balanced effectively with longer term objectives, ultimately we always want you to spend your money on the things that bring you satisfaction. However, what we would say is don’t make the decision based on the FTSE being high. Our portfolios only have limited exposure to UK equities (lowest at the lower risk end) and therefore any market fall would not see the same downside in the portfolios. For example, based on historic data, for every 10% fall in the FTSE, our Low to Medium Risk Portfolio has only fallen 3.41%.

Your question also highlights the need for liquidity when you have objectives such as these. If you just owned buy to let properties as your investment vehicle, it may take months to realise the capital. In contrast, we can always get you your money within 10 working days.

So in short, irrespective of the FTSE, if the new bathroom is affordable within your wider financial plan… you have the liquidity… so go for it!

What things, in retrospect, could you have done better in 2016 and what have you learned from this turbulent year?

One of the core values of our business is to constantly strive to be better, and that is no different within the Investment Committee. With respect to our investment process for example, we are always looking to add efficiencies, challenging the way we work to ensure we stay ahead of the curve. To that end, we will always aim to be better this year than we were last.

2016 in particular was a difficult year from an economic perspective. Even if you had predicted the results of the key political events, you would have positioned the portfolios differently to how markets reacted. When faced with unpredictable risks, we will always choose removing our clients from the situation over hoping to benefit from the flip of a coin. So in this regard, we would not have done anything different if faced with the same situation again.

What it has taught us is that it’s very easy to get dragged into the short term “noise”; media headlines and large market movements. Of course, in reality it is over the long term that you generate sustainable investment returns, so we always come back to remember the bigger picture and what our clients want from our service.