1st July, 2016
Question the Committee: Edition 2
First of all, I’d like to thank everyone who took the time to engage with us in the second edition of Question the Committee. Our pilot in December was extremely successful and in this edition we received even more questions, which I hope is testament to the improved communication channels we now offer. Despite being higher in number, questions often focussed on similar topics, in particular concentrating on the recent EU referendum which was understandable. The winner demonstrated a strong understanding of the economic landscape, and ironically posed a question we have debated on multiple occasions over the last 18 months, so thank you. As always, we welcome your feedback, and thanks again for all your questioning and support. We hope the following is insightful.
Historically global economic performance has been cyclical and investments have experienced alternating ‘bull’ and ‘bear’ markets.
Does the committee think it is conceivable that this age-old pattern could have fundamentally changed due to more accurate, faster financial information and a more globalised economy? Could we be in a long-term era of lower interest rates and equity returns, along with lower inflation? Or does the committee think current conditions are simply another phase within a typical economic cycle?
Fantastic question. We would definitely agree with you that faster access to financial information in an ever changing and globalised world has had an impact on investment movements, in the main leading to greater market volatility, sometimes through efficient filtering of information, and sometimes through inciting irrational investor behaviour. So often in life, where there is a positive there can be a negative, and whilst the information flow is quick and more frequent in supply, it can drive markets to move upwards or downwards to a more significant level than the fundamentals might suggest is appropriate.
So have things profoundly changed forever? In the short term it is easy to see why the answer to this might be yes. It appears that low interest rates are here for longer, and that equity markets will struggle on the back of sanguine economic growth. Of course, globally the current cycle (uniquely) is dominated by central banks trying to support markets and economies like never before. America is currently trying to tighten, whilst Europe and the East are in the process of easing. Despite this, central banks remain the main stimulators of equity and bond markets.
Our view is that the effectiveness of monetary policy on economic activity is diminishing, and in the longer term we are likely to see inflation appear as a consequence. The central banks have provided a lifeboat, that will probably prevent the ‘bust’ scenario from playing out for as long as they can remain proactive. As a consequence, we feel that the current cycle is likely to be much longer than previous cycles, however we don’t think we have seen the end of the traditional boom and bust model just yet.
How does the committee see investments moving forward after the referendum?
We like the way you included “moving forward” in your question, because that’s exactly what we need to do. In our December edition, we argued that the effects of a Brexit on investment markets would be less than anticipated, and although we are in the initial stages still, so far that seems to have been proved correct. At the time of writing, equity markets have recovered the majority of Black Friday’s losses, government bonds have further increased in price, and Gold has only seen moderate inflows. European uncertainty has been added to global headwinds such as the continuing slowdown in economic growth and the Chinese debt situation; which are still yet to be resolved.
In some ways, we would have liked the equity fallout to be larger, because it would have produced some great opportunities to buy over the longer term. This hasn’t happened, so our cautious stance remains intact.
Doubtless, the Brexit vote has produced opportunities. Uncertainty breeds volatility and speculation; with sterling down significantly amidst the prevailing political environment and opposing rhetoric coming out of both the Brexit and EU camp. It is easy to form the view that a ‘bad Brexit’ is becoming ever more priced in, so any outcome more benign to this could see sterling strengthen a little.
In addition, US interest rates are now highly unlikely to be raised this year and consequently, emerging markets look attractive due to US dollar correlations. Moreover, a weaker currency here in the UK will likely push inflation up, justifying our preference towards inflation-linked bonds which benefit in this environment.
In short, it still remains a tricky environment, but one we are navigating through selective opportunities in certain asset classes. The key is to remain agile, as we expect continued volatility through the summer months, and as we often say; “volatility produces opportunity”.
When you ask my permission to move some of my funds into cash does this mean that the situation is so uncertain that you have no idea where to safely invest the funds?
In some respects, you are leaning in the right direction, but we believe there are some key points to be noted. Cash is an asset class just like equities and bonds. It is a low risk asset that produces a guaranteed return, and is one that is highly liquid. The latter point is important, because it means you can quickly respond and move accordingly. If you are looking to take advantage of future opportunities, holding cash can be extremely rewarding. There have been very few examples where our portfolios have held a significant cash weighting, but when they have, it is because we believe better opportunities lie around the corner. So it may seem counterintuitive to hold cash given the low returns available but ultimately our job is to optimise the allocation of investments between different asset classes. Although it’s rare, sometimes cash is a key part of the strategy.
Thank you for keeping us updated on the property pricing changes – how do you pre-empt such a change to protect our capital as clients?
Another great question and thank you for your feedback. To reaffirm, what you are referring to here is the swing pricing mechanisms that commercial property funds implemented in May. Aiming to protect remaining investors from a rush to the exit, they moved from “offer” pricing to “bid”, reducing performance artificially by circa. 6% in the process.
Our wealth of experience is definitely our greatest strength when it comes to pre-empting such changes. Property is no different to any asset class in terms of displaying trigger points that could indicate a future sell-off. We have our key metrics (fund flows and void rates in this case) which we monitor on an on-going basis to identify trends, and always keep on top of market dynamics. We definitely do not profess to have a crystal ball, but we do have fantastic relationships with a variety of fund groups, whose incentive is also to provide us with direction at the earliest opportunity.
Since the start of the year, which parts of the portfolio have been performing strongly, and which haven’t lived up to your expectations?
The first six months of this year have been quite divergent in stages. We saw a large sell-off in equity markets into mid-February, before a rebound up towards the end of April. The volatility around the referendum then saw some areas that had done well in the first four months suffer and vice versa. Overall, we feel we did a good job at riding out these challenges. Our equity exposure has been great relative to equity markets; by way of example, on referendum day our High Risk Portfolio only lost 0.07% despite markets selling off strongly. Property has been a key detractor, due mainly to the pricing swings which reduced each funds’ performance by 5-6%. We decreased our exposure significantly to limit the effect on our clients, but property remains a crucial asset class for diversification purposes, so this has still had a marginal effect on portfolio performance. Avid readers of our blogs will also recall the reasoning for holding back on government bonds, where we see large risks.
Going into the second half of the year, we remain confident about the portfolios’ composition. Limiting the downside will continue as a central mandate, and we are optimistic about the prospects for what are highly diversified investment portfolios.
How active is active management at DB Wood?
The short answer is moderately active. Maybe you would like to hear that we are moving things in and out of the portfolio every day, but we would hope not. As with many things in life, it is about striking a balance. Here we aim to keep ahead of market movements, but also make considered judgements to take advantage of opportunities and pre-empt threats.
One of the most important ways we believe we add value to our clients is through minimising behavioural biases. These are often driven by emotional reactions to short term noise, which can result in overreaction and a loss of vision with regard to the longer term picture.
As a team, we analyse quantitative data daily, question the UKs top fund managers via weekly meetings or webcasts, and debate changes to our views in ad-hoc team meetings. We then bring all this together in structured and minuted quarterly review and assessment meetings.
We ensure that our process remains flexible, which is important. Of course, we have our formal quarterly full reviews that are diligently run and include external independent assessment of our portfolios. But if something unfolds that fundamentally changes our optimal positioning, we will be quick to meet and make the required changes.