Investment Newsletter May 2014
Cost & Value By Mike Deverell Investment Manager
When putting together your investment portfolios we are extremely conscious of the cost of the investments we buy. Charges are a key part of our fund research and we will always try to negotiate the best deal on your behalf. If there are two funds of a similar quality then we will often opt for the cheaper of the two funds. In investment selection there are plenty of unpredictable factors beyond our control. We cannot know whether a fund will outperform or not in advance or what direction a market will go, although we can make informed decisions after detailed research. However, one factor we know for certain in advance and therefore we have complete control of, is the cost of that investment. Of course cost cannot and should not be the overriding factor in our research process. As the old saying goes,
“cost is what you pay, value is what you get.” We are therefore focused on value for money rather than purely cost. We have recently made some changes to portfolios reducing exposure to index tracker funds in favour of actively managed funds. By actively managed fund we mean one run by a fund manager picking and choosing which stocks to buy, as opposed to a “passive” fund which simply tracks an index such as the FTSE. Buying active funds tends to mean an increase in costs. For example, we can purchase a FTSE Allshare tracker for 0.15% whereas a typical actively managed UK equity fund might cost 0.75%. That means the actively managed fund has to outperform by 0.6% pa in order to achieve the same performance as the FTSE. Not all fund managers are capable of doing this consistently.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter May 2014
Cost & Value cont’d
We have conducted a lot of research into active and passive funds in the past and concluded that which approach is best depends partly on which region or asset class we are looking at. For example, we prefer active fixed interest funds, European and Japanese equity funds. We found that over the long term, it was generally better to invest in tracker funds in the US and emerging markets, whilst in the UK a mixed approach seemed appropriate.
between regions have become more pronounced. In addition, we have seen things like the tension in Russia and the Ukraine which has affected Eastern European markets but has little effect on Asian markets, for example. The move towards active funds is also as a result of changing market conditions as we move further away from the financial crisis. The period from 2009 to 2012 was characterised by periods of “risk on” or “risk off”. Concerns over the macro economy and the financial system drove markets. When those concerns rose, all “risk assets” such as equities or higher yielding corporate bonds sold off. When concerns abated, those assets recovered. We saw a period where the whole market either went up or down, with little differentiation between companies. In this period, holding a tracker fund proved a good strategy.
However, the decision whether to go active or passive also depends on market conditions. Over the past couple of years we have reduced exposure to trackers in the UK in favour of actively managed funds. In particular, we increased exposure to small and mid cap stocks which tend to do better in an economic recovery. Our research had shown that an active approach was required in these areas. This has paid dividends and over the past two years (to 7 May 2014) the FTSE Allshare returned 23.5% whereas our actively managed UK equity portfolios returned 36.7% (UK Dynamic) and 34.5% (UK Large Companies) respectively. We have previously invested largely in passive funds in emerging markets but have recently begun to change this approach. We have seen reforms announced in China recently which could reduce some of the advantages of some of the partially state owned businesses and allow private companies to become more competitive. As the state owned businesses make up a big part of the Chinese index we have switched out of our Chinese tracker and into an actively managed fund which can be more selective. Within the wider emerging markets we are also about to switch to a more active approach. As growth has slowed in many emerging economies, the differences
In the past couple of years the correlations between different stocks and bonds has widened as macro concerns become less dominant. The perceived better companies have been rewarded with rising share prices, whilst poorer companies have not done so well. This type of environment is more favourable for active managers. However, it’s all very well saying that a certain period favours active managers, it is another matter being able to find a good manager. Even in this type of environment some managers will get their decisions wrong. When we look for a fund manager we look for one who has consistently added value and who also has tended to do well in market environments like the current one. Sometimes we can’t find a manager who fits the bill and in that instance we would prefer to buy a tracker fund than pay higher fees for a mediocre manager. The other point to note is that a lot of so-called active fund managers really aren’t that active. Some are only allowed to deviate away from their benchmark by a certain amount. For example, many UK funds follow the FTSE Allshare very closely, only deviating by perhaps 5% or 10% away from the benchmark. China makes up around 19% of the emerging market index so most emerging market funds will have between 15% and 25% in China. Funds that are this constrained will find it difficult to add enough value to compensate for their higher costs relative to a tracker fund.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Investment Newsletter May 2014
Cost & Value cont’d
If we are buying an active emerging market fund we want one that would be happy to hold nothing in China if they thought it was the right thing, or perhaps 40% of the fund if they are positive on that market. As always, it is about the blending of different funds and asset classes that is important for portfolios. Sensible diversification is important and if done properly this reduces volatility and leads to better returns in the long run. However, it is also important to be flexible and adapt the portfolio towards not just those asset classes we think should outperform, but also towards the style of fund we think should outperform. In this way we can hopefully add to returns and reduce risks where appropriate.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.
Market Views May 2014
General Economic Overview The global economy continues to grow led by established markets with the UK at the head of the pack. Certain emerging markets are seeing slower growth. CPI inflation is below the Bank of England’s 2% target. However, RPI remains relatively high. Interest rates are likely to go up in 2015 but will do so slowly and settle at levels significantly below the typical 5% level prior to the financial crisis. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets After a recent rally we have reduced our equity outlook from neutral to -1, which means we expect perhaps 9% pa over 18 months. The FTSE 100 has rallied strongly in the past month or so, outperforming all other markets including, unusually, smaller UK stocks. We prefer Japan and Emerging Markets where valuations look more attractive than the US and Europe, as well as actively managed UK funds.
-1
Fixed Interest Corporate and government bonds have had a pretty good start to 2014 after a poor 2013. We believe that returns are likely to remain relatively steady over the next 12 months and believe we could see perhaps 4% to 5% from our funds. We expect some small losses in gilts.
-2
Commercial Property Property returns continue to impress with capital growth supporting rental yields. The improving economy should provide support for returns. We firmly expect returns to exceed our long term 7% pa assumption over the next 18 months.
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
+2 -5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and overweight property, we are neutral positioned towards equity and alternative equity. A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for commercial property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5 means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall. These represent Equilibrium’s collective views. There are no guarantees. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission.