15 Mar 2019
JOHN STOPFORD Head of Multi-Asset Income, JASON BORBORA Assistant Portfolio Manager
Since the global financial crisis, unconventional monetary policy has pushed yields inexorably lower. This means that investors seeking a better rate of return must now either aggressively pursue capital appreciation (an approach which has had limited success over the last 20 years) or evolve their investment process.
Our process starts with, and is focused on, security selection. We look for securities with resilient yields and the potential for capital stability or appreciation. The yield of these individual securities provides the driving force behind our total return. We then ensure diversification of the portfolio by owning a mix of securities based on their behaviours. We believe traditional diversification ideas which rely on whether an asset is a bond or an equity can prove naïve. Finally, we hedge the portfolio when the risk environment appears to be dangerous.
Just as an engineer cares about the nuts and bolts, we care about bottom-up security selection.
We believe a process of selecting resilient income-generating securities to act as an engine for performance can, in combination with appropriate risk-management, produce defensive returns. These attributes are useful not just in the current late-cycle turbulence but in any environment.
The Investec Diversified Income Fund seeks to produce a defensive return with less than half the volatility of the equity market. It seeks to use assets with an above average yield to drive performance. Given this is outcome orientated, rather than benchmark-relative mindset, our process is tailored to these objectives.
This contrasts with a ‘typical’ multi-asset fund which might rely on asset allocation and top-down decision making to generate performance. If attempting to beat an index or manage to a risk profile, we believe a bottom-up approach to security selection is better than the traditional wisdom of focusing on asset allocation decisions (for example equities versus fixed income or developed versus emerging regions). These questions are not focal to running this Fund as we believe that our investors are best placed to perform asset allocation for their clients.
Instead, we spend our time on selecting securities with attributes aligned to the Fund’s objectives. We then think about each security’s behaviour, to avoid biases. Finally, we hedge the portfolio when we believe there is a heightened risk of capital loss.
We see income as a more dependable source of return generation than capital appreciation. The blue areas of the bars in Figure 1 show that over the long term income has been the most important component of total return. This is true across asset classes. In the case of corporate debt, for example, investors actually made a capital loss with income explaining more than 100% of the returns.
Figure 1: Contribution of income and capital appreciation to returns
Source: Bloomberg, in USD, 30.11.18. Period shown is since 31.12.98.
Yield is harder to find Given the pervasive decline in yields following the 2008 financial crisis, investors must now increasingly rely on aggressive capital appreciation for gains (which given historical precedent could be a misplaced hope) or accept a lower rate of return.
Figure 2: The decline in yields since 2008
Source: Bloomberg, BoA Merrill Lynch, yields as at 30.09.08 and 30.09.18. ‡For further information on indices and specific portfolio names, please see the important information section.
We aim to solve this problem by building the Fund from the bottom-up (rather than relying on passive exposure or other managers), which provides a greater number of opportunities, control of risks and precision.
We pick every position based on its potential for total return. Looking simply for the highest level of yield is not enough, because often a high yield is a risk indicator. An inflated yield could either suggest investors want their money back as quickly as possible, or the yield is unsustainable and likely to be cut.
Figure 3: Yield vs. volatility
Source: Morningstar, Bloomberg, BofA Merrill Lynch, Investec Asset Management, in GBP, as at 31.12.18. Annualised standard deviation of monthly returns over 3 years. Indices: Investment Grade Debt: BofAML Sterling Non Gilts TR GBP; UK Government Debt: FTSE Gilts All Stocks TR GBP; EM HC Debt: JPMorgan EMBI Global Diversified; EM LC Debt: JPMorgan GBI-EM Global Diversified; Global Infrastructure: S&P Global Infrastructure TR USD; High Yield Debt - Global: BofAML Global High Yield TR USD; UK Equities: FTSE All-Share TR; Diversified Income Fund: Distribution yield and volatility of I Inc-2 share class.
Looking at individual securities, we find that higher-dividend stocks produce better returns than lower ones, but the pattern isn’t uniform. Given our desire to balance returns, volatility, and drawdown, the best mix sits with yields which are higher than average, but not the highest.
Looking over the past 20 years we split stocks in the S&P 500 (the index about which we have the longest and most detailed information) into 10 groups ranging from Group 1 (the highest 50 yielding stocks) to Group 10 (the lowest 50 yielding). Ranking their return profiles by key metrics shows the advantage of focusing on Groups 2 to 4.
Very high yielding securities are volatile, which is why our process is focused on resilient income across every asset class, not just high yields.
We look for securities with an attractive yield, displaying characteristics which suggest their income streams are sustainable (for example leverage, profitability, or credit quality. We also select for a mix of valuation and technical appeal (for example a low price/earnings ratio or a high yield when adjusted for the country’s inflation rate).
The process relies both on screening, to identify potential candidates, and then fundamental analysis to understand the threats and opportunities of the securities shortlisted. This fundamental understanding is particularly useful for the risk management of the portfolio. In undertaking it, our analysts can also employ the breadth of the firms’ equity and fixed income research capabilities. The process is replicated across every asset class, with relevant metrics used for each. The diagram below represents the steps used to refine our holdings.
The result is a differentiated set of positions if we compare the characteristics of the securities we own to those of the market. We believe this is helpful for our investors as it means they avoid repeating the same investments they might hold elsewhere. These characteristics are aligned with the portfolio’s investment objectives. Additionally, the portfolio holds relatively few securities than might be held in our investors’ portfolios. On average, we own only 250 stocks and bonds, while a portfolio of 60% global equities, 20% corporate bonds and 20% government might contain more than 10,000 securities on a ‘look-through’ basis. This is important for the risk management of the Fund discussed next.
Table 2: Fund characteristics versus the market
Source: Investec Asset Management, Bloomberg, JP Morgan, 31.12.18. Bond exposures use market values. For further information on indices and investment process, please see the Important information section.
Finally, we assess the behaviours of the bonds and shares we have bought and then hedging against capital losses when relevant. Many strategies split exposure by fixed income or equities. We think this fails to recognise the significant variability in asset class behaviour.
We think instead of Growth (risk-on), Defensive (risk-off) and Uncorrelated classifications. One important feature of this approach is that certain bonds can be classified in the same category as equites. This presents a more accurate picture of the susceptibility of the Fund to a fall in markets.
Finally, and perhaps most importantly in the current environment, the Fund can hedge against potential capital losses. It does so directly, unlike many funds that rely on fixed income holdings to offset losses. We think it is more precise to use hedging than bonds, because the correlation between fixed income and equities is variable and has often been positive.
Through understanding the nature of each of the securities held we can hedge against the Fund’s interest rate, currency and equity exposures. We hedge to minimise drawdowns, in line with our view that the aim of a defensive portfolio is to maximise upside capture and minimise downside.
Continuing to think of the yielding securities we have bought as our performance engine, our hedges are like a brake applied when the risk of capital loss looks elevated. The prompt to hedge can either be reactive (in response to a worsening risk environment) or proactive (for example, avoiding volatility over a geopolitical event).
• The risk metrics we monitor (such as data surprises, correlations between and within asset classes and volatility) suggested we should hedge the portfolio.
• We hedged, at points, more than two thirds of equity exposure (net equity reduced to 5% in December) in addition to bonds where we reduced interest rate exposure by taking the Fund’s duration down to less than 1 year, while keeping currency risk to a minimum (GBP/USD more than 90% of portfolio value).
• This insulated the portfolio from bond and stock losses, but allowed the portfolio to benefit from the relatively stronger total returns of our bond and stock holdings which act as a performance engine.
Figure 4: Cumulative total returns over the quarter
Calendar year performance; 2018: 0.4% (-9.5%), 2017: 4.8% (13.1%), 2016: 5.9% (16.8%), 2015: 2.0% (1.0%), 2014: 5.3% (1.2%). Figures in brackets represent the FTSE All Share Index calendar year performance. Source: Morningstar to 31.12.18, performance is net of fees (NAV based, including ongoing charges), gross income reinvested (net of UK basic rate tax pre 05.04.16) in GBP.
By building risk-management into the portfolio through multiple layers (resilient security selection, diversification by behaviour rather than asset class, and hedging), the Fund has minimised its exposure to drawdowns relative to equity markets and peers. Yet by maintaining a reliable engine to drive returns this hasn’t come at the expense of total returns.
Figure 5 shows the peak to trough performance of the Fund and its peers in the most severe recent drawdown episodes. The blue line shows the least dramatic falls during these challenging periods, meaning our approach shielded against capital losses more so than any of our comparative peers. By then ‘un-hedging’ risk when appropriate, we were able to recover losses more quickly to ensure income (as an engine) was always running, even in tricky periods.
Figure 5: Peak to trough performance
Calendar year % returns for the Fund, Index, Income Peer Average and Defensive Peer Average, respectively 2018: 0.4%, -9.5%, -5.3%, -4.1%; 2017: 4.8%, 13.1%, 7.4%, 2.7%; 2016: 5.9%, 16.8%, 10.1%, 0.3%; 2015: 2.0%, 1.0%, 2.3%, 3.6%; 2014: 5.3%, 1.2%, 6.0%, 5.3%; 2013: 6.2%, 20.9%, 11.3%, 7.2%. Source: Morningstar, 11.01.19. Performance is net of fees (NAV based, including ongoing charges), gross income reinvested (net of UK basic rate tax pre 05.04.16), in GBP. The list of competitors is frequently reviewed and is based on our Multi-Asset team’s analysis of the competitor landscape. The defensive peer group average is based on all multi-asset funds within the IA Targeted Absolute Return sector. The income peer group average is based on all funds from within the IA mixed Investment 0-35, 20-60, 40-85 shares and specialist sectors which include ‘income’ and/or ‘distribution’ in their fund names and are over £100m in size. For further information on indices, please see the Important information section.
Figure 6 shows that by concentrating on minimising downside correlation (in contrast to many funds which focus on producing no correlation) the Fund has produced double the upside capture relative to downside. This is a powerful attribute in an environment offering little capital appreciation. When the market has produced positive returns, the Fund has taken over 42% of this. While if the market produced negative returns, the Fund has taken less than 17% of this. In other words, when markets were up 10%, the Fund would have returned c4.2%, and when markets were down -10%, the Fund would have returned c-1.6%.
Figure 6: Attractive upside skew vs global equities
Investec Diversified Income Fund average monthly gain and loss as a proportion of UK Equities average gain and loss. Source: Investec Asset Management, in GBP gross of fees and taxes with income reinvested, UK Equity returns are for FTSE All Share Index, from 01.09.12 to 31.12.18. For further information on indices, please see the Important information section.
In short, there are many ways to drive returns. We believe a process that starts with, and is focused on, resilient income-generating security selection is the best way to generate defensive total returns. This is important not just for the current climate, where yield is harder to find and aggressive capital appreciation tactics aren’t likely to work, but during any time when investors are looking for a more reliable source of capital. Which is why we see income like a dependable engine, able to drive returns through the ups and downs of the investment cycle.
General risks: The value of investments, and any income generated from them, can fall as well as rise. Where charges are taken frm capital, this may constrain future growth. Past performance is not a reliable indicator of future results. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations.Investment objectives and performance targets are subject to change and may not necessarily be achieved, losses may be made.
Specific risks: Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Government securities exposure: The Fund may invest more than 35% of its assets in securities issued or guaranteed by a permitted sovereign entity, as defined in the definitions section of the Fund’s prospectus.
Important info: This communication is for institutional investors and financial advisors only. It is not to be distributed to retail customers who are resident in countries where the Fund is not registered for sale or in any other circumstances where its distribution is not authorised or is unlawful. Please visit www.investecassetmanagement.com/registrations to check registration by country. If you are a retail investor and receive it as part of a general circulation, please contact us at www. investecassetmanagement.com/contactus.
This communication is provided for general information only. It is not an invitation to make an investment nor does it constitute an offer for sale. The full documentation that should be considered before making an investment, including the Prospectus and Key Investor Information Documents, which set out the fund specific risks, is available from Investec Asset Management.
The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. There is no guarantee that views and opinions expressed will be correct. The investment views, analysis and market opinions expressed may not reflect those of Investec as a whole, and different views may be expressed based on different investment objectives. Investec has prepared this communication based on internally developed data, public and third party sources. Although we believe the information obtained from public and third party sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Investec’s internal data may not be audited. Investec does not provide legal or tax advice. Prospective investors should consult their tax advisors before making tax-related investment decisions.
Inc-2 share class expenses are charged to the capital account rather than to income, so capital will be reduced. This could constrain future capital and income growth. Income may be taxable.
THIS INVESTMENT IS NOT FOR SALE TO US PERSONS. Except as otherwise authorised, this information may not be shown, copied, transmitted, or otherwise given to any third party without Investec’s prior written consent. © 2019 Investec Asset Management. All rights reserved. Issued by Investec Asset Management, which is authorised and regulated by the Financial Conduct Authority, February 2019.
Indices Indices are shown for illustrative purposes only, are unmanaged and do not take into account market conditions or the costs associated with investing. Further, the manager’s strategy may deploy investment techniques and instruments not used to generate Index performance. For this reason, the performance of the manager and the Indices are not directly comparable. If applicable MSCI data is sourced from MSCI Inc. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. If applicable FTSE data is sourced from FTSE International Limited (‘FTSE’) © FTSE 2019. Please note a disclaimer applies to FTSE data and can be found at www.ftse.com/products/downloads/ FTSE_Wholly_Owned_Non-Partner.pdf
‡1 month deposit rates for cash; 10yr Government bonds – generic sovereign yields; Investment grade bonds: BofAML Sterling Corporate & Collateralised All Stocks Index; BofAML US Corporate Index; BofAML Euro Corporate & Pfandbrief Index; BofAML Japan Corporate Index; High yield bonds: BofAML Asian Dollar High Yield Corporate Index; BofAML US High Yield Index; BofAML Sterling High Yield Index; BofAML Euro High Yield Index; Emerging market bonds: JP Morgan GBI-EM Global Diversified Index; JP Morgan EMBI Global Diversified Blended Index; JP Morgan CEMBI Diversified Broad Composite Index; Equity indices as stated.