What are the key investment themes for 2018 and beyond?
It is critical to remember that asset allocation is the primary driver of long term returns. Morningstar studies estimate that this could account for up to 90% of the variability of our outcomes. Therefore, factors such as the equity/bond split, geographic allocation within equities and duration levels will have a meaningful impact on outcomes.
A key recent move for us has been to add fixed income assets back into the portfolios in the latter parts of 2017, with a particular emphasis on US Treasuries. This is the first time since the launch of the portfolios that we have done so.
In an expensive world, we have been reducing equities across our portfolio range in 2017 and this has stood us in good stead during the tricky first few months of 2018. Within equities, we currently favour UK, Japan and emerging markets.
Do you have a strong view on the future of the UK?
As bottom-up, fundamental investors we focus on the UK equity market rather than the UK economy. Predicting the near-term paths of economies is not our strength.
We rather look at factors such as the structure of the UK equity market, its fundamentals, in terms of dividend and cash flow growth, and the discrepancy in valuations between international companies and domestically-exposed companies Finally, we consider whether these fundamentals are underappreciated by the market, which we believe they are. We take extra comfort that favouring UK equities is contrarian at the moment, with negative sentiment being priced into assets.
One of the major drivers of the last few years has been depreciation of pound sterling. How has that affected returns?
Currency positioning has been a meaningful contributor to performance. Our exposure to foreign currency was significant going into 2015, when sterling was deemed to be expensive on a trade-weighted basis.
This is far less prevalent now, especially across our conservative portfolios, where our shift towards sterling assets throughout 2016 and 2017 has been additive to performance.
How much of performance was due to a rising bull market over the past five years?
You are right, the bull market has undeniably helped portfolio returns. We were able to capture much of these returns by staying pretty close to our maximum risk budget for the first few years. Despite this tailwind, our distinctive valuation-driven approach has also been additive to performance. Our preference for markets such as European and Japanese equities have helped performance, and our emerging market exposure has helped more recently.
Another position that worked well was UK direct property. We held commercial property exposure from the launch of the service until May 2016. We were fortunate with the timing of our exit, which happened just before the illiquidity issues that saw many property funds close to manage redemptions.
What about the holdings that failed to add value?
All investors are prone to judgement errors and mistakes. As valuation-driven investors, the main challenge is that ideas can be out of favour for a protracted period. In our case, the best example to illustrate this challenge is emerging market equities. There was no hiding that we were far too early favouring emerging equities over US equities, on valuation grounds, from 2013, so it was a real test of patience to hold through the 2016 commodity downturn. Thankfully, our patience has been rewarded more recently.
We also face challenges outside of equities. For instance, our low-beta alternatives exposure and elevated cash holdings have acted as relative drags in what has been a bull market for both equities and bonds.
Has your selection process changed as the popularity of passive funds has risen?
Let’s establish the essentials. First, the increasing availability of passives should be viewed as a welcome development that increases our ability to deliver positive outcomes. We should all be cheering on this movement.
The passive influence has also brought about a reduction in active fees. We hope this will continue as it aligns the interests of the industry with that of our clients.
With this background, it should come as no surprise that we are willing to use the full arsenal of investment options to derive the best outcomes for clients. When it comes to fees, we ideally seek to minimise costs and always have a keen eye on the hurdle rate an active manager must achieve to add value.
In this regard, our process remains unchanged. We place high demands on our active managers, although stand willing to tolerate bouts of underperformance so long as they remain true to their process.
In the Active Portfolios, has manager selection added value for you in the last five years?
Our approach to fund selection has thus far led to positive outcomes, although it has been a volatile ride. Looking more closely, we have found that fund selection has been positive in most equity regions including Japan, Europe, Asia and North America.
It has however been challenging for UK equity managers, especially during the period surrounding Brexit. This was a period which saw most active managers perform poorly and has acted as a headwind to performance.
Since this period, many funds have turned around, however the portfolios have recently been hurt by the underperformance of Neil Woodford’s fund. The extent of the underperformance has been in line with the toughest patches in Neil’s career.
