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Monthly Archives: October 2015

How to choose a China ETF

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TMR Is there hope for no hopers

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Poundland the empire built on bargains

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De La Rue so down the only way is up

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ImmuPharma investing in the future

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UK equity income versus the IFL portfolio

UK equity income versus the IFL portfolio

UK equity income funds are consistently one of the biggest selling group of funds in the UK. This is because most people investing capital are entering retirement and need income. If you are investing for a typical retirement timescale of 25 years – though the actuaries say it may well be 35 years – you must invest a substantial proportion of your capital in equities. Only they can generate an income that rises in line with, or at a faster rate than, inflation.

In theory, you could invest in growth-oriented funds and strip capital out for your income needs. But this is risky. If the markets fall and you keep drawing “income”, you will suffer from “pound-cost ravaging”, eroding your capital to the point where it is virtually impossible to recover. If you have never done this, it is worth testing the proposition with a pocket calculator. Start with £100,000 invested and take a 5% income when the investments are paying out 2%. You are consuming 3% of your capital each year. The market plunges, your capital is now worth £70,000; you draw not 3% of your initial capital to get your required top-up of £3,000, but 4.3% of its current value. That reduces your capital further; now, what if the market falls again? It does not take 25 years to reach Doomsday.

Keep it natural

Whether they get the maths or not, most investors are aware of the risk and try to rely on natural income. And because they avoid currency risk, UK equity income funds are a natural choice – though, as I have argued previously (Issue 353), global equity income funds are in many ways a better proposition.

There are scores of UK equity income funds with historic records ranging from the spectacularly good to the dismally poor. Most analysts focus on the total return to investors, and while this can identify managers who are good at picking stocks, that does not always equate to funds that generate steadily rising income.

Are such funds a good alternative to Douglas Moffitt’s Income For Life portfolio or the RIRP? I will offer a tentative answer.

Drill into fund data

First, I will assume that you can pick the better UK equity income funds. Thanks to the many “buy lists” published by Hargreaves Lansdown, Bestinvest and others, you can easily get the selections of analysts who have crunched a lot of numbers. They may not pick the best but they will certainly avoid the worst and the mediocre.

I am not going to compare lists, but the four funds I am going to focus on do in fact appear on a lot of buy lists. Table 1 lists four funds, three of which have caned the sector average performance over 5 and 10 years. Chart 1 shows how three of them have performed over the 11 years to June 2015. They have generated total returns of between 200% and 275%, equivalent to between 10% and 12% annually.

Chart 1

UK equity income
Key :•A Unicorn UK•B Invesco Perpetual•C Threadneedle UK•D UT UK Equity

Chart 2 takes one of these funds and shows the difference between the total return, where net income is reinvested in additional units, and price, where the investor takes and spends the income. The investor who reinvested income achieves a 20-year return of 800%, while the income taker gets 400%.

Chart 2

UK equity income
Key :•A Invesco Perpetual – Income Inc TR•B Invesco Perpetual – Income Inc

Chart 3 then takes this same fund, Invesco Perpetual Income, and looks at the actual income earned on an initial investment of £10,000 over the same 20-year period. After 13 years the total income earned exceeded the initial investment. As of now, it is more than double the initial investment. Most investors would, I think, be extremely happy with this outcome. In fact, many of them were so happy that when the fund manager, Neil Woodford, left IP to set up his own fund, almost £5bn left IP to follow him to Woodford UK Equity Income. As Table 1 shows, Woodford has started well, with returns well in excess of the sector average for the first year.

Chart 3

UK equity income
Key :•A Invesco Perpetual – Income Inc Net income earned on initial £10,000 investment

For many years Woodford’s returns were head and shoulders above the rest of the sector, but there are now several others with almost as good total returns – though few with his consistency in steady income increases.

Woodford’s style is to make large investments in sectors and companies. Most notably, he took huge positions in tobacco stocks in the 90s and is currently a large holder of Big Pharma shares like GSK. But, at the same time he also allocates up to 10% of his portfolio to start-ups – unlisted companies, often in sectors like biotech, and often university spin-outs.

Given Woodford’s long record, and despite the handicap of a near-£6bn fund, I would expect his fund to generate well above-average returns for investors, including steady dividend increases.

Threadneedle UK Equity Income is one of the best of the traditional funds, with capital almost equally spread between mega cap (£50bn plus), large cap and mid cap stocks. The managers here are cautious types and worry a lot about possible dividend cuts. They note that dividend increases have been greater than profit increases; the UK payout ratio has risen steadily in recent years so the average dividend cover is about 1.8X. This portfolio contains no bank shares as the managers expect returns from “safe” banks to decline sharply and do not wish to own shares in speculative banks.

Possible boost from small-caps

The extraordinarily high returns from Unicorn Income are, in my view, a predictable consequence of the higher long-term returns earned by small-cap shares, as evidenced by many academic studies. Dig into this fund’s history and you will find it is far more volatile than other equity income funds, nor is its income payment record so steady. Unicorn specialise in managing small-cap portfolios, an area where you can still secure good returns on legwork – meeting business owners and managers – and analysis. You might want to combine a holding in this fund with one of the other two.

Now for the major handicap of all these funds. The yields shown are misleading. Every one of them takes its management fees from the capital of the fund. Average management charges and costs are 0.8% of assets, so the actual yield you can take as natural income is in every case 0.8% lower than the yield figure shown in the table.

Taking that into account, the initial yield of the Income For Life portfolio is significantly higher. Because the IFL will hold many fewer stocks than the funds, which typically own 50-100 shares, its capital volatility and the risk to income from disasters, will be higher. Will the IFL generate larger income increases than Woodford or Unicorn? Over the long term (over 5 years), I doubt it – but because the initial income from IFL is significantly higher, the funds will have to grow their income at quite a lick for their total income to exceed the IFL’s.

Of course, the big difference is that the funds require you to do no work at all, nor deal with problematic decisions of the type that Douglas Moffitt has regularly faced with the RIRP. And if you run your own IFL portfolio you must manage it and make those decisions – it cannot be a “buy and forget” investment.

So my conclusion is that for active investors prepared to put time and effort into managing their capital, the IFL is likely to generate higher income than UK equity income funds for the first 5 years and possibly longer. The IFL’s capital value will certainly be more volatile, though if you follow Douglas’s methods you will ignore this except when forced to take action by the system rules – which I have asked him to spell out in more detail in his next article. And, on the other hand, if you do not want to be an active investor, then pick one or more of the funds I have featured, draw 0.8% annually less than the declared yield, and expect an inflation-beating income for as many years as you have left.

Chris Gilchrist, July 2015

Post election purchased for the Income For Life portfolio

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How to lower your portfolio risk

How to lower your portfolio risk

As world stock markets climb, the potential gains shrink in relation to potential losses, or, if you prefer the jargon, the risk-reward ratio deteriorates. When the next bear market will come I do not know, but I feel it is likely to take one of two forms:

  • A sudden fall of 25-30% followed by a quick recovery of part of the loss, followed by a caterpillar market – the 1987-1990 pattern
  • A succession of smaller downwaves cumulating in a larger loss of 50% or more – the 1973-74 and 2007-08 pattern

Either way, investors who are drawing more than the natural income from their equity portfolios face potentially catastrophic losses, as I explained in Issue 365.

In the good old days – the era before QE – we could have relied on bonds. We could simply have sold some equities and bought some bonds to reduce the level of risk in a portfolio. Today, that is much less easy. It certainly cannot be done by buying developed market government bonds, since in no case do these give you a positive net of tax return assuming the central bank’s inflation target is met.

Avoid the greater fool

Buying bonds on negative real returns is “greater fool” investing, which can only work if some factor that is distorting the market distorts it even more. Students of stock market history have almost all concluded that reversion to the mean is the single most reliable phenomenon, which means the loss potential in fixed interest is high.

The only problem is that though we can be confident that most things (P/E ratios, yields, price to book values, etc) will mean-revert, we have little idea over what timescale it will happen. So you can, like many investors, hope that mean-reversion on bond yields is some way off. In this case, you will be happy to bicycle along the edge of the cliff, buying higher-yielding bonds to scalp a few percent above the gilt yield. Alternatively, if you think bond doomsday is near, you can funk it, as many strategic bond fund managers have, and buy nothing but short-dated bonds – in which case you get no yield at all and might as well hold cash.

Holding more cash is the other tactic investors used to apply in the equity market cycle. But that was based on a belief that the stock market cycle anticipated the business cycle. Having a reasonably good idea of where the economy was in its cycle, you could reduce your equity holdings as it entered the “overheating” stage and then wait for the onset of recession before you switched from cash or bonds into shares.

Given the uncertainty regarding the business cycle today, this doesn’t seem a workable strategy. If “lower for longer” means a long slow recovery-expansion phase, there will be no simple sell signal for equities.

I view this as the “new normal”. We have to regard the one-way bull markets of the 1980s and 1990s as aberrations. Choppy trendlessness may well be the future for equities.

Absolute return styles attract investors

I draw two conclusions from this. One is that active management in equities will pay off better in coming years than it has recently. The other is that “decumulating” investors need to add a different asset class to their portfolios to lower risk to acceptable levels: Absolute Return or loss-minimising hedge funds.

Funds aiming for cash-plus or absolute returns – ignoring stock or bond market indices – have grown in number since 2008. Only a few existed prior to 2008, so the problem in selecting newer funds is working out how they would have fared in the 2007-08 meltdown. That is almost impossible. But every small wobble in the markets provides more evidence: if an absolute return fund fell by 5% when the UK stockmarket fell by 7.5% last autumn, it is unlikely to withstand a more serious equity crunch.

I am reasonably confident about the Absolute Return style funds I featured here in previous issues. So I have provided a thumbnail for each of them. The table and chart give some performance data. It adds up to over half the equity return with well under half the level of equity downside risk (especially drawdown). That is, I think, an appealing combination for decumulating investors.

In particular, I suggest that if you are drawing more than the natural level of income from your investments, you should hold at least the equivalent of two years’ worth of income withdrawals in AR funds. The logic is that in a severe bear market you can stop withdrawals from the equity portfolio altogether. Any income generated is then reinvested and is very likely to boost the return.

However if – as I am – you are mistrustful of most types of bond, you might choose to add to your AR holdings much of the capital you would in “normal” times hold in bonds. In this case you could end up with as much as half your capital in AR vehicles.

how to lower your portfolio risk
Key :•A CF Ruffer Total Return•B Standard Life Global Absolute Return •C FTSE All-Share•D Newton Real Return

There are three main categories of AR funds:

Global macro. These use a lot of different strategies employing derivatives, such as currency pairs, relative equity index trades, and “alpha” trades where the fund holds an actively managed fund and goes short of the relevant index. Risk control is paramount: I like such funds to have a separate risk reporting channel that goes all the way up to the fund group’s CEO, independent of the investment department and outside the control of the Chief Investment Officer. This is a style that can only be run by large groups with excellent management.

Long-short equity. These funds aim to make as much profit from short sales as from long positions. They may use index options to eliminate or reduce market direction risk. Much depends on the stock selection skills of the managers.

Asset allocator. Managers actively adjust allocation of capital, especially to unpopular asset classes as well as cash, so the style usually has a contrarian element.

My selected Absolute Return funds

Insight Global Absolute Return (global macro). Insight is part of BNY Newton Mellon which runs billions in AR strategies. This fund was launched in January 2008. It aims for cash plus 4% over a 5-year term. Its current net equity exposure is 22%. A wide variety of derivative strategies are used.

Invesco Perpetual Global Targeted Returns (global macro). IP recruited three leading members of the original SLI GARS team to launch this fund in autumn 2013, since when it has attracted £1.7bn. The aim is cash plus 5% over rolling 3-year periods. It uses a wide variety of derivative strategies.

Newton Real Return (asset allocator). This £9.8bn fund is one of the longest-running vehicles with a strong emphasis on capital preservation. Ian Stewart has managed the fund since 2004 and it consistently does worse than the UK equity market in bull phases and better in bear phases. Its aim is cash plus 4% over a 5-year term, plus a positive return over rolling 3-year periods. It holds 59% of capital in equities but hedging reduces its current net exposure to 39%. Equity hedging is its main risk control. Ruffer Total Return (asset allocator). Ruffer emphasises capital protection. Steve Russell and David Ballance have managed this fund since 2006. It now has £3bn in assets. Active asset allocation is the main risk control. It currently holds 27% in index-linked securities, 19% in Japanese equities, 27% in other equities and 10% in cash; gold and gold shares were over 15% two years ago but have been reduced to 5%.

Standard Life Investments Global Absolute Return Strategies (global macro). Launched in May 2008, GARS dropped 12% in the year of the crunch. It claims to have tightened its risk controls and since then has held drawdown to under 5%. SLI now manages over £50bn in this fund and similar strategies, including Standard Life’s own pension fund. Though it has lost many of the original management team, the current team of 22 also draw on ideas from SLI’s huge team of managers and analysts. Its derivative strategies include some that run for a year or more and others that close within weeks. Its aim is cash plus 5% over a rolling three years with no more than half the volatility of equities.

Fund combinations

SLI GARS and IP Global Target Returns are run using similar methods; the leaders of the IP team came from SLI. Aviva’s Multi-Strategy Target Return is also run by ex-SLI people. So it probably makes sense to own only one of these funds. Though GARS is now a whopping £25bn, it continues to meet its targets.

Newton and Ruffer both use real world rather than hedge fund methods. Ruffer likes off-piste assets like gold bullion, gold shares and index-linked government bonds. Newton likes “bond proxy” equities – mega-cap stocks with rock-solid balance sheets. Despite these differences, returns and volatility of these funds has been similar in recent years.

Suggested asset allocations

For decumulators, I suggest the asset allocations shown in the table, which put capital into AR funds and reduce fixed interest holdings to much lower levels than most asset allocators recommend.

The major risk with this approach is the potential loss of return from fixed interest. Starting from today’s low yields, that may appear modest. But consider Japan again: after the 1980 crunch, government bond yields fell from 3.5% to under 0.5% and never rose significantly for a period of over 20 years. If we really do get Japan-style deflation, my suggested allocations will cost you money.

On the other hand, they also protect you against the loss of capital that will inevitably follow a normalisation of interest rates. If rates do, as many analysts suggest, climb slowly towards 3% over a period of 6 or 7 years, capital losses could easily exceed 20% even on government bonds.

The one problematic issue with this approach is that AR funds mostly generate low income (the highest-yielder is Newton Real Return with 2.6%). I will return to the income problem in a future issue.

Chris Gilchrist, June 2015

Carillion undervalued on assets cash generation and dividend

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Vodafone for profits from the internet

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