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Equities Your choice of refuge against the next storm
I read commentaries from and listen to a lot of investment managers. They are mainly equity managers, since I don’t see the point in discussing whether bonds already yielding less than 1% can end up yielding zero or even less. Yes, you could have made money chasing yields down to negative in German bunds, but this really is “greater fool” investing, which as far as I’m concerned means it isn’t investing at all, but speculation pure and simple.
Most equity managers are nervous, and very few are bullish. They’ve all got the same charts, which show that in developed markets, share prices have risen much more than dividends or earnings over the past 5 years, and they know that share prices cannot go on doing so. Nor can dividend payout ratios keep rising – in fact, most fund managers expect UK companies to hold onto a good part of their sterling windfall gains rather than pass them onto shareholders. Naturally, there are high-growth exceptions, but not that many among large companies and virtually none among the “nifties”, the “growth stalwarts” like Diageo and Unilever where PE ratios are now miles ahead of any likely earnings growth in the foreseeable future.
In fact, the projected rates of growth in earnings in the US, the UK and Europe are pretty lacklustre and only an improbable upturn in GDP growth would give them a boost.
Looking for hedges
With that, and the steep rise in share prices since 2012, on the table, it’s no wonder investment managers are looking for hedges. In true investment parlance, an equity hedge is something that is likely to go up or at least stay level when equities go down. With bond yields so low, the traditional offset of bonds and equities is unlikely to work. Anyone switching from equities to conventional bonds now may just be rearranging deck chairs on the Titanic. It’s quite plausible that both bonds and equities could fall together if we have a proper bear market.
Cash remains the only asset which can be guaranteed not to correlate with equities – except in conditions of hyperinflation. But with inflation heading up – see the inflation projections chart below – most investors are reluctant to embrace an asset which will, in the UK, probably return minus 3% in 2017.
The worry the chart reveals is that this is not just a one-off currency blip, but the start of a global upturn in inflation. Most economists think this is a remote possibility, but what do they know? Their models have proved so consistently useless at predicting anything important since 2007 that I take their comments with ever larger pinches of salt.
So we have serious downside risk in both bonds and equities and rising upside risk in inflation. What should you do about those risks in your portfolio?
Perhaps if you have a 10-year timeframe you can be stoical and pull the blanket over your head. And if you are still adding to your investments and the time when you need to draw on them is 10 years or more ahead this may turn out fine. But if, like me, you expect to be drawing on your investments soon, and moreover you expect to be drawing more than the natural income they produce each year, you need to take action.
Here is what I have done and am planning to do.
Buy gold as an insurance policy. Back in the 1960s and 1970s every Swiss gnome held 5%-10% of his assets in gold. Swiss wealth managers did this for every client. They didn’t do so to make money, but to avoid losing money.
I suggest you adopt this approach to gold. How much of it do you need as insurance? I would say 5%-10%. I am up to 10%, split 70-30 between gold equities and gold bullion. I can envisage raising the allocation to 15% but have no plans to do so.
Among the contrarian managers who hold gold at the 5%-10% level are Alistair Mundy at Investec and Steve Russell at Ruffer.
Gold equities are several times more volatile than bullion, so a more sensible ratio might be 50- 50 in bullion and equities, or even 60-40.
|BlackRock Gold & General (OEIC, £1.4bn, OCF 1.2%). With about 80% of assets in developed markets (mainly Canada and the US), the fund tries to limit political risk. It also holds mainly large established miners and little in exploration.
Punchier funds include CF Ruffer Gold (OEIC, £760m, OCF 1.3%; 40% smaller companies, 48% in Africa, Asia, Latin America) and MFM Junior Gold Trust (OEIC, £20m, OCF 1.3%; 100% smaller and exploration companies).
Spider Gold GLD (ETF, £62bn). This is the largest gold ETF. Others easily tradeable in London include i-shares Gold IAU (ETF, £9bn) and ETFS Gold Bullion Securities GBSS (ETF, £4.5bn). All have the same annual management charge of 0.4%.
Should you trust gold Exchange Traded Funds? I do. Certificated and audited gold bullion in vaults in New York or London is good enough for me. I don’t think you would escape the kind of systemic crisis that would cause these ETFs to fail by holding physical gold in the form of small bars or coins.
If we get a serious “funk” in China, it seems likely to me that Chinese investors will seek the safety of gold. But almost any geopolitical crisis is also likely to benefit gold. As for the old “US$ up, gold down” mantra (and vice versa), I think trusting this relationship to persist in the postQE era is daft.
Buy index-linked bonds
Conventional government bonds are terrible value. Quality (investment grade) corporate bonds aren’t much better. Bond managers say high yield (= junk) bonds are decent value, but that assumes the “low interest, low growth, low inflation” scenario will persist, and if it doesn’t, then they are just junk.
I don’t own any conventional bonds. But, like Ruffer, Personal Assets Trust, Troy and other “defensive” managers, I do own index-linked bonds and am adding to them. UK index-linked have had a tremendous run (up 25% since May 2016), mainly because of shortage of supply and high liability-matching demand from pension funds. So I now own funds that invest globally, which means holding a big slug of US Treasury linkers.
|L & G Global Index-Linked Bond Index (OEIC, £725m, OCF 0.27%). This tracks the Barclays World Government (ex UK) Inflation-Linked Index so is 100% non-sterling.|
|Standard Life Investments Global Index Linked Bond (OEIC, £1.2bn, OCF 0.65%) has 80% of assets outside the UK.|
|Royal London Global Index Linked Bond (OEIC, £117m, OCF 0.5%) has similar asset split but has lower duration than the index.|
At present I have 5% in linkers but will raise this to 10% shortly and perhaps to 15% over the next few months.
I would have bought an index tracking fund but for the disparity between UK and US linkers, which means an actively managed fund could and should add some value by altering the proportions held.
Buy Japanese equities
The one developed equity market that doesn’t look absurdly expensive is Japan (last covered in Issue 381). The big manufacturers have relocated a lot of production overseas, so benefited from the fall in the Yen from its peak. They are still expecting substantial earnings gains over the next year.
The economic outlook is not great, but “Abenomics” is in the last chance saloon, and both government and central bank (with a gigantic ongoing QE programme) seem determined to generate inflation and wage growth. And at some point, all that QE does seem likely to send the Yen lower again.
Meanwhile, despite the conventional view of an ossified economy, Japan is the world leader in one of the big industries of the future, robotics. And modest deregulation is giving disruptive new competitors with established businesses the same chances of meteoric success we’ve seen in other places – but at far more modest valuations. The banks, too, are modestly valued and are in better shape than European banks.
|MAN GLG Japan Core Alpha (OEIC, £1.5bn, OCF 1.5%) has a tightly defined contrarian value selection process applied to large companies.|
|Baillie Gifford Japanese (OEIC, £1.5bn, OCF 1.5%) is a more conventional growth fund holding predominantly mid-cap and small-cap stocks.|
|Baillie Gifford Shin Nippon (IT, £240m, OCF 1%) invests more heavily in smaller companies and has an exceptional longer-term track record.|
There are huge disparities in value between different groups of stocks in the Topix index, so I wouldn’t want to own a tracker fund. And I wouldn’t want to hedge the currency at present – as with the UK, a fall in the Yen is likely to be instantly reflected in higher share prices, but as we’ve seen recently with Japan, QE doesn’t necessarily mean a plunging currency.
Buy value equities
Growth equities have outperformed value since 2010, and by a goodly distance. Because of the uncertainty about the economic outlook, investors have paid more and more for businesses where they feel confident they will get some growth. So the “growth stalwarts” are now overpriced except in the eyes of Buffett-style zealots like Terry Smith at Fundsmith and Nick Train at Lindsell Train.
|Global value style funds|
|Almost none of the dozens of funds in the Investment Association’s Global Equity Income sector adopt a value-driven approach. Almost all hold the “nifties” and, even worse, most slavishly follow a benchmark-driven approach that leads to them having about 40% of their assets in US equities. Two exceptions I like are:|
|Artemis Global Income (OEIC, £3.2bn, OCF 1.5%). You will not have heard of most of the stocks in this portfolio, which now has a strong value emphasis.|
|Murray International (IT, £1.4bn, OCF 0.75%). This is the most diverse of the global ITs, with small investments in many global equity markets and an emphasis on capital preservation. Its shares, after years trading at a premium, are back in line with NAV.|
The historic evidence is that it’s not just the quality of the business but the valuation when you buy that you need to worry about. “A trend is a trend… until it stops.” Reversion to the mean is the norm in financial markets. Over the long term, value has trounced growth. Why shouldn’t it do so again? The only possible reason is because “This time it’s different”. As Sir John Templeton said, those are the four most expensive words in stockmarket history.
So as far as developed markets and established companies are concerned, I think it’s time to buy value. This will work out well if growth picks up – cyclical businesses will benefit more than the growth stalwarts. If growth remains lacklustre, there are still plenty of cyclical businesses that will do OK and which can be bought cheaply today. So I own actively managed “value” funds investing in global equities (covered in Issue 381). If you are getting enough yield from these investments you may even feel you can hold them through a downturn.
Buy Absolute Return funds
Absolute Return funds that aim for a “cash-plus” return with much less risk than equities are showing up in more and more multi-asset and discretionary fund manager portfolios.
I’ve been studying and owning these funds since 2008. I think they should form part of most investors’ portfolios today. The more cautious your attitude, the more you should hold in these funds.
|Absolute return boltholes|
|The lower-risk AR funds I prefer are:|
|Premier Defensive Growth (OEIC, £380m, OCF 0.85%) aims for a positive return over rolling 36-month periods. Most of its holdings are fixed-rate, fixed-term.|
|Church House Tenax (OEIC, £60m, OCF 0.9%) has a “hedge fund lite” approach with modest net exposure to equities or bonds.|
|Higher-risk AR funds I like are:
Henderson UK Absolute Return (OEIC, £1.8bn, OCF 1% plus performance fee); long-short strategy
|Invesco Perpetual Global Target Return (OEIC, £7.2bn, OCF 0.8%). Complex derivative-based strategies.|
|Newton Real Return (OEIC, £9.8bn, OCF 1.1%). Gold and index-linked alongside quality global equities protected by put options.|
|Ruffer Total Return (OEIC, £3bn, OCF 0.8%). 40% in index-linked, just under 40% in global equities with the largest position Japan.|
At present I hold 10% in AR funds but this will be up to 15% shortly and perhaps 20% early next year.
I split my holdings between genuinely defensive funds, with maximum downside of below 10%, and those aiming for “LIBOR plus 5%,” where the downside is between a third and a half that of equities.
Buy Asian equities
As I have said before (most recently Issue 379), China is succeeding in its transition from an investment-led to a consumer economy. The journey is going to be volatile. But from the perspective of the authorities, one thing is clear. A runaway property boom would be a disaster both economically and socially. Fast-rising house prices in the major cities are already causing both social and lending problems. So the government will do its best to prevent this.
But Chinese savings rates are high. Where can the money go? A bull market in shares is highly preferable to a property boom. It has some beneficial economic effects and will have far less damaging ones when a bear market comes along.
I expect the government to sell off stakes in many state owned enterprises, starting with the banks after a mainly cosmetic clean-up of their balance sheets.
|For pure exposure to China:|
|Fidelity China Special Situations (IT, £1bn, OCF 12%). Gearing is 124% so expect this turbocharger to work for both upside and downside. Current discount to NAV is 16.5%.|
|For emerging markets with a China bias:|
|Hermes Global Emerging Markets (Dublin ICVC, £800m, OCF 1.1%). With 54% in SE Asia and 16% in India, this is a tightly focused portfolio.|
|For Asian exposure: BlackRock Asia (OEIC, £45m, OCF 0.8%); managed from Hong Kong, actively selecting on geography as well as stock selection.|
China is now the locomotive of South East Asia, and prospects for the region are good. So I own China-heavy emerging markets funds and pure China funds.
It is at least a plausible scenario that a rise in interest rates in the West causes a bear market in developed market stocks that has very little effect in China.
When evidence shows a much higher fraction of Chinese savings is going into shares, it will be time to sell.
Chris Gilchrist, November 2016
Global income funds the obvious post BREXIT choice
Global income funds the obvious post BREXIT choice
UK equity income funds, which are a core holding for many UK investors, are subject to greater risks after the BREXIT vote. The majority of these funds hold a high proportion of capital in large cap stocks and these are the businesses most subject to uncertainty. Will they move operations, headquarters or even listings away from the UK? How long will it take until the leaders of these firms have any idea what the best course of action is? In the meantime, they are likely to put any major investment decisions regarding the UK on hold.
In any case, UK dividend distributions have risen steadily since the financial crisis, at a faster rate than profits. That cannot continue. So prospects for growth in income distributions from these funds are not great.
I now own no UK equity income funds but hold several global funds using similar styles and strategies, and there are plenty of choices out there, with initial dividend yields of 3-4%.
I last reviewed these funds last December (Issue 374). Now, as then, Scottish American Investment Trust (SAINTS) trades at a 5% premium to its net asset value, and if it were not for this I would own the trust and recommend its shares. Perhaps more turbulence in coming weeks will provide a buying opportunity.
Global IT yielding 5.7%
If you do want an investment trust, then consider the £1bn Murray International, yielding 5.7% and on a 1.8% discount to NAV. The longer-term record of manager Bruce Stout is good, but performance has been relatively poor over the past two years, largely because the fund has only modest US exposure (12%) and almost nothing in Japan. In its favour, it is more widely diversified and defensively managed than many “international” funds that slavishly follow benchmarks and therefore allocate around 50% of their equity holdings to the US.
As is usual in times when volatility rises, Newton has done well since last autumn. The managers remain broadly bearish and their portfolio is heavily invested in huge, solid global businesses that can weather any storm. In contrast, Artemis Global Income owns few such large-cap stocks and is more actively managed, with manager Jacob de Tusch-Lec having moved into more cyclical companies last autumn. This has held back performance in recent months, but previous such moves have been well-judged. Finally, Invesco Perpetual Global Equity Income applies the traditional “value” style used by many UK equity income managers.
In addition to the dividend growth argument, I believe sterling is likely to be weak for years as a result of BREXIT, which adds to the strong case for UK investors increasing their overseas exposure.
Chris Gilchrist, July 2016
Lifetime ISA – Lovely Lisa ramps up Help-to-Buy bungs
The pensions industry had got itself into a right pre-Budget tizz as a result of carefully managed Treasury leaks suggesting the Chancellor was about to abolish the current system of pension tax reliefs. Any such move would be the ultimate administrative nightmare, since merging existing pension schemes with ones designed for the new regime would be all but impossible without either a vast government subsidy or a massive rip-off of taxpayers. This was never a serious proposition. But the speculation about this meant that the Chancellor’s Budget wheeze, the Lifetime ISA, was immediately categorised by pension nerds as a back-door start to replacing tax relief on pension contributions.
Fortunately for Osborne, this has meant that almost nobody has questioned the logic of the huge government bungs involved in Lifetime ISA, the vast majority of which will be used towards property purchase by moderately wealthy kids.
The current Help-to-Buy Isa gives a 25% bung on savings up to £12,000, making the maximum subsidy for home ownership £3,000. With Lisa, the maximum bung escalates to £32,000. You can invest £4,000 a year from age 18 to age 50 and collect £1,000 in subsidy each year. If you spend the entire sum in your Lisa account on a first home valued up to £450,000, you keep the bung. Likewise if you cash it in after age 60. Use it for any other purpose and you lose the bung and pay a penalty.
This is not, as some dim commentators have suggested, an alternative to pension savings for young people. Most young people will get matching contributions by their employer. If they put £1 into the pension scheme, the employer puts in £1. The employee’s contributions get tax relief, so for most it will cost 80p. That means the employee using the pension plan gets an investment of £2 for 80p. With Lisa, it is £1 for 80p. No contest. Even allowing for the fact that you can only take a quarter of the pension fund as tax-free cash, you will end up with far more capital or net income from the pension than from Lisa.
Lisa will, of course, be exploited by the wealthy for their children. I don’t know any 18-year-olds who can save £4,000 annually out of their earnings, but there are plenty of parents who will save that amount for their children’s first home. Unlike the normal ISA, the loving parent will have the comfort of knowing their child cannot access the cash for a wedding beano or a shiny new motorbike. Get planning now for the scheme launch in April 2017.
Gains tax cut will backfire
Most analysts at the Treasury know that if you have differential rates of tax on income and capital, money morphs into the form bearing the least tax. So the only predictable effect of the cut from 28% to 20% and 18% to 10% in gains tax rates for higher rate and basic rate taxpayers, effective from 6 April 2016, is that it will result in financial engineering to benefit the wealthy. I expect by the autumn we will see schemes which transform income taxable at 40% into gains taxable at 10%.
The change might have one good effect, though, which is that Trustees, who have historically been reluctant to take profits and pay CGT, may feel they can now adjust trust portfolios to better meet beneficiaries’ needs.
ISA for more
The annual ISA allowance remains the same at £15,240 for 2016-17, but the following year it leaps to £20,000, a level you should probably expect it to remain at for some years to come. The Lifetime ISA falls within this allowance.
Given that for wealthy people, keeping capital untouched in pension funds is the best way of getting cash to the next generation free of inheritance tax, there’s a strong case for getting as much of your other capital as you can into ISAs so that you can draw as much of your retirement income as you can from this source. And the extra 7.5% tax on dividends is also an incentive to do this.
Dividend tax ahead
The extra 7.5% tax on dividends in excess of an annual £5,000 dividend allowance, announced in the 2015 Budget, takes effect from April 2016.
Apart from private company owners who are paying themselves through dividends, the losers from this tax hike should be able to avoid at least some of the effects by progressively switching capital into pension funds or ISAs. Income from these sources does not count towards the allowance. And transfers between spouses can also be used to avoid breaching the limit.
Simpler with the PSA
The Personal Savings Allowance is that rare beast, a genuine tax simplification measure. From April 2016, interest from deposits up to £1,000 per year for basic rate taxpayers is exempt from tax (£500 for higher rate taxpayers). At current interest rates, over 90% of savers will pay no tax.
From April 2016, banks will pay interest without (as they have done previously) deducting tax at source.
Savers will need to review their Cash ISAs–- many thousands of savers have accumulated large cash piles. Interest rates on cash ISAs are lower than those on non-ISA accounts. You would need well over £50,000 on deposit at current rates to breach the £1,000 annual interest allowance.
Chris Gilchrist, April 2016
How cheap is China? – an update
If China really had had a gigantic bull market, then the tumble of recent months would not have any sensible investor getting ready to buy. But as my chart shows, this simply hasn’t happened. It is only the domestic indices of speculative stocks that soared – in the case of the Shanghai Composite, by 120% from last October to June 2015. So, how cheap is China?
Download this article how cheap is China? as a pdf
But look at the poor old Hang Seng index of blue chip HK and China shares – it managed just a 40% gain over the same period and after the crash it is now trading at last October’s level.
Given the bungled way the authorities tried to put a floor under the market, it’s not surprising that most now mistrust all official pronouncements. But last week the government confirmed it wanted to sell off more stakes in State Owned Enterprises. That simply will not be possible until and unless domestic sentiment improves.
Meanwhile the FT reports that the powerhouse factories in South China are struggling to recruit enough workers to keep their production lines for Apple, Benetton and others humming. And retail sales are rising at around 10% and so are wages.
So I think investors should either start investing or add to their China holdings in coming months. Fidelity China Special Situations investment trust, with 30% gearing and at a 15% discount, is my own choice.
But real contrarians ahould be looking at Latin America. Here is an investment that has fallen by 20% over three months, 25-30% over six months and by 35-50% over the past 12 months. This is the one to buy if you want to prove your contrarian credentials.
I have indeed started buying, on a monthly drip-purchase. I have chosen Invesco Perpetual Latin America, an OEIC managed by Dean Newman, IP’s head of emerging market equities who has been managing this fund since 1994. He has seen this movie before. Rollercoasters can go up as well as down.
Performance of the China stockmarket indices
Download this article how cheap is China? as a pdf
Chris Gilchrist, October 2015
Time to top up China and EM equity holdings
My recommendation in last month’s editorial column to “buy through the pain” could hardly have been better timed. Chinese stocks proceeded to provide all the pain anyone might have wanted with a vertiginous sell-off, as shown in the chart. The Shanghai market registered a decline of 8.5% on August 24th, its biggest one-day decline since 2007. Chinese stocks are now some 50% below their June peak. Thousands of stocks have hit the limit of one-day declines of 10% and had trading suspended. Excitable news commentaries soon blew this up into a general panic that hit all world stockmarkets.
In fact, the China story is not the key to where economies and markets go next. The major developed markets either have growth momentum (the US and UK), or QE that looks as if it is starting to generate momentum (Europe and Japan). These economies (Germany is the possible exception) are not highly dependent on trade with China and the major growth that is happening is in services rather than manufactured goods. So while China and emerging economy slowdowns will reduce world GDP growth, perhaps to 3.3% in 2015, growth in developed markets overall is more likely to accelerate than decline. The low rate of core inflation in developed markets (averaging 1%) gives central banks an excuse to delay interest rate rises still further. Oil at under $50 per barrel and lower commodity prices mean headline inflation rates will probably trend down until well into Q1 2016.
The global macroeconomic background is therefore quite positive and neither macroeconomic nor monetary indicators signal an end of the bull trend. Some analysts say everyone still has far too much debt and this will act as a progressively worse drag. But much of this debt is accounting fiction. For example, how much of the government debt held by central banks can be said to still actually exist? And if an interest rate rise of about 1%, and hence the discount rate used to value liabilities, would eliminate all the pension deficits of the FTSE 100 companies, how real are those supposedly vast pension deficits?
The challenge for China
The transition from an investment-led to a consumer-led economy was always going to be a huge challenge for China. It has achieved as much of a consumer boom as anyone could expect – wages continue to rise at 10-15% and so does consumer spending. The only problem is that investment has declined even faster – as it had to – and the process of making massive state-owned businesses more efficient is a work of years rather than months. I suspect that if the Chinese authorities had got a large placing of shares in one of the SOEs away in Spring 2015, they would have slowed the market enough to prevent the summer sell-off. As it is, with only 6% of Chinese actually owning shares, and virtually no institutional investors in the market, the market in local shares is like nothing anyone alive today has ever seen, though if you could channel the ghosts of late 19th century US investors you might get close. To be fair, the authorities are rushing to introduce regulation to the wild east of China’s markets, and are probably ahead of where the US was at this stage of its history, for example in restricting trading on margin, where the US only introduced serious restraints after the 1929 crash. But as history proves, nothing can restrain the madness of crowds.
Performance of Chinese stocks and Fidelity China Special Situations
The divergence in performance and rating within China is vastly greater than most people assume. For example, according to fund managers Hermes, recently the average prospective PER on the Hang Seng China Enterprises Index, consisting of large HK listed companies, was 8, as compared with a figure of 70 for the ChiNext index of high-tech start-ups. The Shanghai Composite, with 1,100 companies, had an average PER of 15 while the larger Shenzen market (1,700 companies) had a ratio of 30. Fund managers tell me they continue to find good businesses to buy on very undemanding ratings.
The Chinese authorities’ reactions to the panic have been inconsistent. They banned large investors from selling stakes and effectively stopped short selling, then deployed a sum of between $150bn and $200bn to “market stabilisation” purchases, which has predictably been ineffective. On the other hand, they are improving brokerage and market regulation. They have cut interest rates and also bank reserve requirements, providing a monetary boost, and analysts expect a supplementary fiscal boost shortly. Most analysts expect the Chinese to avoid a meltdown or a “hard landing”: GDP growth this year may end up nearer 5% than 7%, but if it is inefficient and unproductive investment that is being subtracted from GDP, the effect will probably be smaller than most people think.
JPMorgan’s data confirms the valuation opportunity: their composite figures as at end-June showed China trading on a prospective PER of 10.6 as compared with a 10-year average of 11.8, and a price to book ratio of 1.2 versus a 10-year average of 2.1. Those figures will be at least 20% lower now. Its data also shows emerging markets as a whole at well below their historic average valuations.
Meanwhile, most fund managers have cut emerging market equity holdings and are underweight or heavily underweight the entire asset class. So it is at least arguable that we are being offered a once-in-a-decade opportunity to buy into an asset class at bargain levels.
If you go along with this, then you need to decide whether to buy a global emerging markets fund and leave the managers to decide how much to allocate to China, or pick a dedicated China fund and endure greater volatility. Or, as I have done, do both. I have selected three emerging market funds, all with highly regarded managers and better than average performance records. Somerset’s Edward Lam is very long-termist and with EM dividend-generating stocks at a discount to their long-term averages you could view this fund as offering a double discount. Its lower Asian allocation means it will likely be less volatile than the others. Fidelity and Hermes are both active asset allocators. Both managers are positive on China and Asia – we have yet to see any manager allowing themselves to express a bullish view on Brazil or Russia, both of which now have pariah status in the investment community – and both say there are plenty of good businesses whose shares they can buy at sensible prices. My own recent choice of these funds has been Hermes.
Emerging market funds’ performance
For a pure China exposure, I am sticking with Fidelity China Special Situations investment trust. Its level of gearing at 29% has pulled it down but will also propel it up when the market turns. Add that to a current discount to NAV of 15% and there is scope for sizeable and rapid gains. I have recently added to my holding and may well do so again.
Chris Gilchrist, September 2015
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 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 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.
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
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.
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.
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
China – The dragon roars into life
In September 2014 (Issue 359), I advised readers to ignore the GDP numbers for China and trust the consumer boom then taking off. Since then, the GDP numbers have got steadily weaker, leading to plenty of bearish comment on the stock market. But, as I said at the time, if consumer spending and wages are both rising at 10-15% annually while inflation is under 5%, why wouldn’t you invest? A return of over 40% since then is good enough, but my feeling is there could be a lot more to come.
Since last Autumn, the Chinese themselves have started to pile into the market in a major way. Obviously, the main reason is that they can’t make easy money in property any more. Property prices continue to slide gently, but with no sign of a crash. So new brokerage accounts have been opened at record rates and prices of small domestic stocks have soared. Whether such stocks are sensibly priced on PERs of 30 to 50 is debatable, but a well-run business ought to be able to raise profits at a much faster rate than 15% if that is the average growth in consumer spending. This isn’t a scenario that lends itself to analysis using the “secular stagnation” models of Western analysts.
Central bank maintains control
The central bank seems to have learnt its lesson from last time around, when a vast wave of liquidity and investment spending created all sorts of problems including much bad lending. Having tightened monetary policy by raising rates, it is now easing policy not with rate cuts but by reducing the size of the deposits commercial banks have to keep at the central bank. At the same time, central government is starting on plans to consolidate and tidy up local authority debts, while state owned enterprises (SOEs) are under pressure to become efficient and earn a return on their capital. All this is positive for the long term, so the drop in investment that is causing the decline in the GDP growth rate is, to my mind, almost irrelevant.
Go wild, go East
Naturally, a market like China is likely to have Wild East qualities for a long time to come. It’s probably best to think of it as like Wall Street in the 1920s. Individual investors will probably trade with greater and greater leverage as the market climbs. There is a serious risk of sudden shocks and market plunges. But these are, I think, likely to be short-term so long as that consumer boom continues. The reason is simple: if a stock is overpriced on a PER of 50, it takes only two years of earnings growth at 15% to reduce the PER to 22.
There is no doubt the domestic market is getting speculative. The Shanghai index is up 107% in 6 months and 144% over a year, as against 46% and 61% respectively for the MSCI China index and 31% and 44% respectively for the Hang Seng index. But the Chinese are the greatest gamblers in the world and have only just started to party. The local index, which carries less weight of boring behemoth SOEs than the MSCI index, could easily double again over the next couple of years.
Fidelity Special Situations Investment Trust, my major holding, is up 43% from last October and 69% since last May. Jupiter China, the best of its OEIC rivals, is some way behind as the chart shows. Fidelity has benefited from its gearing and so long as the bull market continues will go on doing so. Taking into account gearing of 26% and a current discount to NAV of 13%, it looks the obvious fund to buy as compared with ungeared OEICs.
Chris Gilchrist, May 2015
Why the barbell approach makes sense for funds
Most fund managers I meet have pretty conventional views, and some just about justify their fees through skill and diligence in stock selection. It’s rare to meet one who makes you think again.
One such is Chris Burvill, manager of the Henderson Cautious Managed Fund, a plain vanilla lower-risk vehicle that can invest a maximum of 60% of assets in shares but more usually has a roughly 50-50 bond-equity split. He’s been managing the fund since 2003. I met him recently and he explained why he thinks a barbell approach – holding both low-risk and higher-risk assets but nothing in the middle – can make sense.
On conventional valuation metrics, especially relative yields on gilts and equities, UK equities are cheap. On CAPE and book ratios they are pretty much in the middle of their historical range. Granted, short-term corporate earnings prospects aren’t great, but you can argue that they are improving. So on valuation grounds, equities are still the asset of choice.
For bonds, it clearly makes no sense to buy government bonds (for example German bunds) at zero or negative yields. This is a madhouse created by the European Central Bank’s QE. Does it make sense to buy 10-year gilts yielding 2.4% when the Bank of England’s mandate remains 2% inflation and its Governor says he can see that being attained next year? Only if you play the safety card and say that – as in 2008 – gilts will be the investment of last resort when we have another crisis.
Beware the greater fool
Note that this is just another variation on “greater fool” theory – “I know I’m foolish to buy this investment at this price but there are bigger fools than me who will pay even more for it”. This may be a viable tactic for short-term traders but is not something any intelligent investor will sign up to.
So conventional gilts are lousy value – the 10-year probably has 10-15% capital downside on a 1% upturn in yields – and in fact, when you look at fund portfolios, you find that most managers who do hold conventional gilts hold only very short-dated ones where there’s no such downside risk.
Next out along the yield curve are corporate bonds, but we can jump over AAA and AA rated bonds because they yield no more than gilts. You need to get to the bottom of investment grade – BB – to get a yield pick-up and more and more funds have big holdings of high-yield or junk bonds with lower ratings. The problem here is that a rise in interest rates will mean higher financing costs when companies need to refinance their debt, and the kind of businesses that have C ratings will probably have to pay a much bigger yield premium when interest rates rise – which suggests default rates on high yield bonds will rise. Then you ask if the current yield premium you get in high yield is sufficient compensation for that risk, and the answer is Yes only if you believe the current gap between gilt and high yield bond yields will remain the same. But any crisis is likely to see the gap balloon out, at least temporarily. That suggests high yield bonds are a very risky place to be, on top of which John Snowden’s liquidity concerns are shared – off the record – by most managers I speak to.
Where else can you find a safe haven? Chris Burvill’s answer is index-linked gilts, in which he now holds 10% of his fund’s assets. Linkers are also a big holding of absolute return managers like Ruffer and Troy. Burvill admits that after last year’s astonishing gains in index-linked, they no longer offer sensible value in relation to the short-term inflation outlook. But if you are thinking about the end-game they may.
After financial repression, expect inflation
The argument here is that we have had five year of financial repression – minimal interest rates plus QE plus regulations forcing banks and insurers to hold more government bonds. Once you reach negative interest rate territory, you have reached the end of the road – repression can only result in people doing what the Swiss are already doing, hiring bank safe deposit boxes in which to store banknotes – in their case to avoid the negative interest now charged on Swiss Franc deposits. Clearly at this point financial repression starts to have deflationary effects.
So end-game theorists reckon the next move has to be towards inflation. The argument here is that QE has already called into question the independence of central banks, since no central bank would undertake large-scale QE without the backing of its Treasury. We are likely to see further blurring of the boundary between political control and central bank control of monetary policy. Another way of putting it is that the distinction between monetary and fiscal policy is breaking down.
Either way, what policymakers want is inflation, to erode stubbornly high levels of government and household debt. And the trouble is that by the time they get it, it is likely to be accelerating past current inflation targets. In which case, index-linked gilts are the safe haven everyone will want to flee to.
I don’t think I’m ready to embrace this argument completely, though I had already been thinking about a strategic investment in index-linked. I do feel sure I don’t want to own any conventional bonds – I don’t want those with long duration because of downside capital risk, and I don’t want those with no duration because they deliver no return.
I would urge any investor with significant capital in long-duration conventional bonds to review their holdings. A panicking crowd all rushing for the exit from bonds remains the most likely cause of the next major market crisis.
If that is a realistic scenario, it’s also realistic to expect that equities will drop and recover – because there will not necessarily be a change in valuations, assuming the economic trends remain unchanged. So having, as Chris Burvill does, about 15% of your assets in cash ready to pick up bargains may also prove a worthwhile tactic for 2015.
Chris Gilchrist, April 2015