Archives for February 2016

Peter Pan, Central Banks and markets

J M Barrie’s Peter Pan had a very strong grasp of the necessity of faith – “Whenever a child says “I don’t believe in fairies”, there’s a fairy somewhere that falls down dead” was written in 1911, and his own ability to fly was critically dependent on his lack of doubt that he could fly.

Ever since the introduction of QE in 2009, markets have had faith that the unconventional actions of the Central Banks would lead to economic recovery. The markets’ expectation of better times ahead itself played a key role in boosting confidence in the real economy, so helping to generate that recovery.

In the last three months however, that faith has been eroding as markets have come to believe that central banks are no longer in control of events. In Japan, the failure to boost QE further at the end of 2014, when the Bank of Japan were expected to do so, closely followed by the adoption of negative interest rates a week after denying they would do so looks like panic. In Europe, Draghi encouraged markets to believe that further ECB easing would be forthcoming in December, only to be unable to deliver it, and then repeated the encouragement that action would be taken in March after market weakness in January. The ECB appears to be a very divided Central Bank. In the US, the Federal Reserve clearly indicated in December when it raised interest rates for the first time in seven years that it expected four further such increases in 2016. Yet markets now assign an equal probability to their next move being a rate cut as a rate hike – the Fed is losing credibility.

Behind all this is the continued deterioration in growth expectations – a year ago there was a general sense that 2015 would see economic recovery around the world as the enormous global monetary easing over the previous six years finally bore fruit. The reality was that once again growth disappointed expectations even with the tailwind of a much lower oil price. Market sentiment is giving up on monetary policy producing economic recovery, and their lack of belief will make it even harder for Central Banks to deliver it.

In particular the move to negative interest rates in Europe and Japan, and the admission by Janet Yellen that the Federal Reserve would also do so if they believed it was necessary has alarmed investors in bank securities, both equities and bonds. Coming as it does with further downgrades to global growth expectations, markets have drawn the implication that central banks themselves are losing confidence that further QE will stimulate economies and thus they are moving towards the idea of negative interest rates. If the Central Banks no longer believe in QE, why should anyone else?

Widespread negative interest rates have not been adopted before – perhaps they will incentivise people to spend rather than save, but that is unclear. What is clear is that negative interest rates are bad news for banks – they have been very reluctant to extend negative interest rates to most depositors, with the result that their net interest margins are falling, at a time when loan growth is slow or non-existent. Banks are the worst performing equity sector so far in 2016.

Markets have now lost faith in the ability of Central Banks to create economic growth – falling bond yields and falling equity prices demonstrate this. To recapture that faith, Central Banks will have to take even more aggressive, unusual and unexpected action.

Did fund size matter to performance in 2015?

This was originally published in Investment Week

2015 saw the two largest funds in the UK market enjoy very different fortunes. Continued strong inflows into SLI Global Absolute Return Strategies (GARS) saw net inflows into the UK version fund to November of £2.6bn and its assets rise to £26.8bn, though total assets in the strategy now total over £44bn, whilst M&G Optimal Income saw net outflows to November of £6.2bn and its assets decline to £16.3bn. GARS’ performance of 2.2% in 2015 was below its 3-year average rolling target return of Cash +5% gross of fees, but nevertheless was a reasonable outcome in a tricky year for financial markets – the inflows came on the back of delivering good performance over previous years whilst staying within its volatility target of 4-8%. For Optimal Income however, disappointing performance in 2014 relative to its Morningstar category and a decline of 1.2% in 2015, along with increasing investor concerns about future returns from bond funds as the Federal Reserve moved closer towards raising interest rates, have come together. For both funds, size has meant that it is increasingly difficult to generate meaningful outperformance from individual security selection, which was a feature in the early days of both funds. However both funds seek to deliver returns from a wide variety of sources of alpha, which are generally asset-allocation and top-down in nature. Even though both funds appear to be very large, given their aims to trade in the money, bond and equity markets all over the world and their ability to use derivatives to efficiently manage exposures, we don’t think liquidity is as pressing an issue as it might seem. M&G’s recent disappointing performance was mostly due to its underweight stance on duration in its bond holdings. This stance could be reversed quickly through the use of derivatives even for a large fund like Optimal Income.

If there were an impact of size on fund performance, the expectation would be that relative performance would deteriorate over time as funds become more unwieldy to run. Where issue selection or rapid trading of less liquid securities is key to a fund’s success, this is a common scenario. However, there is also the notion of “reflexivity”, whereby a large fund that starts to see outflows is forced to sell down its largest positions which damages the prices and performance of the rest of the portfolio. This can also work positively as funds seeing inflows buy more of their favourite positions, so boosting prices and performance.

In most categories, the fund universe is highly fragmented and UK funds are small relative to their market liquidity. In addition, funds which are long term investors in the companies they invest in and thus have low portfolio turnover, are able to cope with large size much more easily than funds with high rates of portfolio turnover as they demand less liquidity. If a fund’s strategy is contrarian in nature, it may also be a liquidity provider—selling when others are buying and vice versa—allowing it to run at a greater scale than would otherwise be the case.

The largest active UK equity funds are the Invesco Perpetual High Income and Invesco Perpetual Income funds, now managed by Mark Barnett, following the departure of Neil Woodford in 2014, at £12.6bn and £6.5bn respectively and Neil Woodford’s new fund CF Woodford Equity Income at £8.0bn. All three of these funds performed well in 2015, the Woodford fund performing exceptionally well (with performance of 16.2%) whilst dealing with inflows of £2.9bn over the year.  The largest contributors to the excellent performance of the Woodford fund were the exposures to healthcare and tobacco, two themes in which he has been invested for well over a decade – at year end he held a 7% position in Imperial Tobacco which rose by 33% in 2015 and was the largest single contributor to the performance of the FTSE All Share index. A further 3.5% position was held in Reynolds American which rose in value by 56% in 2015. The healthcare exposure performed well on the back of much smaller or unlisted holdings. Woodford has run enormous amounts of money for some years now, but his excellent stock-picking and low-turnover style has meant that he has been able to deliver strong performance despite the size of his portfolios.

Mark Barnett‘s approach has been slightly different to that of Woodford – he is less inclined to hold unlisted companies and tends to hold smaller positions in his most favoured stocks. Whilst his funds saw heavy outflows in 2014 as Woodford left Invesco Perpetual, these tempered over 2015 as investors have seen him continue to deliver good performance on these funds. His performance in 2015 of 9.3% for the High Income fund and 8.4% for the Income fund, were comfortably ahead of the benchmark index and sector peers, and this followed very good performance in 2014. The size of his funds and his similar low-turnover style has not led to any difficulties in generating excellent performance.

The sector which would be naturally least liquid and where size could quickly prove to be a handicap for managers is UK Smaller Companies. However, in 2015 the two largest UK smaller companies funds, SLI UK Smaller Companies and Marlborough Special Situations, both of which ended the year over £1bn in size, delivered 28.2% and 19.2% respectively, strongly ahead of both the benchmark and the category average. Many funds outperformed their smaller companies’ benchmarks last year, where the resource-related stocks performed very poorly but many domestic industrial stocks performed very well.