Posts by Brendan

Brendan McLean

Brendan McLean

Brendan works as a Manager Research Analyst and is responsible for selecting and monitoring the investment funds recommended to clients.
Brendan McLean

Illiquidity alert

The expanse of liquidity scandals coming out of the asset management industry should be a warning to investors. In less than a year, there have been at least three well-published events: GAM, Woodford and H20. Even the governor of the Bank of England, Mark Carney, has warned that daily dealt funds that are not liquid are “built on a lie” and if nothing is done they could pose a systemic problem.

With the increasingly difficult search for yield, fund managers are diving deeper into more illiquid assets. When investors in their daily dealt funds want their money back after a change in sentiment, some negative news or performance of a fund, a ‘fire sale’ can be triggered where investors want their money back immediately. In reality, this may not always be possible for some daily dealt and other funds with longer redemption periods. When a client wishes to redeem, the manager normally disinvests from holdings which are the most liquid and the cheapest to sell. When more and more investors redeem, the fund becomes more illiquid. Then investors panic as they do not want to be left with the illiquid assets resulting in many redemptions happening at once. This overloads the manager, who is unable to sell the underlying investments to meet the redemption requests and often they must suspend the fund to manage the sale of these assets.

Investors should understand their fund managers’ investment philosophies and have confidence in their portfolio management skills, in addition to seeing that they have a robust risk management team. Clients should be cautious of star managers who have too much influence over the risk management process. They should avoid making up a large portion of a fund as they may struggle to redeem even under normal circumstances. Investors should not be chasing yield without considering the risks carefully; whilst it’s frustrating that returns are low, having money tied up in an illiquid suspended fund would be even more so.

GAM

In July 2018, the Swiss asset manager GAM suspended leading bond manager Tim Haywood after a whistle-blower raised concerns about his conduct, namely breaching due diligence rules and company policies. This triggered a huge wave of redemptions and ultimately the closure of £8.5bn of fixed income funds. Subsequently, the GAM chief executive stepped down and the share price declined 70%. The main issue faced by investors was getting their money back as the funds had a lot of illiquid holdings which were hard to sell.

Woodford

On 3 June 2019, the popular Woodford Equity Income Fund, managed by fallen star manager Neil Woodford, began to make mainstream headlines as dealing in the fund had been suspended. This was due to serious liquidity issues after continued mass outflows from consistently poor performance. According to MSCI, at the end of 2018, 85% of the fund’s net asset value invested was in illiquid securities, which creates a major issue around selling assets and returning clients’ capital.

The FCA is now investigating Woodford for breaching liquidity rules.

H20

The most recent case study took place on 18 June. H2O Asset Management, a subsidiary of French group Natixis Investment Managers, was the subject of a Financial Times article detailing that the fund had bought some illiquid bonds linked to entrepreneur Lars Windhorst, who has a history of bankruptcy, various legal troubles and a suspended jail sentence. The CEO of H20 was appointed to the advisory board of a Windhorst company raising the appearance of a possible conflict of interest; he has since resigned, but needless to say this has triggered a wave of redemptions.

With $13 trillion of global fixed-income assets currently generating a negative yield, the temptation for fund managers to take more risk and move into more illiquid assets to generate higher yields is hard to resist. This means it is highly possible that more illiquidity scandals will happen. Mark Carney has called for increased regulations to ensure investors are not misled, and European regulators are designing new liquidity rules for funds, which will hopefully offer better protection for investors.

Brendan McLean

Since the events of the global financial crisis in 2008/09 most markets have gone up, driven mainly by quantitative easing. This has made it very difficult for any active manager to outperform.

However, following large capital flows from active into passive investing and changing regulations, could active managers outperform in the future?

Investors have moved huge amounts of capital from active to passive funds. This change started in 2006, even before the crisis. According to Morningstar, the size of the passive fund market in the USA now equals the assets in active management. As passive funds buy all holdings in an index indiscriminately, with no sense of value, could active managers now have a better chance of exploiting this? I feel active managers could capitalise on less money chasing market mispricing and outperform over the long-term, although managers would need to hold concentrated portfolios to capitalise on this, which increases the risk. For risk averse investors passive funds will still be preferable as the appeal is in their diversification, where a single holding declining in value would not have a material effect.

Since the introduction of MiFID II in January 2018, asset managers have been required to make direct payments for investment research rather than using clients’ trading commissions to cover the cost. Due to the large fees involved, many asset managers do not want to pay for research which was previously free. As a result, many brokerage firms have cut their research personnel. Given that there are fewer analysts covering stocks, could this lead to more mispricing and extra opportunities for active managers (who have their own research capabilities) to add value?

Over the short-term it may not make any noticeable difference due to the depth of coverage particularly for large caps. However, over the long-term we may see fewer research analysts in general which could lead to better opportunities for active managers. Small cap active managers generally have more success in adding value verses their large cap peers, partly due to a lack of research coverage. With MiFID reducing the number of research analysts even more, small caps may become an even greater area of the market where active management can outperform.

With the ever increasing flow of capital from active to passive funds and with less research analysts identifying mispriced stocks, perhaps there is a future for active managers to outperform.

Brendan McLean

All major equity markets gave a positive return over the quarter. This was mainly driven by the Federal Reserve (Fed) confirming it would not increase interest rates (as previously indicated) due to declining economic growth and easing of concerns over the China/US trade dispute.

UK equities rallied over the quarter in line with global equities. Investor sentiment improved as it became clear that there was no majority in the House of Commons for a ‘no-deal’ Brexit. A number of domestically-focused equities increased following the delay to Brexit beyond March 2019 as hopes that a disorderly exit from the EU could be avoided. Sterling increased versus the Euro and US dollar. UK long-term inflation expectations were unchanged over the quarter.

US equities were the best performing region as investors responded positively to the Fed stating it will not increase interest rates. Emerging markets equities performed well over the quarter led by China. The US administration’s decision to suspended tariff hikes on $200 billion of Chinese goods, together with ongoing government support for the Chinese domestic economy, was all supportive.

The price of Brent crude oil increased by 27% over the quarter as OPEC followed through on promises to cut production.

Corporate bonds performed well due to the Fed signalling it will not raise interest rates and that quantitative tightening will end in September.

UK gilt yields decreased over the quarter as investors flocked to safety due to fears of slowing growth. All else being equal, this acts to increase the value placed on pension schemes liabilities.

Brendan McLean

Markets performed very well in January with the MSCI World up over 7% in USD. This was driven by the US Federal Reserve signalling that it may not raise rates as fast as previously indicated. Also, US/China trade relations are improving, which resulted in the MSCI China Index being up over 11% in January in USD. However, even with the strong returns most asset classes have not recovered from last quarter’s negative performance.

Despite the improving US /China trade tensions assisting in boosting equity markets in January, the US economy is beginning to see effects of this trade war as leading indicators such as the ISM manufacturing survey reported its largest monthly decline since 2008. The tensions have had a greater effect on China, which has resulted in the monetary authorities having to provide stimulus to the economy. Europe has also been affected by the trade dispute, mainly caused by slowing Chinese demand for manufacturing equipment.

In the UK, Brexit continues to dominate the news in the run up to the exit from the EU on 29 March 2019. Throughout January, a number of votes held in Parliament indicated that the majority of MPs are against a no-deal scenario and would support May’s deal if she can re-negotiate the Irish border backstop, however, the EU have so far said this is not an option. If she can receive concessions from the EU regarding the backstop then it is possible that a version of her deal could pass in parliament. Sterling increased on the possibility of a deal being reached. There could be increased volatility in markets if there is no deal agreed by the March deadline, as markets seem to be pricing in some kind of deal at the moment.

In January, Italy officially went into recession, which is defined as two successive quarters of economic contraction. This result did not surprise markets, as over the last six months the new Italian government has been in a dispute with the European Commission over the size of its government’s spending budget.

Despite the bounce in markets in January, we expect them be volatile going forward and Trustees should continue to monitor their investments and speak with their advisors to ensure their investment strategy remains suitable.

Brendan McLean

Market Volatility

Recent market volatility has created a lot of news headlines, as well as causing multiple asset classes to record some of the worst annual performance since 2008. The last quarter of 2018 was particularly painful with global equities returning -10.6%, UK equities -10.2%, oil -40% and 10 year treasury yields -19%. This was mainly driven by fears of slowing global growth and investor de-risking and moving into safer assets.  It is worthwhile noting that strictly speaking the definition of market volatility is markets moving a lot both down and up however, in periods in higher volatility markets tend to decline as investors panic and sell.

The cause of the volatility has not yet dissipated, and 2019 could be an even more volatile year due to a range of factors including tightening global liquidity because of the withdrawal of quantitative easing, rising interest rates, rising geopolitical concerns including Brexit, Italian politics, US political gridlock, and the ongoing trade conflict between the US and China.

But what does all this mean for pension schemes and their investments? 

I think pension schemes should not be panicking.  They are long term investors so should not be too duly influenced by short-term volatility.  That said such volatility does provide challenges (as well as opportunities) and it does alter market dynamics.  I mention below a few areas that I think pension schemes should be thinking about as follows:

  • Asset switching – with such volatility schemes need to be careful when switching.  The impact of market volatility can be reduced by trading over a number of days or trading on days when news announcements are not expected.
  • Active management – In recent years there has been a lot of capital flowing into passive funds, due to the low cost and better performance net of fees, versus active managers. However, active management may be able to reduce volatility and provide better returns by using their skill to protect against such volatility. Also they can hold more cash in falling markets than passive managers so protecting values. This could mean active managers could outperform the aforementioned passive index funds.
  • Diversified Growth Funds – If you look over the last 5 to 10 years these funds have often provided returns significantly less than equities during the bull equity market run, despite being sold as equity replacements.  Perhaps they can now in a more volatile environment prove their worth and provide equity like returns with lower volatility.
  • I believe that pension schemes should have trigger structures in place to benefit from any potential upside if it does occur. Given the current volatility with market movements occurring rapidly, having a robust process for implementation will benefit pension schemes and help them take advantage of these opportunities.

I am sure that there a lot more areas that pension schemes need to be thinking about and it is worthwhile that Trustees speak to their consultant about what is going on at the moment to seek their views as well as their managers’ views.

Brendan McLean

The UK property market is one of the most developed and stable in the world. For investors, that means greater potential for stable income and capital growth over the long-term. We believe this potential still exists despite market concerns over Brexit and high street store closures.

Since Brexit, UK property has performed well and has seen a surprise surge in transaction volumes, particularly from overseas investors; this can be partly attributed to sterling weakness. There is the possibility that some international companies may choose to locate themselves outside of London post-Brexit, which could negatively impact central London offices – however outside of the capital other segments should prove more resilient. A broad portfolio, well-diversified across sectors and locations, should help weather any headwinds.

The high street retail sector continues to underperform due to the shift towards online shopping; high profile casualties such as Toys R Us, Maplin, New Look and Carpetright have decreased high street rental demand.  However the shift to online shopping has benefited distribution warehouses that store online purchases, these will continue to grow for the next few years as more people shop online.

The property market is not without its challenges, both from Brexit and from consumers choosing to shop online rather than in-store. Nevertheless, there is still room for capital appreciation and secure income. We are confident that diverse UK property allocation continues to have a place in portfolios.

We particularly like property for its ability to produce a steady income stream that is potentially inflation linked.  This income stream can be used by pension schemes to meet their cashflow profile.  Investors are also being paid a premium to invest in an asset class which is illiquid in nature – more below.  An Investment in property should be a serious consideration for a pension scheme.

A downside to investing in property is the significant transaction costs to enter and leave this asset – sometimes you might not even be able to enter or leave!  However, for most pension schemes with a long term time horizon and other liquid assets this should not be too much of an issue.

Brendan McLean

The annual Pensions and Lifetime Savings Association (PLSA) conference in Edinburgh brought together leaders of the pension industry from trustees to investment managers, and addresses the biggest challenges faced by the industry with the aid of key guest speakers and expert knowledge.

This year’s focus was on cost transparency, regulation, and diversity, and below are some of my personal highlights.

Gaining the public’s trust again

The pension industry gaining more public trust was a key theme of the conference, with reference to a focus on cost transparency. Costs are an obviously important issue for investors; however I feel there should be concentration on the best value manager, not the cheapest.

Remembering the financial crisis

Nick Clegg, former Deputy Prime Minster in the years of the financial crisis, was one of the key speakers and discussed the notion that people are already starting to forget the way that imbalances, exposures, and liabilities can brew in a financial system, as during the 2007/8 financial crisis, if left unchecked. I believe he was making reference to senior members of systemically important firms (such as banks) having left their businesses or retired from work, leaving people who did not experience the crisis in their previous positions in charge.

The impact of advances in technology

Advances in technology were also alluded to – firms now have access to blockchain technology to help reduce costs trading (although this isn’t yet widely used), however there is concern with this in that firms will need to share information which will probably cause a greater delay than getting the technology.

Ethical investing

Ethical/impact investing was mentioned often. Ethical investments are not just about ethical investing, but also about reducing the risk in a portfolio – for example, challenges facing tobacco firms due to increased regulation will reduce sales and therefore share price. Ethical investing is more aligned with long-term investing, allocating to things such as renewable energy.

Asset bubble

A panel discussion was held on asset bubbles because of equity markets being at all time highs. It was debated that given the high valuations of equities it would not be unimaginable for the US equity markets to halve in value based on P/E ratios, and counter-argued that other valuation techniques don’t consider them to be overvalued at all. I struggle to see the where the growth in equites will come from given the rise of interest rates in the US.

If you would like to discuss any of the topics or issues raised above you can get in touch with me by phone on 020 3794 0193 or email I’d love to hear from you.

 

Brendan McLean

Autumn for me represents two things: colder, darker days, and a new budget. I wait excitedly for the budget in the hope of fewer taxes, but it seldom happens – however this year, something else exciting happened. Philip Hammond, Chancellor of the Exchequer, declared the Government wants to see pension funds invest in patient capital as a way of financing growth in innovative firms as part of his mission to unlock over £20bn of new investment over the next 10 years, ensuring the UK economy is fit for the future.

This move follows a government consultation that closed in September 2017 which discussed lowering barriers to patient capital investment, such as long-term illiquid investments in start-up companies, for defined benefit (DB) and defined contribution (DC) schemes.

This change won’t take place overnight – The Pensions Regulator will still need to provide guidance on how trustees can increase patient capital investment, which both the regulator and HM Treasury has not yet provided a timescale on. However the Treasury has said they will establish a working group consisting of institutional investors and fund managers with the goal of increasing access to patient capital for innovative firms, and removing barriers to investment for DC members.

Investment-Pension-Budget-2017

In this current low yielding environment with various asset classes valued at record highs the thought of allocating to alternative long-term investments such infrastructure and venture capital which are less correlated to traditional asset classes offers a hope of a higher level of future returns for DB schemes. This could help decrease funding deficits. I believe over time illiquid long-term assets which are currently more accessible for larger schemes will become available for smaller schemes, as previously occurred for LDI.

Investment in long-term patient capital represents an opportunity to encourage younger DC members to get involved with investing in their pension.  As they are unlikely to retire for decades the benefits of long-term patient capital will be more visible to them. However most DC pensions’ assets are currently daily priced and normally offer daily liquidity. These two factors make it extremely difficult to make illiquid assets available to DC investors.  On a technical point, DC funds are offered in life assurance wrappers and the rules around those wrappers typically prohibit investment in illiquid asset classes.

Removing barriers to entry can only be a positive thing as it will help investors allocate capital more appropriately. These new changes will benefit DC members as they currently have a greater challenge accessing long-term illiquid investments. DB schemes will also benefit as they will have a greater opportunity to allocate to diversified less correlated assets.

For more information or to discuss the content of the blog please get in touch.

Brendan McLean
t:/ 020 3794 0193
e:/ Brendan_McLean@spenceandpartners.co.uk

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