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

Diversified Growth Funds (DGF) are an easy way for investors to access a broad range of asset classes through one fund – ranging from equities and real estate to emerging market bonds. This diversification provides investors with exposure to various return drivers which can improve risk adjusted returns over the long term.

DGFs also come in a range of different styles, from highly dynamic absolute return funds to passive multi-asset funds. Within defined benefit pension schemes, DGFs are often sold as providing equity-like returns with lower volatility over the long term.

In recent years, DGFs have not lived up to this aforementioned return promise. This is primarily due to the fact that equities have seen huge increases and many DGFs have not kept up the pace of positive returns. However, investors see DGFs as more than just a vehicle for high returns, as they like to believe that their DGF will be better able to control risks and protect capital when markets crash, as they did in Q1 2020 or Q4 2018.

This was proved true over Q1 2020, when the average DGF return was -11% with global equities in pound sterling posting -16%. Absolute return type DGFs were better able to preserve capital and on average were only down 2% over the quarter. This is a good result, but it is expected due to their low beta allocation. The lack of protection from some DGFs during Q1 is due to the broad market selloffs with almost every asset declining in value; even more defensive assets such as investment grade corporate bonds declined. However, in Q4 2018 global equities declined -11% while the average DGF return was -5%, demonstrating that DGFs can protect on the downside.

The range of returns for DGFs is broad. While the average performance has been below expectations, they can still offer investors access to a range of diversified assets which is important for long-term diversification and returns.

Brendan McLean

The Retail Price Index (RPI) plays a significant role on both the asset and liability side of a pension scheme and any changes to the Index will have a far-reaching impact. Therefore, trustees need to take note of the recently proposed reforms to RPI.

What are the reforms?

In September last year, Sajid Javid, then Chancellor of the Exchequer, confirmed a public consultation would be held on the implementation of the UK Statistics Authority’s proposed reforms to RPI, with a specific focus on aligning it to the Consumer Price Index including Housing costs (“CPIH”).

These changes are proposed to take effect from 2030, however, to be considered as part of the public consultation, this date could be brought forward to 2025.

What impact will this have on pension schemes?

The impact of the reforms relates to the fact that the method of calculation is different for RPI and CPIH, which results in CPIH being lower by approximately 1% on average (this is sometimes referred to as the “formula effect” or “wedge”). This means that any instrument that has payments with a linkage to RPI, index-linked gilts for example, will see a reduction in those payments, thereby reducing the value of the instrument.

An individual’s pension or annuity, where payment increases are linked to RPI, would also see a reduction in the future expected cash flows.

Pension schemes will see the following effects:

  • If a scheme has RPI linked benefits, the total liability of the scheme can be expected to reduce.
  • Where schemes have hedged CPI linked liabilities using RPI linked assets, a loss can be expected (it is not uncommon for CPI linked liabilities to be hedged using RPI linked assets due to the fact that CPI linked assets are much less common).

The net position will be different for each individual scheme – action can be taken now to reduce the risk/impact of the proposed reforms, though the markets already seem to be pricing in some of the expected effects.

Further developments

There are many aspects of the reforms which are still undecided, and, as a result, leave the potential impact uncertain:

  • Possible compensation to those holding index-linked gilts (Insight Investment has estimated the potential loss to gilt investors at around £90 billion).
  • The date at which the reforms will be implemented.
  • What other related indices will be affected.

Once the exact nature of the reforms is finalised, the impact will be easier to assess. However, given the length of time until implementation, there is scope for further changes. Trustees and other affected parties should keep updated on developments and maintain a dialogue with their investment consultant to ensure the correct measures are put in place.

Meanwhile, schemes should at least be aware of any mismatch on assets intended to hedge inflation risk and trustees should satisfy themselves that they remain comfortable with the overall risk profile of their investment strategy.

Brendan McLean

Coronavirus and volatility

Stock markets reached all-time highs at the beginning of 2020; then came Coronavirus which caused panic selling in most asset classes due to the adverse impact it could have on businesses and the global economy.

The following week the panic seemed to be over, with some major equity markets rallying. This was particularly evident in the US which posted record highs again, driven by strong quarterly earnings and growth projections from the world’s largest companies, in addition to strong US job creation.

It is impossible to predict the full affect Coronavirus may have on the world economy. The World Health Organization has declared the epidemic a public health emergency, so Coronavirus could still cause markets to decline. The future outcome is unknown.

Highs and lows

What I find most interesting is the volatility it has caused. One example is Tesla, the electric vehicle manufacturer, which saw its shares increase by around 115% in 2020 only to fall by 15% in one day – its worst day ever. The sudden decline was driven by reports that Coronavirus would impact production and deliveries at its factory in China. This highlights the increasingly volatile market.

For bond issuers, 2020 also started off well, with the highest issuance of US high yield debt in a decade at $37bn – until Coronavirus fears saw investors pull $2.9bn out of high yield funds. One high profile US high yield ETF saw its asset base shrink by 7% in a single day – a rapid increase in volatility.

One to watch

The recent bout of volatility may be a sign of things to come for 2020. Trustees need to avoid making decisions based on short-term events and focus instead on their long-term investment strategy.

Brendan McLean

2019 reflections

The year began negatively with many commentators predicting poor returns. This was mainly because 2018 was a particularly poor year for assets. Deutsche Bank said 93% of assets were down in 2018 – worse than during the Great Depression – and December 2018 was the lowest performing month since the 2008 financial crisis for global equities. In Q4 2018, Brent crude oil fell by 35% due to rising crude inventories and increased production, in addition to fears that global growth may be slowing.

The main causes of the large declines in 2018 were: US central bank increasing interest rates, a slowdown in Eurozone business confidence, tightening global liquidity due to the withdrawal of quantitative easing, and weaker Chinese growth.  There were also rising geopolitical concerns including Brexit, Italian politics, US political gridlock, and the ongoing trade conflict between the US and China.

Key features from 2019 were the liquidity issues affecting Neil Woodford’s flagship fund, the Woodford Equity Income Fund, H2O Asset Management and the M&G property fund. As investors continue to hunt in riskier, illiquid parts of the investment universe (due to the decreasing yields available), I would not be surprised if similar events occurred this year.

Environmental, social and governance issues (ESG) became more important in 2019 as trustees faced new requirements to document the way in which they take account of ESG issues in their Statement of Investment Principles (SIPs). This resulted in a frantic push from asset managers to make their funds meet the relevant standards. Suddenly every fund became an ESG focused fund, which going forward is likely to result in a degree of ‘greenwashing’. There will be additional ESG requirements in place from October 2020 so trustees should prepare to spend more time on this area.

2020 predictions

2020 has certainly begun differently to 2019, mainly because 2019 was a fantastic year for assets. It would have been hard to lose money with equities and bonds both going up. Global equities increased by 22% – even a 60:40 equity bond fund would have increased by 20%. Commentators have been claiming that 2020 will be a good year, but I wonder how influenced they are by the joy of 2019.

Nevertheless, there are reasons to be optimistic about 2020. Due to the large Conservative majority in the House of Commons, progress on Brexit will hopefully be made and years of uncertainly should come to an end. There has also been progress on the US/China trade war. In the USA strong real wage growth, low debt levels and rising house prices means the US consumer, the key driver of the economy, is more likely to keep spending, which could prolong the economic cycle and be supportive for assets.

However, bonds and some equity markets do appear expensive by historical standards. There is a high level of global debt and the increased tension between the USA and Iran could very quickly escalate. This means that asset values are susceptible to any type of global shock.

To reduce the effects of such a shock, investors should aim to be highly diversified, allocating not only to the traditional asset classes of bonds and equities, but also alternative asset classes such as infrastructure, commodities, emerging market debt, structured finance, and currency.

Brendan McLean

The liquidity mismatch

Once again, the liquidity of daily dealt funds has made headline news.

Back in June 2019, Neil Woodford’s flagship fund, the Woodford Equity Income Fund, stopped taking redemption requests and will now be wound up, which has prevented 300,000 investors from accessing their investments.

More recently, in December 2019, M&G suspended dealing on its £2.5bn property fund due to £1bn of redemptions in a 12 month period, and the difficulty the firm has had in selling assets to meet all of its redemption requests.

These high profile cases highlight the problem of liquidity mismatch. Both funds offered daily dealing, which enables investors to buy and sell units in the fund each day. However, as the underlying assets cannot be sold at such quick pace, the funds were forced to suspend redemptions while assets were liquidated to meet the withdrawals.

One issue with the M&G property fund is that it had a high retail investor base. This class of investors has historically been quick to move money around at the slightest hint of ‘trouble’. Normally, defined benefit pension schemes will invest into ‘institutional only’ property funds, which makes redemption requests more stable and the funds less likely to be suspended.

Systemic risk

The Bank of England (BoE) has said that the issue of liquidity mismatch has the potential to become a systemic risk – this highlights the seriousness of the issue.  This risk being realised would potentially see similar funds suspended; this contagion effect was reflected following the M&G announcement, as investors started selling other property funds.

To combat the issue of liquidity mismatch and to protect investors, the BoE and the Financial Conduct Authority (FCA) are considering making daily redemptions of property funds incur a financial penalty. This is aimed at preventing large withdrawals and aligning redemption periods with the length of time it takes to sell underlying assets at a fair price.

In September 2019, the FCA announced new rules requiring property funds to suspend dealing if there is uncertainty over the value of 20% of their assets. This may see more property funds being suspended, which could damage investor confidence in the asset class and discourage investors from allocating to open-end property funds. Fund managers will likely respond to the new rules by holding a high cash balance, which will result in lower returns.

It is encouraging that both the BoE and the FCA recognise the importance of liquidity. In my view, the measures may create additional risks and potentially sacrifice returns, however, liquidity mismatch is a serious issue for investors and I am glad more efforts are being made to stop it.

Brendan McLean

ESG is on the agenda

There has been a growing demand on UK defined benefit pension schemes to consider environmental, social and governance (ESG) factors. Since October 2019, trustees need to set out how they take account of those issues in their statement of investment principles (SIPs).

This has led to investment managers adjusting their funds to meet the new requirements and satisfy the needs of trustees on considering ESG. However, defining ESG is open to debate. Different individuals have a different view on what it means, which could give rise to ‘greenwashing’, the term used to describe investment managers veiling their funds as greener than they truly are.

To combat this potential issue, the European Parliament has voted on new disclosure requirements for sustainable investments. Also, the Investment Association in the UK has released a framework to try to prevent confusion around responsible investment stemming from inconsistent use of terms and phrases. We believe this will naturally make it harder for managers to greenwash their funds, giving investors more confidence to invest in genuine sustainable funds.

Data issues

A potential issue caused by the increased disclosure requirements is the reliance on ESG data to ensure managers consider sustainability risks and opportunities. Currently, the main ESG data providers have vastly different methodologies for scoring companies, resulting in a wide range of results. One provider may score a firm highly and another, using a different scoring metric, may score it lower. We feel it is important for the ESG data providers to score firms consistently and recognise that the new classification system should help.

Investment managers place a heavy reliance on ESG data, which increases pressure to provide overly positive results for a higher score. Many ESG metrics are currently not audited in the same way as financial information, so it is easier for firms to inflate their ESG credentials. We would hope regulations will prevent this from happening.

No overnight fix

We feel the most important thing pension schemes can do to ensure they are really investing in line with their own sustainability objectives is to discuss the topic more frequently and understand what their aims are. We are pleased to see ESG and sustainability aims are a more common feature of trustees’ meeting agendas. While the change won’t happen overnight, we feel that over time, as more people become aware of the benefits of considering sustainability, it will get much more attention.

Brendan McLean

Greenwashing

In recent years there has been a huge push for society, and fund managers, to consider environmental, social and governance (ESG) factors. This has led to claims of greenwashing. Greenwashing is when a firm claims to have a greater ESG focus than they actually do.

As people grow increasingly interested in ‘going green’, the issue of greenwashing is becoming a problem faced by all of society, not just pension schemes. Investment managers and companies are seeing opportunities to capitalise on the changing sentiment by making their products appear greener than they really are. A recent example is the fast food restaurant McDonalds. They swapped their single-use plastic straws for a paper alternative. However, in August 2019, a leaked internal document showed that the straws were non-recyclable.

From October 2019, trustees need to set out how they take account of ESG issues in their statement of investment principles (SIPs). This has resulted in a frantic push from managers to make their funds meet the standards – which could encourage greenwashing. A key issue with ESG factors is the lack of clarity on what it means, making it easier for managers to greenwash their funds.

Going colour blind

Pension schemes could have been affected by untrustworthy ‘green’ credentials from investment managers. I suspect many may not realise it has happened as it is difficult for trustees to scrutinise managers’ ESG claims. A concern for trustees is that if they allocate to a manager based on their ESG values, the manager may not act as expected, which would create a lack of trust with ESG investing. Greenwashing could, therefore, destroy investors’ confidence as they may lose faith in companies or fund managers that promote themselves as focusing on ESG issues. This could have a knock-on effect by slowing down the pace of ESG investing, which would be detrimental to the positive impact it can have. Greenwashing also makes it harder to identify managers who are truly trying to make a difference, potentially reducing the pace of ESG innovation.

The grass can still be greener

Often managers state they have been integrating ESG for many years, but their team and head of ESG are all recent hires. Trustees should look for a more seasoned team to mitigate this concern. Many managers make assertions that they have been following ESG practices for many years by excluding certain sectors. However, this is often driven by client demand rather than the managers’ ESG beliefs, so it can be tricky to get a clear understanding of a managers’ ESG credentials.

It is difficult for trustees to ensure that their investments are as environmentally responsible as managers claim. Trustees place a great deal of trust in their investment managers to act in their  best interests, but it is hard for them to monitor. Often, the easiest way for trustees to be confident that their investments are environmentally responsible is to allocate to managers who have a genuine track record of integrating ESG into their investment philosophy and process; and not to those managers who have simply jumped on the bandwagon to include it.

Trustees should look at managers’ track record of stewardship and engagement with companies, and to the quality of their ESG team. They should also work with their investment consultants to help provide a deeper understanding of the managers’ credentials.

Brendan McLean

Recently, the government rejected the suggestion from the British Business Bank (a state-owned bank that helps finance new and growing businesses) to reform the current 0.75% cap on annual charges that defined contribution pension scheme members pay for the default investment strategy. Maintaining the current charge cap can reduce members’ ability to invest in more alternative (and also more expensive) asset classes such as venture capital (VC).

No entry to the dragon’s den

Venture capital involves investing into early stage companies, as in the premise of the BBC show Dragons’ Den. VC investments can grow from minor beginnings into hugely successful companies, e.g. Facebook and Uber. It offers investors the opportunity of significant returns. The government’s rejection denotes that members may find it difficult to get access to a potentially rewarding area of the market which would help diversify and increase their pension pots. However, it will save them from paying high management fees, and also from the risk of their capital being locked away for a long time due to the inherent illiquid nature of the asset class.

Allowing VC and other expensive and illiquid funds to be accessible to DC members would increase member potential returns, but also increase risk. Selecting any investment manager that outperforms net of fees is notoriously difficult and there is little evidence to suggest retail, or even institutional investors, can do this successfully over time. The performance of VC managers varies considerably and there is no way of knowing which would be successful – this would put members’ capital at risk.

What’s the alternative?

A key challenge to changing the charge cap is in answering the question ‘what do we change it to?’. VC fees can become complicated as they charge carried interest, similar to a performance fee. This could result in the member paying many multiples of 0.75%. Carried interest could encourage the VC manager to take excessive risks to get their very lucrative carried interest fee. Perhaps having a higher base fee could be a solution i.e. some funds have two share classes, one with a performance fee, the other with no performance fee but a higher standard fee.

An alternative to VC could be investing into small or micro-cap passive indices as these are more correlated to VC than traditional large cap indices. This may help members achieve higher growth but will increase the volatility of returns. As most members are likely to be invested for an extremely long time (e.g. 30-40 years), many listed and passive funds could provide a similar return to their illiquid active peers without the need to allocate to expensive and illiquid VC funds.

Brendan McLean

Unrated bonds

Rated bonds have been assessed for a fee by a credit rating agency (Fitch, S&P or Moody’s), and the agency issues a rating based on the likelihood of a bond’s default. Unrated bonds are simply bonds which have not been through this process and do not appear in benchmark indices.

Many companies, particularly large multinational firms, have both rated and unrated debt in issue; they may just choose not to pay a ratings agency to analyse a particular bond.

This can be for a number of reasons, including the size of the debt issuance, the cost of obtaining a rating, the need (or lack of) for visibility, and the level of complexity of the issue. Unrated bonds do not necessarily mean less liquid, for example, The Kingdom of Spain government bonds are highly liquid, but not rated. The sovereign (i.e. the country as a whole) is rated but not each bond.

Active bond managers are able to identify market inefficiencies between two similar bonds, one rated and the other unrated. The rated bond will often command a higher price, without necessarily offering better security or value, purely on account of being rated by one of the rating agencies (the enhancement of the rating).

By investing in unrated bonds, investment managers can increase the diversification of their portfolios, enabling them to better manage risks and enhance yield.

We prefer investment managers which can make full use of their credit research skills and investment universe by allocating to unrated bonds and build portfolios that are designed to achieve superior long-term returns.

Brendan McLean

How low can rates go?

The recent decline in yields is a sign of how quickly market expectations can change.

While the UK base rate has remained at 0.75% since August 2018, longer dated rates have recently been falling fast. Between April 2019 and August 2019, the UK 10-year government bond rate has fallen from 1.27% to 0.52% and 20-year rates from 1.77% to 1.11%. This will have dramatically increased pension scheme liabilities unless they have been fully hedged.

Global decline

It is not just the UK where rates have seen dramatic declines – it is happening across the globe. The 10-year US Treasury yield fell from 3.24% in November 2018 to 1.69% in August 2019, with a 0.38% fall in the last few weeks alone. This huge decline can be explained by the US Federal Reserve reducing its benchmark rate by 0.25% on 31 July (the first reduction since 2008) and also deciding to end the process of shrinking its balance sheet, known as quantitative tightening, two months ahead of schedule.

PIMCO estimates that $14 trillion in government bonds, or 25% of the global government bond market, has negative yields. In early August 2019, German 10-year yields were -0.58%, and the Japanese 10-year yield was -0.22%. Large bond managers say it would not be impossible for the US Federal Reserve to reduce rates to 0%; they are currently 2% to 2.25%. It seems unlikely that UK rates will go as low as Germany or Japan, but it highlights that investors are willing to accept negative returns in government debt.

Monetary policy driver

The driver of the recent declines is changing central bank monetary policy. Global central banks have started to reduce interest rates due to slowing economic growth and investors are pricing in more rate cuts. Recently, India, New Zealand and Thailand surprised investors with larger than expected rate cuts. Investors are becoming more concerned about global growth, particularly in light of the US/China trade war which is showing no sign of ending and is beginning to develop into a currency war. Investors are worried, which is leading to declines in equities, more flows into safe-haven fixed income assets and depressing yields even more.

A popular recession indicator is the yield spread between US 10-year and 3-month Treasuries. It has turned negative before every recession since the Second World War and has been negative since May – so investors could have good reason to believe a recession is likely.

A key tool central banks use to encourage growth when there is a recession is to lower rates. But considering how low rates currently are for developed economies, they will not be able to pull this lever and will need to find alternative solutions to avoid a prolonged recession.

So – just how low can rates go?

No one knows. We are in a period of low but stable global economic growth (except for the UK) with high employment – central banks are beginning to reduce rates to prolong the business cycle. Therefore, when the next recession occurs, central banks will cut rates even more. We may not have seen the bottom yet.

The recent decline in yields poses a question for pension scheme trustees. Should they increase the level of interest rate hedging even though rates have fallen? This has been a key challenge for trustees over the last 10 years as rates have declined. While hedging won’t offer the same benefits as it did previously, because yields are lower, it should provide trustees with a more stable funding level.

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