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

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.

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.

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