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

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.

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.

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