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Peter Elston’s Investment Letter – Issue 32: January 2018

15 January 2018

Looking back…

All three of our funds have been blowing passive multi-asset funds out of the water based on volatility adjusted returns for five years now and even more so over three years (see Table 1). Importantly, the bond bear market that could crucify these passives and their high fixed allocations to investment grade bonds may only just be getting started.

cartoon snip

I’m certainly now pleased with our past performance as well as very much excited about the future. And I implore those with exposure to a bond bear market that could last for the next 20 years to reconsider.

Table 1: Performance of Seneca funds versus passive multi-asset funds (sorted bythree-year volatility adjusted returns)

Table 1

2017 was very good to us and thus to our customers. Not only did equities and other risky assets generally perform well, but our investment performance in relation to markets was also good (see attribution tables).

Both our OEICs finished in the top ten in their respective sectors for the year (the income fund was 8th of 147 and the growth fund 7th of 143), while our investment trust, in a slightly more eclectic sector, finished 3rd of 13 (NAV based). As long-term investors, we do not target 12-month performance, but the long term is made up of short terms, so we expect shorter term performance to be good more often than not.

Table 1.1

Table 1.1

Table 2.1: 2017 performance attribution for LF Seneca Diversified Income

Table 2.1

Table 2.2: 2017 performance attribution for LF Seneca Diversified Growth

Table 2.2

Table 2.3: 2017 performance attribution for Seneca Global Income & Growth Trust

Table 2.3

This bull market has been called ‘the most hated ever’. We have never considered it so. I suspect the principal reason many have hated it is because they anticipated its demise prematurely. Whether it was QE, the feeble economic recovery, the belief that the problems in the financial sector that caused the downturn in 2008 still lurked just beneath the surface, or the increasingly popular notion that secular stagnation had set in, there were plenty of reasons to be nervous and uncertain.

But central banks have been very aware of this nervousness and its impact on economic confidence, and have been operating very loose monetary policies. It is these loose monetary policies that have supported economies and thus equity markets in recent years and continue to support them; with negative real deposit rates, why would you want to hold cash? Those who have sold equities have been quick to realise their error, or indeed quick to blame it on the bull market being generally despised (it is human nature to pass the buck).

2017 has thus seen markets continue to be supported by ultra-loose monetary policy. Furthermore, this ultra-loose monetary policy seems to have finally resulted in the global economy reaching escape velocity. Unemployment has fallen to very low levels over the last several years, while inflation is now either out of the danger zone or causing monetary authorities to ease off on their largesse.

We’ve been decently positioned in equities and other growth assets such as high yield bonds, loans, REITs and infrastructure funds. And the economic recovery has hit safe haven bonds where we have no exposure. We also tend to have relatively low foreign currency exposure, believing over time that it adds lots of volatility but not much return. So the sterling strength this year has also helped, at least relative to peers.

At a holding level, our funds have benefitted from a general mid cap focus in the UK, as well as from the good performance of a number of our chosen mid-caps. And as you can see from the attribution tables, selection elsewhere has been good too.

All in all, therefore, 2017 was a good year, which probably means 2018 will be challenging. And this brings us nicely onto the outlook.

…and forward

My asset allocation framework is based on business cycle analysis. Asset classes tend to behave differently in each phase of the business cycle, so if you can determine where you are in the cycle, you can add value from asset allocation.

Key developed economies are either now in expansion phase (US and UK) or still in recovery phase (Europe and Japan). The expansion phase is evidenced by unemployment having fallen to low levels and inflation hitting levels that require central banks to start tightening monetary policy. The phase behind the expansion phase is called the recovery phase, where employment conditions and inflation are improving but are still weak, and thus where economies still require a great deal of central bank support.

My belief is that 2018 will see key developed economies progressing further along the business cycle and thus towards the point at which monetary policy becomes tight. This will be when a global downturn becomes a real possibility.

When do I think we will reach this point? Probably sometime in 2020, so we have a little way to go yet. In the meantime, though, I expect returns from equities and other risky assets to fall, albeit remain positive. We have already been reducing our equity weights and will continue to do so, with the expectation that we will be materially underweight by the time the next bear market starts in or around 2019, in anticipation of the aforementioned economic downturn that will begin in 2020.

There isn’t a great deal of science behind these predictions. I could be wrong by a year or more. But with asset allocation it is not so much about the ‘when’ as the ‘what’. And I’m not going to wait until the end of the cycle to reduce risk – this would be like braking when you get to the bend rather than gradually as you approach it.

I know that many see quantitative easing as the sickness rather than the cure. Not I. True, the global economic recovery has been slow and at times elusive, but this is as much about the severity of the 2008 downturn as it is about underlying structural problems. A nasty accident necessitates a longer recovery time and much care and attention. QE is simply what central banks must do when interest rates hit zero – they have no choice. In other words, negative real interest rates do not portend a bleak future, but are what is required to get growth going and thus secure a bright future.

The same goes for the other factors that have caused the concern. It was US economist Alvin Hansen who coined the term ‘secular stagnation’ in 1938 in response to two very nasty recessions. It wasn’t that long after that the world embarked on a multi-decade period of high, silicon-induced growth. Consider all the amazing technologies hitting the headlines, and you may conclude as I have there may just possibly be a bright long-term future ahead.

Monthly review and outlook

Review

December saw a number of key economic data releases indicating continued strength across both the developed and emerging worlds. Latest inflation data in the US, the UK, Europe and Japan all showed increases, providing further evidence if any were needed that more interest rate increases are on the way. The US and the UK, which have both already seen interest rate hikes, saw inflation rising away from what should be considered target (US and UK CPI increased, respectively, from 2.0% to 2.2% and from 3.0% to 3.1%). The Eurozone and Japan have yet to hike rates for the first time this cycle, but both saw increases in inflation (respectively from 1.4% to 1.5% and from 0.2% to 0.6%).

As for the emerging world, Mexico, India, Indonesia and Brazil all saw inflation increase, while China’s and Russia’s were flat.

Such broad rises are indicative of a strong global economy and what one would expect at this stage of the cycle. In fact, if anything it is a surprise that inflation hadn’t risen earlier.

The major source of inflation pressures at any time and in any place is wages, which themselves tend to be a function of levels of employment. In key developed economies, December saw jobless rates either fall or stay steady. Indeed, employment trends have been very consistent with the inflation data. The US and the UK are later cycle than the Eurozone and Japan, and so should be seeing lower employment growth. This is exactly what we saw in December with unemployment rates in the later cycle countries showing no change, while the Eurozone and Japan announced further declines (respectively from 8.9% to 8.8% and from 2.8% to 2.7%).

From a longer term perspective, unemployment rates in the US and the UK are now close to historical lows, while Europe and Japan appear to still have scope to fall further (Japan’s 2.7% may seem low but it is still well above previous cycle lows).

Employment data in the emerging world is less reliable (China’s has been close to 4% for years!), but even so, the trends are positive and indicative of broad economic strength. Unemployment rates in Russia, Indonesia and Mexico have been falling steadily over the last few years and have now reached historically low levels. Encouragingly, Brazil, which has been going through an economic rough patch for the last 3 years, is now seeing its unemployment rate fall (having peaked at 13.3% in the second quarter last year, it fell to 12.1% in the fourth quarter).

Given the economic backdrop described above, and where various countries are on the interest rate cycle, one should have expected equities and commodities to be strong and bonds to be weak. This is in fact exactly what we saw, with energy, industrial metals and precious metals all posting strong gains. Having paused somewhat in November, equity markets were also firm across the board. Bonds were a little more mixed, with the US, Europe and Japan seeing their 10 year yields rise, while the UK’s fell slightly.

Outlook

There was nothing in December’s economic data releases to cause us to question our outlook, namely that the world economy is now moving firmly into expansion phase and that we should continue to reduce our exposure to risky assets. We think that equities on the whole can continue to rise for another couple of years and that peak phase, the point at which interest rate hikes start to bite, will arrive around 2020.

Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example

Table 3: Current fund tactical asset allocation (TAA) target weights as of 29th December 2017 (prior month’s targets in brackets)

Table 3

General

  • There were no asset allocation target changes in December
  • Equity markets were generally buoyant after a somewhat tepid November
  • Inflation rose in the UK, the US, Europe and Japan, indicating continued economic strength
  • The Federal Reserve increased its Fed Funds rate by a further 25 basis points as expected
  • The target weight for Babcock International was increased, in order to take further advantage of the compelling dividend yield
    which is over 4% and close to 3x covered by earnings
  • Strong results from Victrex; healthy cash generation enabled the company to announce a larger than expected special dividend.
  • Following the announcement that Aberdeen Private Equity Fund is to be wound up at NAV we reduced the position following
    the 16% leap in the share price.
  • We participated in the equity raise for Ediston Properties Income Fund which has bought a portfolio of retail parks with asset
    management opportunities.

SDGF

  • In Japan, the Goodhart Michinori Japan Equity Fund and CC Japan Income & Growth Trust were reduced to bring back to target
    weight

SDIF

  • Activity in overseas equities was limited over the month with the only transaction being an addition to European Assets Trust to
    bring in line with its target weight
  • The sole transaction during the month was a small reduction in the Muzinich Short Duration High Yield Bond Fund following the
    final dividend for the current financial year going xd

SIGT

  • Positive trading update from Legal & General. The shares offer an attractive dividend yield of 6%.
  • A new position was initiated in the Samarang Asian Prosperity Fund. The manager Greg Fisher, focuses on small cap Asian
    equites that are undervalued and not on the radar of most investors
  • To fund the purchase of Samarang, the Aberdeen Asian Income Fund was reduced to a smaller position size
  • There were no fixed income transactions during the month

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP18/008

 

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Peter Elston’s Investment Letter – Issue 31: December 2017

19 December 2017

A new, simple, comprehensive measure of fund ‘active-ness’

In the spirit of Christmas, I present in this final letter of the year some truly psychedelic charts!

2017 saw the debate (ok, it’s a war) between active and passive intensify further, with flows into passive funds, ETFs and smart beta products reaching unprecedented levels. In this letter I put forward a suggestion for a comprehensive but simple measure of the ‘activeness’ of a fund. This I hope might provide an easy way to distinguish between ‘good active’ and ‘bad active’ and thus determine which active funds stack up well against their passive equivalents.

Cartoon

The ‘activeness’ of an active fund tends to get measured in various ways. It has also at times been ill defined, and by those who should know better. Nobel laureate William Sharpe said, “An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Because active managers usually act on perception of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade fairly frequently – hence the term ‘active’”. Trade frequently? I guess he’d never heard of Warren Buffett and the many other great long-term investors.

Yale CIO David Swensen on the other hand got it right. He wrote that, “There is no way to succeed in active management if you try to control for benchmark risk. You must be willing to deviate from the benchmark if you want to earn returns commensurate with the risk of owning equities. And you must be patient.”

Here then in Swensen’s simple words are the two key requirements for active management: deviating from the benchmark and patience. Put another way, good actively managed funds must be concentrated and long term.

This proposition is both logical and empirically well supported (I will not elaborate here but I have written about both concentration and time horizon in relation to investment returns on previous occasions). However, I have yet to see a study either by an academic or practitioner that combines both portfolio concentration and portfolio time horizon into one score or measure. The two always seemed to be considered separately.

And that may be because many do not see the link between concentration and time horizon. I suggest there is a clear, logical link between the two and also that there is a way to measure both at the same time.

Chart 1 below is a so-called soil chart, depicting the positioning over time of an actual investment trust (psychedelic man!) Note that totals in excess of 100% imply net gearing, while totals less than 100% imply net cash. The large mauve band represents the introduction of a fund to gain exposure to a particular country. The rest are individual equities.

Chart 1: holding weights over time of an actual investment trust

Chart 1

It should be clear that the portfolio concentration of the fund can be understood in terms of the width of the lines while portfolio time horizon in terms of the length of the lines. The point is that both concentration and time horizon measure the exposure of a fund to a particular holding, one in terms of ‘how long’ and the other in terms of ‘how big’. Being active is not just about being high conviction but also about how long you hold something.

Both concentration and time horizon can be measured at the same time by considering the area of each line, then calculating the average line area. The area of each line would be the length of the line multiplied by the average width. All the data required for this calculation is readily available in the chart data, which is available within our annual reports.

Funds with a low average line area are thus lowly concentrated, or short-term, or both, while those with a high average are highly concentrated, long term, or both.

The units for this measurement would be % times ‘time’ since the x-axis is ‘time’ while the y-axis is ‘percentage’. A standard unit could be ‘% months’ (if data is monthly) or ‘% quarters’ etc. The higher the score, the more active the fund.

The charts below are highly stylised representations of funds that would fit into various categories, starting with the two extremes (low concentration/short term and high concentration/long term).

Chart 2: Low concentration/short term

Chart 2

Chart 3: Ultra high concentration/very long term

Chart 3

Chart 4: Very high concentration/very long term

Chart 4

Chart 5: Low concentration/very long term

Chart 5

Chart 6: Ultra high concentration/short term

Chart 6

Chart 7: Very high concentration/short term

Chart 7

Chart 8: Very high concentration/medium term

Chart 8

Chart 9 Very high concentration/long term

Chart 9

Chart 10: High concentration/long term

Chart 10

Now, I bet you never realised that funds could be so beautiful!
More seriously, we can calculate the average area of each “line” in ‘% quarters’ as per the below table.

Table 1: Combining holding sizes and holding periods for 9 hypothetical funds

Table 1

Interestingly, there are three configurations that deliver a score of 100 (charts 5, 6 and 8). Clearly, the fund that has just one holding but changes it every quarter should not be  awarded the same score as a fund that more sensibly has 10 holdings and changes them on average every 10 quarters (2 and a half years). The same goes for chart 3.

In other words, there must be an optimal holding size which should be rewarded more than holding sizes that are either bigger or smaller. This can be achieved by normalisation of the data.

As for average holding period, let us propose that the optimal average holding period is 20 quarters (or 5 years).

So, if we can agree that chart 10 has the optimal mix of concentration and holding period (academic evidence supports such a suggestion), this then is the chart that should receive the highest aggregate score after data normalisation.

Table 2 below sets out scores for each of the nine funds after data normalisation (I am happy to share the details of the process of normalisation of data upon request, suffice to say it is purely systematic).

Table 2: Active-ness scores after data normalisation

Table 2

The two funds that only have one holding now score very lowly which has to be correct. The next lowest scores are the funds that have very high turnover. Chart 10 has the highest score of 9 which is also consistent. Charts 8 and 9 are not too far behind which feels about right.

There is no doubt that a trained statistician could do a better job of normalising the data and also of interpreting academic evidence with respect to the optimal holding sizes and holding periods that have tended to produce the best performance.

However, applying the above methodology to the actual investment trust data cited earlier provides an interesting insight. Average holding size is 1.7% and average holding period is 14.5 quarters. This generates a high “activeness” score of 8.7 which is thoroughly appropriate. The fund in question is Aberdeen New Dawn, and during the period in question it returned 1918% (1) compared with its benchmark, the MSCI AC Asia Pacific ex Japan index, which returned 1127%.

If there is a trained statistician out there who would like to collaborate on turning this into a more formal research paper, I would be delighted. The objective of course would be to determine if there is a correlation, presumably positive, between the activeness score and investment performance. If there is, that I think would certainly be interesting.

Happy Christmas everyone!

Macro and Markets Monthly

Review

From an economic perspective, November was in many respects a repeat of October. On the whole, macro data supported our belief that economies in general are making good progress at the moment, in both the developed and the emerging world.

In the US, the ADP Employment Change (2), which precedes the official government numbers by a day or two, came in at 235,000. This was both stronger than expected and the previous month, though the latter was revised down slightly. As for the government numbers, the change in private payrolls was a strong 252,000 although expectations were for 302,000. The previous month however was revised up from a fall of 40,000 to an increase of 15,000, meaning that the amalgamated two-month number came in bang in line with expectations.

The unemployment rate declined further to 4.1% from 4.2% in October. Some of this decline will have been the result of the fall in the participation rate from 63.1% to 62.7%, meaning that some without jobs stopped looking, thus pushing down the number of unemployed. This effect may have shown up more in the underemployment rate, which fell from 8.3% to 7.9%. The substantial fall in the participation rate over the last few years has been one of the interesting features of this economic cycle. Part of this fall will have been due to the US’s aging population but not all. The prospect of disaffected workers returning to the workforce at some point, thus pushing up the participation rate, provides hope that this cycle has further to run without putting undue pressure on wages and thus the Fed to raise interest rates more quickly than is currently anticipated.

On the inflation front, core inflation in the US nudged up slightly, from 1.7% yoy to 1.8% yoy. This is a good thing, as some had worried that the decline earlier in the year was a sign of trouble to come. The Fed has said that they are still not sure why core inflation dipped, but it is possible that it was the delayed effect of the strong US dollar. Nevertheless, it is always a relief when a central bank can breathe a sigh of relief. The stronger employment conditions are not yet feeding through to wages. Average hourly earnings growth in October fell from 2.9% yoy to 2.4% yoy, while real average hourly earnings fell from 0.7% yoy to 0.4% yoy. This may be due to the fact that productivity growth is picking up, with non-farm productivity in the third quarter rising by 3.0% compared with 1.5% in the previous quarter. As with the participation rate, further gains in productivity would enable the cycle to progress further without inflation pressures intensifying.

In the UK, the Bank of England raised its base rate as expected from 0.25% to 0.5%. It thus joins the US as the only two major developed country central banks to increase interest rates this cycle. However, the case for raising interest rates in the UK appeared to be more about dealing with inflation pressures that were the result of the weak currency rather than a strong economy. That said, the economy did make progress during the month, with purchasing manager indices all much stronger than expected, whether in construction, manufacturing or services. The unemployment rate held steady at 4.3% while, encouragingly, core inflation came in below expectations at 2.7%.

Elsewhere, key data in Japan and Europe gave no cause for concern. The unemployment rate in Europe fell from 8.9% to 8.8%, and core inflation held steady at 0.9% yoy. As for Japan, joblessness held steady at 2.8% while CPI ex Fresh Food rose slightly from 0.7% to 0.8%.

There were further encouraging signs that growth in the emerging world has become healthier. For example, purchasing manager indices in China were both strong and stronger than expected, with a similar pattern in India.

As mentioned last month, the reason for focusing on employment and inflation is that these are the key indicators that central banks target when deciding on monetary policy. Thus, in November, there was nothing to suggest central banks needed to reconsider the monetary policy roadmaps that they had previously laid out.

As for financial markets, equity markets generally rose in October, though there was a bit of weakness in the UK and Europe which, at least in the case of Europe, can be put down to previous strength.

Outlook

We continue to believe the global economy as a whole is moving from recovery phase to expansion phase (some like the US are firmly in the latter while others such as the Eurozone are still in the former). Thus we expect equity market returns to continue to fall slightly, but remain positive for the two or so years up to the point at which monetary policy becomes much tighter and when economies are likely to start peaking.

Inflation we think will continue to rise and we thus remain negative on safe haven bonds which anyway are very expensive in light of low or negative real yields.


(1) Bloomberg

(2) A report that measures levels of non-farm private employment based on payroll data from over half of ADP’s U.S. business clients. The data represents about 24 million employees from all 19 of the major North American Industrial Classification (NAICS) private industrial sectors.


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 3: Current fund tactical asset allocation (TAA) target weights as of 30th November 2017 (prior month’s targets in brackets)

(from 18 December 2017 the funds names will change to LF Seneca Diversified Income Fund & LF Seneca Diversified Growth Fund)

Table 3

General

  • Economic news was generally good during the month, with employment and inflation conditions improving in key jurisdictions.
  • The Bank of England raised its base rate from 0.25% to 0.5% as expected, though this was as much a response to high inflation
    induced by the weak currency as to broad economic strength
  • Conviviality was exited on valuation grounds and because we had some concerns regarding two accounting errors. Having
    yielded close to 6% back in January, the yield had fallen closer to 3% when we exited following strong performance
  • A good update from Bovis Homes in which net cash was guided to be higher by the year end than previously forecast,
    supporting substantial shareholder returns by way of special dividends.
  • Due to the successful deployment of initial capital proceeds through 2017 by Civitas Social Housing REIT, we participated in the
    C share offer.
  • Fair Oaks Income Fund announced further equity issuance in order to finance additional investments into new Collaterialised
    Loan Obligations where they are taking a controlling equity stake.

SDGF

  • Equity target reduced from 57% to 55%. This was related to decision to exit one of our UK companies (see below) but is
    consistent with gradual reduction in risk as business cycle matures.
  • After good performance across the Fund’s Japanese holdings, reductions were made in order to bring weights back towards
    target size

SDIF

  • Equity target reduced from 38% to 37%. This was related to decision to exit one of our UK companies (see below) but is
    consistent with gradual reduction in risk as business cycle matures.
  • Schroder Asian Income Maximiser Fund was added to in order to bring the position to target weight
  • Small additions to three existing holdings to maintain weightings following cash inflows early in the month

SIGT

  • Equity target reduced from 58% to 57%. This was related to decision to exit one of our UK companies (see below) but is
    consistent with gradual reduction in risk as business cycle matures.
  • Schroder Asian Income Maximiser Fund was added to in order to bring the position to target weight
  • Goodhart Michinori Japan Equity Fund was exited, with proceeds reinvested into the CC Japan Income & Growth Trust, an
    existing holding which is delivering a growing dividend to shareholders
  • Small additions to Royal London Short Duration Global High Yield Bond Fund and Templeton EM Bond Fund to invest share
    issuance proceeds

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/490

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Peter Elston’s Investment Letter – Issue 30: November 2017

28 November 2017

Keeping it simple – how to add value effectively through tactical asset allocation

Take a look at the equity weight over time of some multi-asset funds (1) and you’d have thought that the manager was at best flipping coins and at worst drunk. Up one month, down the next, up again, down again. It is well documented that markets are unpredictable over short time frames, so can this be the right approach?

I think not.

I have espoused the merits of keeping it simple on numerous occasions, but nowhere is this mantra better demonstrated than with respect to tactical asset allocation.

Cartoon

Over the years, I have become increasingly cognisant of the parallels between tactical asset allocation and the operation of monetary policy (stay with me). As I gradually learned the hard way that predicting short-term market movements is for the foolhardy (one can never learn fast enough!), and began to focus all the more on the longer term, I realised that my monthly market reports didn’t change much month to month. What did change was the odd word here and there, with ‘strong’ replacing ‘modest’ or ‘am confident that’ instead of ‘believe that’. In other words, it was all about gradual change in nuance, as is the case with minutes of Fed or Bank of England meetings (2) (that said, I very much doubt anyone will ever hang on my every word as they do with Yellen and Carney, other than my dog of course!)

I also found that as I matured as an asset allocation specialist, my proposed changes in equity weight or the weights of other asset classes became much smoother (yeah man!) in the same way that over the course of a business cycle central bank policy rates tend to move up gradually, stop, move down less gradually, then stop again. None of the constant chopping and changing you get with fund managers (unless your name is Jean-Claude Trichet that is! (3)).

Most importantly, monetary policy tells you everything you need to know to be able to predict medium-term market movements with a reasonable degree of accuracy and thus to add value to portfolios through tactical asset allocation. And as far as monetary policy is concerned, all you really need to keep an eye on is the unemployment rate and inflation.

In other words, keep it simple – you really don’t need more information.

The CIA was particularly interested in this idea, and indeed wrote a paper in 2005 called, you guessed it, do you really need more information (4)? In it, author Richard J Heuer Jr, referred to an unpublished 1973 manuscript by Paul Slovic entitled, “Behavioural Problems of Adhering to a Decision Policy”, which described an experiment to measure the utility of information. In the experiment, eight experienced horse handicappers were asked to choose their fifth, tenth, twentieth and fortieth most important variables found in typical past performance tables e.g. the jockey’s record, weight to be carried etc.

The handicappers were then given data for 40 actual races (sterilised to hide the race identities) and asked to predict the top five horses, in finishing order, as they were progressively given the 5, 10, 20 and 40 variables of their choosing. They were also asked at each stage to assign a degree of confidence to their predictions.

The results are shown in the chart below.

Chart 1: Accuracy of horse bettors’ predictions versus their confidence in their predictions

Chart 1

As the handicappers are given more data, the accuracy of their predictions does not increase, but in fact decreases slightly. Just as interesting, their confidence in their predictions increases materially. In other words, the more information the bettors had, the greater their overconfidence.

The problem is that while overconfidence was useful for early humans in facing down a sabre toothed tiger or a woolly mammoth, it causes all sorts of problems when it comes to making good investment decisions. And while our intelligence and knowledge might have increased immeasurably over the last 100,000 years, we still have the same brains and thus the same instincts. Financial markets are there to make you look stupid and understanding this would make most people better investors.

Back to simple asset allocation.

The next two charts illustrate the simple link between monetary policy, future returns from equities, and tactical asset allocation. Over an hour or two recently, I played around with data comprising only monthly central bank policy rates and monthly MSCI World data.

Chart 2 shows the clear link between the central bank policy rate (average of US, UK, Eurozone and Japan) and the performance of the MSCI World index, going back 20 years (both relative to trend).

Chart 2: High correlation between central bank policy rates and performance of equity markets

Chart 2

Using this, one can derive an equity target weight (5). for a hypothetical balanced fund that is based only on the central bank
policy rate, then measure the performance of the tactical asset allocation (TAA) portfolio against a fixed weight strategic asset
allocation. The results are shown in Chart 3 below.

Chart 3: A very simple tactical asset allocation framework adds significant value

Chart 3

Why have I chosen 53%/47% for the strategic asset allocation? Because I wanted to make sure that the volatilities of the strategic asset allocation index and the tactical asset allocation portfolio were exactly the same, and thus ensure that none of the outperformance came from higher beta (market risk).

If it isn’t obvious, 23%pts of outperformance over 20 years is nothing to be sniffed at. This could be the difference between portholes or balcony on that retirement cruise you are dreaming about. Furthermore, with one or two refinements that might take another hour or two, I suspect the model could deliver even better results.

Simple refinements of course, not complicated ones.

Macro and Markets Monthly

Review

There were few signs during the month of October that the global economic improvement of late was starting to stutter. Labour markets in the developed world continued to strengthen, while inflation trends also remained positive. In other words, there was no reason to think that monetary policy roadmaps set out by developed world central banks would need to be adjusted any time soon.

In the US, the ADP Employment Change (6) came in at 135,000. This was bang in line with expectations but lower than the previous month’s increase of 228,000, revised down slightly for the original 237,000. Nonfarm payrolls two days later were on the weak side, showing a decline of 33,000 jobs over the month. This however should be viewed in the context of a revision upwards in the September increase from 156,000 to 208,000. As for the unemployment rate, it fell from 4.4% in September to 4.2% in October. Furthermore, the underemployment rate showed a decent improvement from 8.6% to 8.3%. The labour force participation rate also ticked up slightly, from 62.9% to 63.1%, indicating that more people were being drawn back to the workforce. We now consider the US to be very much in expansion phase, during which we would expect to see employment growth start to decline slightly. In other words, the aforementioned employment data is what we would have expected to see at this point on the cycle.

Continuing in the US, on the inflation front, there are signs of stability appearing following a few months in which core inflation has fallen below the central bank target of 2%. Although core inflation fell short of the expected 1.8% year on year, it was in line with the previous month’s 1.7%. Real average hourly earnings growth rose from 0.6% in August to 0.7% in September, another sign that price growth is at a comfortable level.

Elsewhere in the developed world, employment numbers continued on the whole to improve. In the UK, the three-month unemployment rate held steady at 4.3%, while the 3 month/3 month employment change was a reasonable 94,000. In the Eurozone, the unemployment rate for September came in at 8.9%, compared with 9.0% the previous month, while in Japan it held steady at 2.8%. Inflation numbers too in the UK, the Eurozone and Japan remained comfortable.

The reason for focusing on employment and inflation is that these are the key indicators that central banks target when deciding on monetary policy. In other words, there was nothing to suggest central banks needed to reconsider the monetary policy roadmaps that they had previously laid out.

Economic improvement was also seen in the emerging world, where inflation rates in China, India, Brazil, Russia and Indonesia are now at a much more comfortable level than was the case a year or two ago.

As for financial markets, equity markets generally rose in October. Asian and emerging market equities performed particularly well, as the global economic backdrop continued to improve. The improvement in inflation may also have helped to boost sentiment towards these regions.

Outlook

We think the global economy as a whole is moving from recovery phase to expansion phase (some like the US are firmly in the latter while others such as the Eurozone are still in the former). Thus we expect equity market returns to continue to fall slightly, but remain positive for the two or so years up to the point at which monetary policy becomes much tighter and when economies are likely to start peaking.

Inflation we think will continue to rise and we thus remain negative on safe haven bonds which anyway are very expensive in light of low or negative real yields.

Source for all data: Bloomberg


(1) Investment Association 40-85% shares sector October 2002 to October 2017

(2) https://www.federalreserve.gov/econresdata/notes/feds-notes/2015/semantic-analysis-of-the-FOMCs-postmeeting-statement-20150930.html

(3) As President of the ECB Jean-Claude Trichet raised interest rates in both 2008 and 2011 but quickly had to change course
(see https://www.bloomberg.com/news/articles/2017-10-23/boe-rate-hike-risks-carney-repeating-policy-errors-of-ecb-japan)

(4) https://www.cia.gov/library/center-for-the-study-of-intelligence/csi-publications/books-and-monographs/psychology-of-intelligence-analysis/art8.html

(5) The equity target weight is calibrated directly from the central bank policy rate, such that it stays within a range from 30 to 70%. The equity target weight is at its lowest when central bank policy rates are at their highest in relation to trend (tightest), and highest when rates are at their lowest (loosest).

(6) A report that measures levels of non-farm private employment based on payroll data from over half of ADP’s U.S. business clients. The data represents about 24 million employees from all 19 of the major North American Industrial Classification (NAICS) private industrial sectors.


 

Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights as of 31st October 2017 (prior month’s targets in brackets)

TAA table

General

  • Equity weights lowered again as further evidence of continued progression of the business cycle emerged in the form of stronger purchasing manager indices
  • European markets were boosted by the European Central Bank’s announcement that its asset purchase program would be extended for nine months
  • Intermediate Capital was exited on valuation grounds and in order to instigate the asset allocation reduction to UK equities. The dividend yield had close to halved since 2014, to stand at just 3%
  • Corporate activity within the specialist lending sector highlighted the value that exists in the sector. First Rand approached Aldermore, providing some read across to OneSavings Bank
  • Fund holdings in the Royal London Short Duration High Yield Bond Fund were increased following an lift in the tactical asset allocation to corporate bonds
  • We supported the further equity raising by Greencoat UK Wind having previously taken profits at higher price levels. The management team have built a solid portfolio of wind assets
  • After a solid first 10 months building a conservatively balanced portfolio of asset backed loans, we participated in the further equity issuance by RM Secured Direct Lending

SDGF

  • The equity reduction came in the UK and North America, with proceeds spread between short duration high yield and specialist assets where yields still look decent
  • Following a reduction to the tactical asset allocation weight to North America, the Yacktman US Equity Fund was reduced

SDIF

  • The equity reduction came in the UK, with proceeds spread between short duration high yield and specialist assets where
    yields still look decent

SIGT

  • The equity reduction came in the Japan, with proceeds spread between short duration high yield and specialist assets where yields still look decent
  • Small additions were made to the Invesco Perpetual European Equity Income Fund and European Assets Trust in order to bring positions to target weight
  • Following the reduction to the tactical asset allocation weight to Japan, the Goodhart Michinori Japan Equity Fund and CC Japan Income & Growth Trust were both reduced

Download this investment letter as a PDF


 

 

Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/464

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Peter Elston’s Investment Letter – Issue 29: October 2017

24 October 2017

Five points about active management in the multi-asset space

I was presenting a slide deck entitled ‘The Art and Science of Multi-Asset Investing’ at five venues across the country recently, as part of Professional Adviser’s Multi-Asset Roadshow (1). Back at my desk, I thought it would be interesting to distil the numerous conversations we had with interested parties on the subject of ‘good active management’ – a key theme throughout my presentation – into five distinct topics. So, here they are.

Size of AUM – Small is beautiful (but not too small)

This is a point that I make frequently, so I’m happy to make it again. As I said in my August letter, “the big firms…continue to peddle the notion that bigger is better – witness a certain recent merger – when in fact my – and Warren Buffett’s! – opinion is that the opposite is the case.”

It is completely understandable that the big firms take this line – they’re hardly likely to say that big is bad! And because it is the big firms who spend the most on advertising, and thus get the bulk of the column inches, the myth tends to get perpetuated.

Cartoon - Active Management 5 points - PE IL 29 - October 2017

So, why do Buffett and we think that small is beautiful?

Simple.

With less AUM, there are more investment opportunities available – think about a fishing net with smaller holes. And often, the smaller investments are the more interesting – in the case of equities, smaller companies have more potential to grow than larger ones. Why? There is more blue sky. It’s that simple.

With football clubs, for example, bigger is better. Not so with fund management companies.

High tracking error is bad but low tracking error is worse

Good active management is firstly about structuring funds such that they have the  scope (potential) to produce alpha well in excess of fund costs, and secondly about having a strong investment style that will enable them to achieve this potential.

If a fund doesn’t have the potential to outperform, it doesn’t matter what investment style it adopts. So, in many ways, the first step is more important than the second.

What this first step says is that a fund must be sufficiently different from its benchmark index. If a fund is similar to the benchmark index, gross performance will be similar to the benchmark index, and net performance will be below the benchmark index.

To have the chance of producing gross alpha well in excess of fund costs, funds need to be different. Such difference can be measured by looking at tracking error. As a rule of thumb, my experience is that a fund’s tracking error should, over time, be around three times its OCF.

Anything less, beware.

Passive multi-asset funds do not capture the opportunity in ‘specialist assets’

Our three multi-asset funds are simple creatures, but they are more than just balanced funds. What makes them different to balanced funds are what we call ‘specialist assets’. These on the whole are listed specialist investment trusts that own illiquid tangible assets such as property, infrastructure, aircraft, and loans. Because these tangible assets are easy to understand – what can be less complicated than bricks and mortar or an airplane? – the trusts themselves are easy to understand.

As a result, our funds are also easy to understand (2).

Although in recent years they have been very popular, and indeed continue to be, passive multi asset funds such as those offered by Vanguard, Blackrock, L&G and HSBC (3) are not able to capture the opportunity offered by specialist assets. In fact, they are either balanced funds or close to being balanced funds – HSBC and L&G have small allocations to property, without  which they would be just comprised of equities and bonds.

Our ‘specialist assets’ offer useful features in relation to both bonds and equities, which is what makes them interesting.

In relation to equities, they have more stable income streams – they don’t have the operational gearing that companies have. While in relation to bonds, they tend to have higher yields and income streams that are either explicitly or implicitly linked to inflation.

As for price behaviour, their volatility is generally lower than that of equities, and they are lowly correlated with broad equity markets. So you can imagine what having a quarter of portfolios in these things, as we do, does to their Sharpe Ratios!

Shame to miss out on such a great opportunity.

Passive beats active in the ’single-asset’ space, but in multi-asset the opposite is the case

We’ve all seen the headlines:

“99% of actively managed US equity funds underperform”
“86% of active equity funds underperform”
“Nine out of 10 active funds underperform benchmark”
“87% of active UK equity funds underperformed in 2016”

Source: FT.com

All of the above headlines relate to pure equity funds, whether in the US, Europe, the UK or emerging markets. You never see such headlines in relation to active multi-asset funds.

Why?

What distinguishes a multi-asset fund from an equity fund (or a bond fund) is one key feature: asset allocation.

In my September letter, I wrote, in relation to funds in the IA Mixed Investment 20-60% Shares sector, the following:

“It is encouraging that although only 23 of the 102 funds generate active alpha equivalent to three times  the active fees (i.e. at least two thirds of gross active alpha go to the customer), the vast majority (71 funds) produce positive alpha net of fees. The implication of this is that ‘multi-asset’ may be an area where active management works pretty well (as opposed to ‘single-asset’ where evidence clearly indicates the opposite).”

I surmise that the reason for this is that it is easier to add value from tactical asset allocation than it is from stock selection, so actively-managed multi asset funds have an advantage over actively managed equity funds.

There is plenty of academic research that has found close relationships between the starting valuation of equity and bond markets on the one hand and subsequent performance on the other. This can be understood most easily with respect to bonds. As I noted in September:

“If the real yield of the five-year linker is -2%, you know that the real five-year return will be -2% annualised. You also know that the real return of the five-year “nominal” will on average be pretty close to -2% annualised (breakeven inflation rates are generally a reasonably good predictor of actual future inflation). Furthermore, if  the real yield of the ten-year linker is -2%, the subsequent five-year real return is likely to be pretty close to -2% annualised. And so forth.”

There is a similar logic with respect to equity markets, but the link between yields and subsequent performance is not quite so stark.

In summary, you really don’t need to do anything complicated to add value through active (tactical) asset allocation.

Are there ‘suitability’ issues in relation to putting clients into passive multi-asset funds that have massive bond risk?

Back in 2008, the real 10-year Gilt yield was around 1%. Although this was low – 10 years earlier real yields were 4% – one could still justify buying Gilts on the basis that the real yield was positive.

Fast forward to today and real 10-year interest rates in the UK are close to -2%. This means that if you buy them and hold them to maturity, your real return will be -2% per annum (-1.79% to be precise) (4).

To make money in real terms, real yields would have to fall further and you’d have to sell the bonds before maturity. But yields are already at -2%! Expecting them to fall to, say, -3% is, in my humble opinion, not investing but speculation.

In the previous section, I mentioned four providers of the more popular passive multi-asset funds. If you consider their offerings that sit in the IA Mixed Investment 20-60% Shares sector, they generally have around 40% in equities.

Where is the other 60%? All or mostly in bonds, where one has to be lucky to win.

In other words, are these funds really suitable for your clients?


(1)  http://events.professionaladviser.com/mars

(2)  Many active multi-asset funds invest in complex investments such as derivative strategies, hedge funds, structured products or the like. We avoid these. Can’t understand, don’t invest.

(3) Vanguard LifeStrategy, Blackrock Consensus, L&G Mixed Investment, Architas MA Passive, HSBC World Index

(4)  Source Bloomberg


 

Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 2: Current fund tactical asset allocation (TAA) target weights as of 30th September 2017 (prior month’s targets in brackets)

Table 1

General

  • Sterling rose sharply in September on signs of rising inflation, an improving economy, and progress in Brexit talks
  • Inflation also rose in other parts of the developed world which helped quell concerns over weakness in recent months
  • Equity markets were generally firm, reflecting the improved inflation, and by implication growth, picture
  • There were no asset allocation changes during the month
  • New holding in Babcock International, which has unjustifiably been tarnished with the same brush as other support service companies, such as Capita, Interserve and Mitie. Dividend yield at 10 year high at time of investment (1).
  • Good results from Kier Group, in which the dividend was increased 5%. Shares yield close to 6% (1)
  • There were no changes to Fixed Income holdings during the month.
  • International Public Partnerships announced a solid set of results for the 6 months to June 2017 (2). The primary risk surrounding this space is the scope for political interference.
  • We are seeing trusts that have delivered on their stated objectives announce further capital raisings to enlarge their portfolios. We are reviewing these opportunities to assess whether we participate.

SDGF

  • Goodhart Michinori Japan Equity Fund was reduced back to target weight following strong performance this year.

SIGT

  • Aberdeen Asian Income Fund was added to in order to bring to target weight. The Trust trades at a 4% discount to net asset value.

(1)  Source Bloomberg

(2) Source: International PPL half year results, posted 7 September 2017


 

Download this investment letter as a PDF


 Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/420

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Peter Elston’s Investment Letter – Issue 28: September 2017

29 September 2017

More great news

Following the announcement about two awards in my last letter, this month we have been shortlisted for another one. This time, our investment trust is up for ‘Investment Company of the Year 2017 – Flexible Investment Sector’. I would like to commend and thank my teammates on the investment desk. This has been a team effort. Of course, we haven’t won it yet, but we would hope that the Trust’s highest ranked volatility-adjusted returns (1), as well as the clearly articulated investment style and process that produced them, will stand us in good stead. We manage a total of three publicly available funds, and we’ve been nominated for three awards in recent weeks. This is a substantially better ratio than that of most, if not all, of our larger peers who have much bigger stables of funds.

Yet more shocking findings about active management

Most of you will have heard of ‘active share’ the simple measure of the ‘active-ness’ of an actively managed fund popularised in 2009 by Yale’s Martijn Cremers and Antti Petajisto (2).

Cartoon - Active management PE IL 28 - September 2017

However, you may not have heard of ‘active share’ (sic), another measure of ‘active-ness’ that has been around since 2005.

This was the brainchild of the State University of New York’s Ross Miller, as presented in his paper The True Cost of Active Management by Mutual Funds (3). Sadly, Miller’s ‘active share’ did not appear to get as much attention as that of the Yale chaps.

Not, that is, until now.

To recap, the active-ness of a fund is not about activity (turnover). It is about how different a fund is in comparison with its benchmark or passive equivalent. Knowing this helps one gauge whether one is paying for genuine active management or (overpaying) for passive in disguise.

There are a few ways you can do this for a particular fund.

The simplest way would be to eyeball the investment performance to see how much it deviates from its benchmark from period to period (months or weeks, say). This is fine, but it does not provide you with a quantitative measure of ‘active-ness’ and thus the scope to compare funds with each other.

Or, you could do something similar, but do it systematically. How? By looking at the tracking error of the fund’s returns in relation to its benchmark index. However, although tracking error is a quantitative measure of ‘active-ness’, and thus can be used to compare funds, it is simplistic and thus limited in meaning.

A third way would be to use the Yale chaps’ ‘active share’. This is indeed an interesting and useful yardstick, but it does require one to know all the holdings of the fund and their weights, as well as the holdings – and their weights – of the benchmark index. These may not, in many cases, be readily available. Furthermore, this version of active share only calculates ‘active-ness’ at one point in time, which may not be representative.

One unique attribute of ‘Yale active share’ is that it distinguishes between funds that have high tracking error but low stock concentration (what Cremers and Petajisto term ‘Factor Bet’ funds – funds with highly active sector positions but low stock level concentration within sectors) and those that have high tracking error and high stock level concentration (what they call ‘Concentrated Stock Pickers’). The latter is where they find the great performers, with ‘Factor Bet’ funds on average doing OK before fees but nothing net of fees.

However, it is somewhat limited in that it neither tells you what you are effectively paying for the active service, nor what the active service is generating in terms of investment performance (alpha).

For this, please welcome Ross Miller.

Miller’s key insight is that any fund can be thought of as the combination of an active part (the active share) and a passive part and that these parts, though not ‘observable’ as such, can be objectively calculated as portions that add to 100%. Once this has been done, one can isolate what one is paying for the active part (the active expense ratio) as well as the value added one is receiving in relation to the active part (active alpha) by attributing typical passive fees (e.g. 0.1%) as well as the (zero) passive alpha to the passive part, then seeing what’s left.

Having calculated the active alpha and the active expense ratio one can divide one by the other to get what is arguably the key metric for all active funds, namely the cost of one unit of alpha.

So, how does Miller divide funds into their constituent parts?

First, he notes that if one can discern a passive part of an active fund, it should be the part that is 100% correlated with the benchmark index. Similarly, the active part should have zero correlation. Aggregating the two would then give you something that had the same overall correlation features as those of the fund itself (defining active management in conceptual terms as ‘that which bears no relation to the index’ is, I think, Miller’s key and brilliant intuition).

Second, to derive the numerical proportions, he applies some clever maths using only the correlation coefficient, R. (For more detail, take a look at The True Cost of Active Management by Mutual Funds (3). You can see in Table 1 of the paper that the full sample to which Miller applies his analysis comprises 4,752 US mutual funds whose average active share is calculated to be 22.1%. Although this might sound low, and it is, it is still a fairly meaningless number. What really matter are the active expense ratios and the active alphas.)

Now, it is important to understand that the active and passive parts are not ‘observable’ – in other words they are not sub-portfolios with their own holdings and weightings. Rather, they are conceptual, albeit measurable, components. Imagine mixing 40% yellow paint (representing passive) and 60% blue paint (active). One cannot separate the two but what one can do is calculate the proportions by assessing the precise shade of the resulting green.

Calculations of the active expense ratios and the active alpha involve similar maths, but in addition to R require two further independent variables: the typical fees of the equivalent passive fund (one that seeks to track the index that the fund uses as its benchmark) and the expense ratio of the fund itself.

One other interesting aspect of Miller’s analysis is that it allows the direct comparison of mutual funds with hedge funds. One can compare the active expense ratio of a mutual fund with the actual fee (management plus performance) of a hedge fund that is producing the same level of alpha. This does however assume that hedge funds produce only alpha (no beta) which as we all now know is not quite true.

As for the results of Miller’s analysis, many of them were astonishing. Below is one extract pertaining to Fidelity’s Magellan Fund, which had previously been managed by the great high conviction stock picker Peter Lynch (the below appears to indicate that things changed dramatically under one of his successors).

“The 5.87% annual cost of the active management implicitly provided by Magellan’s management, which we will call its active expense ratio, could be justified on economic grounds if the fund provided superior returns to its investors. For purposes of comparison, a hedge fund that charges the standard annual fee of 2% of funds under management plus 20% of its positive returns would have to earn 19.35% on the actively managed assets (and provide investors with a net return of 15.48%) in order to earn a total of 5.87%. Unfortunately, not only did Magellan fail to post that performance on the active portion of its portfolio, it managed to lose substantially more than that on an annual basis over the three years from 2002 through 2004. When Magellan’s alpha of –2.67% per year over that period is allocated solely to the active component of its portfolio, it has an active alpha of –27.45%.”

Source: Measuring The True Cost Of Active Management By Mutual Funds (3).

In other words, the fund had such a high correlation with the benchmark index that its active share was very low. Thus the not unheard of overall alpha of -2.67% became a shamefully high -27.45% active alpha when calculated in relation to the small active portion.

Another of Miller’s interesting observations is that the difference between the average overall alphas of funds with the ten lowest and ten highest active expense ratios can be explained almost entirely by the difference in overall expense ratios (more on this later).

I now come to what you may all have been waiting for: an analysis of UK funds.

We at Seneca are multi-asset managers, so it seemed only right to consider a multi-asset fund sector, specifically one that contained one of our funds. The below table sets out the results of Miller’s framework as applied to the IA Mixed Investment 20-60% Shares sector (investment performance was assessed over the last five years, with 102 funds measurable over this period).

I have used the same passive equivalent for all funds, namely the Vanguard LifeStrategy 40% Shares Fund. Since some may argue that this is not the benchmark they seek to beat, I have also provided volatility-adjusted returns. It can be seen that all funds at the bottom of the list score poorly on this measure, so use of the Vanguard fund appears justified.

I have only named the best ten funds, though I would be happy to provide my full Excel spreadsheet upon request.

Table 1: Results of Miller’s analysis as applied to the IA Mixed Investment 20-60% Shares sector

It is encouraging that although only 23 of the 102 funds generate active alpha equivalent to three times the active fees (i.e. at least two thirds of gross active alpha goes to the customer), the vast majority (71 funds) produce positive alpha net of fees. The implication of this is that ‘multi-asset’ may be an area where active management works pretty well (as opposed to ‘single-asset’ where evidence clearly indicates the opposite).

I would surmise that the reason for this is that markets are more predictable than individual stocks. Take the government bond market, for example. If the real yield of the five-year linker is -2%, you know that the real five-year return will be -2% annualised. You also know that the real return of the five-year “nominal” will on average be pretty close to -2% annualised (breakeven inflation rates are generally a reasonably good predictor of actual future inflation). Furthermore, if the real yield of the ten-year linker is -2%, the subsequent five-year real return is likely to be pretty close to -2% annualised. And so forth. (See http://www.conincomasterclass.com/pdf-dia/2013-Aberdeen.pdf).

There are similar findings with equity markets (4) in relation to starting period dividend yields. If starting yields are above average, subsequent returns tend to be above average (the opposite holds when yields are below average).

Back to Miller and the 20-60% Shares sector.

In relation to the Vanguard fund, the average fund’s beta is a low 79.7%, meaning that funds are on average taking less market risk. All else being equal, this naturally allows alphas to be higher.

Perhaps the most interesting chart that can be derived from the numbers in the above table is the one below, which compares net overall alphas with OCFs (Ongoing Charges Figure). The correlation (R-squared) is very low, which means that factors other than OCFs mostly explain alphas. Where OCFs do provide some explanation, it is that the higher the OCF, the higher the alpha (note the upward sloping best fit line). In other words, funds with lower OCFs do not necessarily produce better returns for investors. In fact, returns tend to be worse. Perhaps the FCA might like to give Prof. Miller a call.

Chart 1: Net alphas (%) versus OCFs (%) for constituents of the IA Mixed Investment 20-60% Shares sector

Chart 1 PE IL 28


(1)  Source FE based on AIC Investment Trust Flexible Investment Sector Sharpe Ratio for the three years ended 25/09/17

(2)  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719

(3)  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=746926

(4)   http://www.nber.org/papers/w12026.pdf


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 2: Current fund tactical asset allocation (TAA) target weights as of 31st August 2017 (prior month’s targets in brackets)

Table 2 PE IL 28

General

  • Sterling slipped back in August folloiwng several months of strength as Brexit fears resurfaced
  • Safe haven bond yields fell and gold rose, as tension on the Korean penninsular spooked markets
  • Equity markets were mixed but on the whole firm as growth expectations continued to improve
  • We reduced funds’ equity targets and are now underweight in relation to strategic asset allocation; proceeds moved into fixed income and specialist assets
  • Steady interim results from Legal & General, which continues to offer an attractive dividend yield of close to 6%
  • Royal London Short Duration High Yield Bond Fund was added to following an increase in the tactical asset allocation to fixed income
  • We increased the holding of UK Mortgages Limited now that it is close to fully invested and returns should now improve
  • The high inflation linkage to returns from infrastructure projects within International Public Partnerships led us to increase the weighting as a destination for capital raised from equities

SDGF

  • A good update from Diploma, ahead of the company’s financial year end. Total revenue growth is in the high teens, including 6% organic growth
  • Following a reduction in the tactical asset allocation weight to North America, we reduced the holding in the Yacktman US Equity Fund
  • Overweight positions in the Goodhart Michinori Japan Equity Fund and Somerset Emerging Markets Dividend Growth Fund were reduced back towards target weights

SDIF

  • Liontrust European Enhanced Income Fund was added to in order to bring the position back to its target weight

SIGT

  • Invesco Perpetual European Equity Income Fund and Liontrust European Enhanced Income Fund were both added to in order to bring the positions back to target weights

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/401

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Peter Elston’s Investment Letter – Issue 27: August 2017

25 August 2017

Stop press: Awards announcement

We have been shortlisted for two awards – Multi-Asset Manager of the Year and Investment Boutique of the Year. I am very proud of my team. In a world of rising ‘passive’, it is incumbent on us to continue to offer our customers highly differentiated products. This is what they pay for and this is what they will get.

An attack on poor active management

I abhor poor active management.

I abhor it because there are so many individuals whose retirement savings have been invested in poor products; because it has given the active management industry in general a bad name; and because the big firms who are the worst offenders (1) continue to peddle the notion that bigger is better – witness a certain recent merger – when in fact my – and Warren Buffett’s! (2) – opinion is that the opposite is the case.

Small & interesting PE IL 27 - August 2017

With, for example, football clubs and DRAM companies, bigger generally means better quality. This absolutely should not be the case with active management, where the more interesting investments tend to be smaller and thus out of the reach of large firms.

While I abhor poor active management, I adore Gina Miller (on a strictly professional basis I should add). I too get an itch when I think “people are being bullies, or being dishonest or hypocritical”(3). Most big fund management companies for me tick all three of those boxes.

I do not think I am alone in thinking this way. Indeed, although I am very critical of my industry, there are many outside it whose criticism of active management is far more vitriolic. Some will have had a bad experience investing in an active fund, others will have been appalled at the asymmetrical rewards on offer in the industry, others still may see us as a bunch of coin tossers masquerading as skilful practitioners.

Whatever the reason, there is plenty of evidence that most actively managed funds fail to beat their benchmark net of costs (4) – this is indeed the way the newspaper headlines always seem to be framed. However, the implication of this – and the headlines – is that funds that beat their benchmark have done a good job, and that funds whose performance is in line with the benchmark have achieved what they set out to achieve.

This has to be wrong.

Active managers should be aiming to beat their benchmark by a wide margin to compensate investors for the risk that they will fail to reach it. Why on earth would I as an investor accept index performance with risk when I could get, from a passive fund, index performance with no risk?

Most single asset class funds have an investment aim or objective that is vague, and a benchmark which is an index (this was certainly the case with ten UK equity funds that I selected at random). Where there is a benchmark stated, it is not generally clear what it is there for, but let’s assume it is for investment performance measurement purposes – after all the proper definition of a benchmark is ‘a measuring device’ rather than ‘something to be copied’, not that you’d know it by looking at many funds’ holdings.

So, I have a simple solution. Active funds should state the margin by which they aim to beat their benchmark, net of costs. For example, FTSE All Gilts + 2% per annum, or S&P500 + 3% per annum. At Seneca, we do this with our multi-asset funds, either explicitly or less formally, taking account of the value we seek to add from active management decisions.

Furthermore, why would performance in line with benchmark be acceptable when what this means is that managers give all the outperformance to themselves in fees once other costs have been paid, leaving nothing for the customer!

So, I have a different approach.

My starting point is to consider the costs for a particular fund, then to aim to produce a multiple of these costs in gross outperformance (alpha). I make sure that we have sufficient tracking error to give our funds the potential to produce this alpha (too little tracking error is in my view worse than too much) then trust our value-oriented investment style and process to achieve it.

What is the multiple? It depends on the total costs, but for all three of our funds, it’s considerably above two.

We recently changed the benchmark for our investment trust, the Seneca Global Income & Growth Trust, to:

“Over a typical investment cycle, the Company will seek to achieve a total return of at least CPI plus 6 per cent per annum after costs with low volatility, and with the aim of growing aggregate annual dividends at least in line with inflation, through the application of a Multi-Asset Investment Policy.”

Benchmark changes are generally met with great scepticism, and rightly so, but in our case we have raised the bar rather than lowered it. Furthermore, the change will not mean we have to start jumping higher (we will not change the way we manage the fund). The bar has been raised to a level commensurate with our process rather than at an inappropriately low height.

It had become increasingly clear to us and to the Trust’s Board in recent years that the previous benchmark of LIBOR + 3% did not reflect how the trust was being managed. Nevertheless, there were some who expressed concern that the new benchmark was too ambitious.

Given my earlier remarks, I would argue instead that the objectives of most actively managed funds are not ambitious enough. Perhaps this is why the active management industry is so despised. Many, including me, think it is still providing a safe harbour for the cowardly.

Interesting anomaly with respect to global fund managers’ AUM rankings

I mentioned at the start of this letter that we had been shortlisted for two prestigious awards. We were nominated in two of 18 categories, which I thought was very impressive for a firm of our size. As I thought about size, I wondered where we ranked in the world, and came across a list of the top 400 fund managers by AUM(5) compiled by Investment & Pensions Europe. We were not on it – the 400th largest was 20 times bigger than us – so I wondered if I could extrapolate the numbers to estimate where we stood.

What revealed itself was fascinating.

I plotted AUM against firm size rank and added a power law trend line (Chart 1). The trend line didn’t fit very well, so I tried an exponential trend line. That didn’t work very well either (Chart 2) but I wondered if the biggest companies followed a power law and the next biggest followed an exponential pattern. The results were extraordinary (Chart 3). The top 65 companies clearly follow a power law, and the next 365 an exponential pattern.

I would welcome suggestions from readers as to why this might be the case. And I’d be keen to collaborate on a research paper if there are academics out there with time on their hands!

For further reading on the subject of power laws in relation to size ranking, whether fund managers or cities, see Power Laws in Economics – An Introduction (6).

Incidentally, the equation for the exponential trend line in Chart 3 that relates to the lower ranked companies can be reworked as:

Firm rank = 556 – 91.5 times the natural logarithm of AUM

At the end of December 2016, we had AUM of £300 million, which translates to US$370 million. Plugging this into the above equation reveals that (drum roll) we are the world’s 647th largest fund manager.

Blackrock had better watch out. We’re a-comin’ to getcha!

Chart 1: Applying a power law trend line to all 400 companies

PE IL 27 - Chart 1

Chart 2: Applying an exponential trend line to all 400 companies

PE IL 27 - Chart 2

Chart 3: Applying a power law trend line to top 65 and an exponential trend line to next 365 (including trend line equations)

PE IL 27 - Chart 3

Wealth creation from US equities since 1926

I was alerted by an article in the Evening Standard to an interesting research paper entitled Do Stocks Outperform Treasury Bills?

The author used data from the Centre for Research in Securities Prices (CRSP) to analyse performance of all listed companies in the US going back to 1926. He found that just 30 stocks (Table 1) accounted for one third of total listed equity wealth creation, 90 for half, and 1,092 (out of a total of 25,300) for all (meaning that collectively 24,208 created zero wealth). Let that sink in.

If you are wondering how 24,208 firms can create zero wealth, take a look at Chart 4. It looks like around half of the 24,208 firms created wealth, but the wealth they created in aggregate was cancelled out by the other half that destroyed wealth.

Interestingly, the top 30 company that created wealth at the fastest rate was Facebook. It created $181,243 million in 56 months, which equates to $1,232 per second. This was almost double second placed Alphabet’s speed of $678 per second. I wonder if this says something about the relative value we place on communicating with friends on the one hand and looking for stuff on the other. Another research paper perhaps?

Table 1: Lifetime Wealth Creation

From Do Stocks Outperform Treasury Bills? (7) By Hendrik Bessembinder, Department of Finance, W.P. Carey School of Business, Arizona State University.

“This table reports lifetime wealth creation to shareholders in aggregate. Wealth creation is measured by text equation (2) [see page 23 of the paper if you are feeling brave! – Ed] and refers to accumulated December 2016 value in excess of the outcome that would have been obtained if the invested capital had earned one-month Treasury bill returns. Results are reported for the 30 firms with the greatest wealth creation among all companies with common stock in the CRSP database since July 1926. The name displayed is that associated with the Permco for the most recent CRSP record.”

PE IL 27 - Table 1

Chart 4: Cumulative % of wealth creation, all companies

PE IL 27 - Chart 4

 


(1) http://betterfinance.eu/media/latest-news/news-details/article/better-finance-replicates-and-discloses-esma-findings-on-closet-indexing/

(2) https://www.fool.com/investing/options/2013/06/03/is-this-buffetts-secret-to-50-returns.aspx

(3) https://www.psychologies.co.uk/gina-miller-philanthropy-and-transparency-politics

(4) Source: S&P Dow Jones data from 25,000 funds over ten years to end 2015

(5) https://www.ipe.com/download?ac=71409

(6) http://pages.stern.nyu.edu/~xgabaix/papers/pl-jep.pdf

(7) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 2: Current fund tactical asset allocation (TAA) target weights as of 31st July 2017 (prior month’s targets in brackets)

PE IL 27 - Table 2

General

  • The US dollar continued its decline that began in December, most notably against the Euro
  • Inflation in the US has been weak of late, prompting many to wonder about monetary policy
  • As expected, the Fed left interest rates unchanged, but indicated that it would start to shrink its balance sheet soon
  • Equity markets and commodities were generally firm, reflecting improved global growth
  • Excellent results from Conviviality, with strong cash generation evident. The benefits of ‘One Conviviality’ i.e. providing a “onestop
    solution” are starting to emerge
  • We are moving towards an exit of Blue Capital Alternative Income where we feel the trust is too small to support its long term future

SDGF

  • Good trading updates from Clinigen, RPC and Victrex
  • Following strong performance, overweight positions in Invesco Perpetual European Equity Income Fund and Somerset Emerging Markets Dividend Growth Fund were trimmed
  • There were no fixed income transactions during the month

SDIF

  • Good trading updates from Dairy Crest, RPC and Victrex
  • Following very strong performance during the month, BlackRock World Mining Trust was reduced back towards target weight. The Trust remains at an attractive discount to net asset value
  • Fixed income positions were reduced over the month to build cash balances
  • The recent cooling off by the US Dollar enabled us to modestly increase the holding of DP Aircraft, the listed aircraft leasing vehicle

SIGT

  • Good trading updates from Dairy Crest, RPC and Victrex
  • There were no transactions in overseas equities during the month
  • There were no fixed income transactions during the month
  • The recent cooling off by the US Dollar enabled us to modestly increase the holding of DP Aircraft, the listed aircraft leasing vehicle

Download this investment letter as a PDF


 

Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/342

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Peter Elston’s Investment Letter – Issue 26: July 2017

26 July 2017

Preparing for the next downturn

The whole point of a fund is to pool investments and thus diversify risks. Multi-asset funds particularly embody the concept of diversification, because, unlike single-asset class funds, they diversify risks across asset classes as well as holdings. Seneca only manages multi-asset funds, so, with respect to tactical asset allocation, correctly anticipating downturns is critical, enabling us to strengthen our funds’ defences. Bear markets, after all, are when asset allocators earn their spurs.

I am anticipating a global economic downturn in or around 2020. This, I think, would precipitate a global equity bear market, beginning some time in 2019. I might be early, but that’s better than late.

Downturns and bear markets are as inevitable as death and taxes, so I doubt that this time is any different. Over the last year or so we have already been reducing our funds’ equity weights as markets have risen. We will continue to reduce them over the next two years such that by the onset of the next bear market our funds are defensively positioned (like driving, slowing down when you get to a bend rather than well before it is, frankly, nuts).

Cartoon 2020 vision - PE IL 26 - July 2017

The current growth phase that began in 2009 is now eight years old. This by most standards should be considered ancient – according to the NBER (National Bureau of Economic Research), the average length of the 11 growth phases in the US since 1945 was 59 months, a little under five years (1)(note: does not include the current cycle).

So, why do I expect the current expansion to reach the grand old age of 11, more than double its life expectancy?

The growth phase of any business cycle is itself made up of three sub-phases: ‘recovery’, ‘expansion’ and ‘peak’. The recovery phase is when economic indicators are rising but remaining below trend; expansion phase when rising and above; and peak phase when falling and above (the other sub-phase of the cycle is ‘recession’, when indicators are both falling and below trend). It is during the expansion phase that monetary policy gets tightened, as central banks seek to restrain growth and inflation, and the peak phase begins when monetary policy has become tight and is starting to impact growth.

So, since in much of the developed world monetary policy tightening has yet to begin, we are arguably still in the recovery phase (the US is probably in expansion phase but only just). If that’s the case, a global downturn is far from being imminent.

The current cycle has been characterised by weak inflation. This is despite unemployment across the developed world falling to levels which in the past would have been inflationary (to put this into more technical language, the Phillips Curve has shifted to the left). It is my belief that there are two key reasons for this, one structural and one cyclical. The structural reason is that automation has reached a tipping point such that labour no longer has the pricing power of days gone by. As for the cyclical reason, there may be more slack in labour markets than the headline unemployment rates suggest.

In the US, for example, the participation rate has hardly risen, as might be expected during a growth phase. Some of this is no doubt due to demographics, but then the increasing need for retirees to continue working should render this moot. The large number of disaffected workers who left the workforce following the Great Recession and retirees who need to work should keep a lid on wage pressures for a while longer.

In the UK, the rise in employment this cycle has to a greater extent been in lower paid jobs than might have been the case in previous cycles. Plus, we have the same issue with retirees increasingly needing to continue working. Let’s face it, the gap between retirement age and life expectancy has reached unsustainable levels. Not just in the UK but in much of the developed world.

These cyclical issues have shown up in terms of weak productivity growth. In the UK, productivity growth has at no point risen above 2% during this cycle, while in previous cycles it has hit 4%. A similar pattern can be seen in the US. Thus there is scope for a cyclically-driven rise in productivity to hold back inflation pressures for a little while longer.

Another simple point to note is that because unemployment rates rose to high levels in 2009, they subsequently had a long way to fall. Naturally, this was always going to take more time than normal. The worse the accident, the worse the injuries, and the longer the recovery time. 2009 was, in no uncertain terms, a car wreck.

So, extrapolating current trends in unemployment rates, and taking account of the aforementioned shift in the Phillips curve which should have the effect of extending the current cycle, I get to a downturn in 2020 (see chart). There is not a great deal of science behind this prediction. It is based on what is essentially simple analysis. But to paraphrase Warren Buffett, simple behaviour is more effective than complex behaviour. And let’s face it, the dismal anticipation by most economists of the Great Recession should have proved once and for all that their trade is not a science.

Chart: Unemployment rates in the developed world (%)

PE IL 26 - Chart 1 - unemployment rates

Source: Bloomberg, Seneca IM

 

Our tactical asset allocation framework

In light of my views on the next global downturn as set out in the above section, I thought it would also be worth touching on the framework I use for tactical asset allocation. Although valuations of asset classes are important, I believe these need to be considered in relative rather than absolute terms. What I mean by this is that valuations need to be considered in the context of monetary policy, namely real short term interest rates. Business cycle analysis can do this effectively and so is at the core of my tactical asset allocation framework.

The main research that I have drawn on is titled Dynamic Strategic Asset Allocation: Risk and Return across Economic Regimes (2) written by Robeco’s Pim van Vliet and David Blitz in October 2008. In it, the authors map real returns of various asset classes to each of the four phases of the business cycle, drawing on data going back to 1948. They found that risky financial assets (equities and credit) perform worst in the peak phase, risky real assets (commodities) perform worst in the recession phase, and, in view of what other asset classes are doing, cash performs worst in the recovery phase. One can therefore vary one’s asset allocation to align it with these findings, as per the graphic below.

Graphic: The business cycle, asset class returns, and tactical asset allocation

PE IL 26 - Graphic - business cycle

As I mentioned in the first section, I think in aggregate the developed world is close to the end of the recovery phase. The analysis above suggests that, given this, we should have been lowering our equity weight from overweight to neutral which is exactly what we have been doing over the last 12 months. From here, the analysis suggests we should be lowering our equity weight further which, again, is what we intend to do.

How severe will the next downturn be? Frankly, I don’t know. Some suggest it will not be nearly as severe as the last one as central banks will prevent it from infecting banking systems. Others suggest that because central banks’ balance sheets are still bloated, and the next downturn will start from lower interest rates, they have less scope to step in.

The good news is that I think I have a decent amount of time to develop my views further in relation to this question.

 


(1) https://en.wikipedia.org/wiki/List_of_economic_expansions_in_the_United_States#cite_note-NBER-1

(2) https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=1343063


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights as of 30 June 2017 (prior month’s targets in brackets)

PE IL 26 - Table 1 - TAA weights 06 17

General

  • Equity exposure reduced by 1% bringing weighting to neutral position against strategic asset allocation
  • Equity market valuations look less compelling following further strength this year
  • Reduction in equity weighting taken from UK equities
  • Rise in interest rates in the United States with commentators beginning to focus on higher rates in the UK and Europe following
    Draghi and Carney comments
  • Good trading update from Kier Group, whilst the new CEO of Bovis Homes further increased his shareholding in the company
  • In Europe, we trimmed the holdings in Invesco Perpetual European Equity Income Fund and European Assets Trust
  • Gilt yields rose to highest level for 3 months towards the end of the period following more hawkish comments by Mark Carney

SDGF

  • A strong share price performance from Aberdeen Private Equity Fund, aided by some heavy buying by large shareholders,
    moved us to take some profit from the overweight holding

SDIF

  • New investment in RPC, following share price weakness. Company has grown its dividend for 24 consecutive years and we
    believe it will continue to grow at a healthy rate
  • Somerset Emerging Markets Dividend Growth Fund was reduced to bring in line with target weight
  • Holding in TwentyFour Select Monthly Income Fund was reduced following strong performance over the past 12 months
  • A recovery from previously “”oversold”” levels in LondonMetric allowed us to move the position back down to its target weight
  • Following our participation in the recent equity raising in Sequoia Economic Infrastructure the shares returned to their previous
    strength, consequently we took some of the profit

SIGT

  • Following reductions in the tactical asset allocation weights to North America and Japan, we reduced the positions in the Cullen
    North American High Dividend Value Equity Fund and Goodhart Michinori Japan Equity Fund

Download this investment letter as a PDF


 

Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.

The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).

Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.

Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/258

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Peter Elston’s Investment Letter – Issue 25: June 2017

21 June 2017

Beware dividend concentration among UK large caps

Much has been written about dividend concentration among UK large caps of late. According to a recent article(1) in Investment Week, more than half of the 79 funds in the Investment Association’s UK Equity Income sector derived over 40% of their income from their largest ten holdings. Furthermore, according to an article in Money Observer(2), half of FTSE 100 dividends this year will come from just seven companies. These figures reflect extreme concentration risk and should be a concern for investors in UK large cap income funds.

That said, although dividend concentration may have increased somewhat in recent years, it is not particularly out of line with history. According to our analysis, dividend concentration was lower in 2016 than in 2006, 2007 and 2010. This can be seen in the chart below.

Chart 1: % Decrease in yield when top 10 dividend payers taken out of top 100

 

SIM-Investment-Letter-June-17-Chart-1

 

But fear not, help is close at hand. Venture into the mid cap space, and you can find plenty of decent yielding stocks. According to an April article in Investors Chronicle(3), “Analysis of the FTSE 350 reveals 117 companies with a trailing yield over 3.5 per cent, and even if we tighten up our selection criteria to those with strong cover of at least two times and PE below 13, we are left with 35 companies that pay a healthy dividend.”

In the UK equity segment of our multi-asset funds, we have a focus on mid caps. This is principally because over time mid caps tend to perform better than large caps, both in terms of returns as well as volatility-adjusted returns (since 1998, the FTSE 250 index has beaten the FTSE 100 index by 5%pts per annum).

But this is not the only reason. Mid caps are under-researched, so stock picking opportunities abound. Furthermore, as mentioned, you can find decent yields in the mid cap sector.

Our UK stocks, most of which are mid caps, on average yield 4.3% compared with 3.0% for mid caps in general. You may think we are sacrificing dividend cover but this is not the case. Average coverage for our stocks on a forward looking basis is 1.9 times compared with 2.1 times for the mid cap universe (and with 1.6 times for large caps!) Nor are we sacrificing quality: our return on equity is 21.4% on average compared with 13.8%.

According to Trustnet, the median fund yield in the IA UK Equity Income sector at the end of May was 3.9%. Furthermore, the median FE Risk Score for the sector was 85 (this means that on average, the volatility of funds in the sector was equivalent to 85% that of the FTSE 100 index). Finally, the median two-year fund performance was 13.8%.

A search for income does not need to be confined to the UK Equity Income sector though. Comparing these numbers with those of our LF Seneca Diversified Income Fund reveals some interesting results. Our fund yields 4.7% versus the median income yield of 3.9% for the IA UK equity income sector. Ah, but that’s because it is sacrificing total return, I hear you say. Not true. Two year total return has been 16.6% versus 13.8%. In that case it must be because the fund is more volatile. Again, no. The fund’s FE Risk Score is 43 half that of the UK Equity Income sector average!

The merits of a multi-asset approach in general and of our fund in particular are, we think, obvious.


 

(1) https://www.investmentweek.co.uk/investment-week/analysis/3007907/how-concerned-should-investors-be-about-dividend-concentration-risk

(2) http://www.moneyobserver.com/our-analysis/half-ftse-100-dividends-to-come-just-seven-companies-2017

(3) http://www.investorschronicle.co.uk/2011/09/09/the-best-dividend-payers-OC7nBGwijAvjAVCwzyQNbL/article.html

 


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights  as of 31 May 2017 (prior issued letter’s targets in brackets)

SIM-Investment-Letter-June-17-Chart-2

General

  • Specialist Assets was increased by 1.2%pts to accommodate new holding (see below). This increase came out of cash.
  • Sterling fell as opinion polls showed the gap between Conservatives and Labour narrowing
  • It was broadly a good month for equities, though in the UK mid caps lagged large caps, reversing April’s gains
  • Employment and inflation data across the world in general continued to improve
  • Very good results from Intermediate Capital, which included a 17% increase in the total ordinary dividend.
  • Increased prospect of a special dividend from Victrex, following very strong cash generation in the first half of the company’s financial year.
  • A review of the CouplandCardiff Japan Income & Growth Trust during the month highlighted the attractions of the portfolio, with its bias towards smaller companies and focus on dividend growth.
  • European Assets Trust performed well, driven by its large exposure to the industrial sector.
  • We invested in PRS REIT which launched with a successful IPO. The REIT will build a portfolio of newly built private rental properties and benefit from significant economies of scale.
  • We participated in the additional equity raise of International Public Partnerships, the listed infrastructure vehicle. The team have a proven track record, high quality operational assets and inflation protected income.

SDIF

  • Small additional investment in Muzinich Short Duration High Yield Bond Fund

SIGT

  • Additions were made to the Cullen North American High Dividend Value Equity Fund, Invesco Perpetual European Equity Income Fund and Magna Emerging Markets Dividend Fund.
  • European Assets Trust was reduced, in order to bring position to target weight.
  • Small increase in Royal London Short Duration Global High Yield Bond Fund
  • We added to the holding of RM Secured Direct Lending as the team has constructed a good quality secured loan portfolio with solid asset backing.

Download this investment letter as a PDF


 

Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/188

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Peter Elston’s Investment Letter – Issue 24: April 2017

18 April 2017

Is a computer going to steal my job as a fund manager?

Question: what is significant about the dates February 1996, October 2015 and January 2017? Answer: these were the dates on which, for the first time, a computer beat the world’s best at chess (1), the Chinese board game ‘Go’(2), and poker (3), respectively. How long will it be before computers are beating the world’s best fund managers?

I have a general fascination with the artificial intelligence systems (computers) that lie behind these three momentous conquests. But I also have a particular interest in relation to whether my job as a fund manager will at some point be usurped by a computer.

I’m 51 and so do not worry too much about my own personal situation in this regard. Although the active management industry is under pressure and will continue to be, it is not going to disappear in the next few years. If anything, the relentless shift towards passive investing and, more recently, so-called smart beta, has helped to promote the value of truly active management. But artificial intelligence is to passive investing what the computer chip was to the internal combustion engine, and I do wonder how my younger colleagues will fare a decade or two from now in their battle with silicon.

PE IL 24 - Cartoon3

To assess this question effectively, it is important first to consider how active management works. There are many well-renowned academics who believe that it is impossible to ‘beat the market’(4), and thus that active managers are in effect tossing coins with each other (and being paid by hapless customers to do so). This is also a position endorsed by practitioners in the passive investment industry (though presumably passive fund providers believe it is possible to beat their competitors!)

Market inefficiency, or the lack thereof, is thus framed in objective terms, with consistent index-beating performance being beyond the reach of everyone. Herein lies my beef. I think market efficiency should be framed subjectively not objectively. In other words, there are some individuals who can beat the market; in the same way, there are individuals who tend to be good at poker.

If stocks and markets truly followed a random walk, I would be the first to hang up my boots. But they don’t.

Randomness in markets means that price movements are not dependent on previous price movements. Coin tossing is a good example of this – no matter how many consecutive heads are tossed, the probability of another head is still 50%, biased coins excepted. Non-randomness, also known as ‘pattern’, means that there is dependence.

The two most common patterns in markets are ‘momentum’ and ‘mean reversion’. Momentum means that if the market price moves in a particular direction, the future price is more likely to move in the same direction. With mean reversion, the price is more likely to move in the opposite direction. These patterns exist in financial markets, over both short and longer timescales.

Furthermore, randomness and pattern can co-exist – there will always be a ‘noisy’ element to prices. In fact, randomness tends to predominate.

What I as a fund manager seek to do is to identify patterns that are bold enough for me to take advantage of, having assessed that in all likelihood they are patterns that will persist i.e. continue into the future.

In the case of asset allocation, the patterns that I believe I can take advantage of relate to the business cycle, namely the tendency of unemployment to rise and fall in a somewhat predictable manner. Take a look at the chart below of the unemployment rate in the US, then tell me that looks random!

Chart 1: US unemployment rate

PE IL 24 - Chart 1 - US unemployment rate (%)

I also suspect it is highly likely that unemployment will continue to rise and fall as it has in the past. In fact, the chart above suggests that the cycle has become more discernible in recent decades not less!

In their 2009 paper titled “Dynamic Strategic Asset Allocation – Risk and Return Across Economic Regimes”(5), Robeco’s David Blitz and Pim van Vliet set out a framework for using the business cycle to inform tactical asset allocation (what they call ‘dynamic strategic asset allocation’). They mapped the four phases of the cycle (expansion, peak, recession and recovery) to the performance of various asset classes, using data going back to 1948. Their study revealed some interesting results, which are set out in the table below.

Table 1: Annualised returns in excess of cash (%)

PE IL 24 - Table 1 - Annualised returns in excess of cash (%)

Excess returns from equities ranged from 0.2% per annum during ‘peak’ phases to 10.2% during ‘recession’ phases. Bonds performed worst during ‘expansion’ phases. These are empirically derived results, but they are also logical. Expansion phases tend to see both inflation and central bank policy rates rising, which naturally is bad for bonds. Peak phases see tight monetary policy begin to impact economic growth, which is bad for equities, while recession phases see the opposite (readers may be interested to know that we will very likely continue to reduce our funds’ equity targets over the next two years, in anticipation of the onset of the next global recession in or around 2020).

So, back to the question of whether computers will make the business of active management redundant.

The simple point I would like to make is this. While the games of chess, Go and poker are complex in that there are an unimaginable number of permutations, either in terms of possible moves (in chess and Go) or possible hands (poker), the rules that govern each of them are simple and could be written on the back of a cigarette packet. In chess, there are only six different pieces, and each is only allowed to move in a particular, simple way. In poker, there are a small number of meaningful hands and the rules clearly state which beats which.

The same cannot be said about investing. Why? Because financial asset prices are driven by human behaviour, and you can’t write the rules that govern human behaviour on the back of a cigarette packet as you can with chess, Go and poker.

Simplistically, but importantly, what distinguishes computers from humans is that humans have the ability to imagine. And it is the ability to imagine that gives and perhaps may always give humans the edge over computers.

The US Air Force knew this. Top brass there realised long ago that pilot capability could be more effectively appraised by a test of a candidate’s imagination, rather than by an IQ test. As recounted by renowned scientist Michio Kaku (around the 5 minute mark in this video (6))the USAF tested prospective pilots on their ability to imagine different solutions to a problem. The particular case that Kaku cites was one in which candidates were told they were stuck behind enemy lines, then asked how many escape plans they could hatch.

How does all this relate to investing? Simple.

Imagination requires an appreciation of the future. As Kaku says, computers can only at best appreciate the future in one dimension – they can predict, for example, the airflow over an airplane wing. Humans, on the other hand, have the capacity to predict the future on multiple scales. This ability is the result of the hundreds of millions of years of the evolution of life that have culminated in the emergence of the human brain. It does not therefore take a huge leap of logic to believe that humans have a key edge over computers, whether in the world of investing or in other areas.

Indeed, in a recent article in Prospect Magazine, Resolution Group’s chief economist Duncan Weldon wrote, “Machines are less likely to be able to replicate creativity, social interaction, and the need for human-to-human contact anytime soon, and a surprising number of jobs involve these attributes”.

Furthermore, although there are many instances in which artificial intelligence is helping to improve decision making, there are others where this is not the case. AI systems designed to perform the same task can end up in conflict rather than working together. One example of this is so-called ‘bots’ designed to correct errors on Wikipedia. According the The Guardian (7), “One of the most intense battles played out between Xqbot and Darknessbot which fought over 3,629 different articles between 2009 and 2010. Over the period, Xqbot undid more than 2,000 edits made by Darknessbot, with Darknessbot retaliating by undoing more than 1,700 of Xqbot’s changes. The two clashed over pages on all sorts of topics, from Alexander of Greece and the Banqiao district in Taiwan to Aston Villa football club.”

One can imagine bots of the future designed to make investment decisions also coming into conflict with each other, with a plethora of inputs telling one to buy and the other to sell.

Even if AI can be used to make good investment decisions, we are a long way from such systems becoming refined and widespread. A search on ssrn.com for the terms “artificial intelligence” and “investing” yields just one result (8) and the paper in question, which puts forward a framework for picking stocks based on an analysis of past data, concedes that there are flaws in its methodology.

It looks like my younger colleagues can breathe a sigh of relief.

 


 

(1) http://www.nytimes.com/1996/02/11/us/in-upset-computer-beats-chess-champion.html
(2) https://en.wikipedia.org/wiki/AlphaGo
(3) https://www.theguardian.com/technology/2017/jan/30/libratus-poker-artificial-intelligence-professional-human-players-competition
(4) https://en.wikipedia.org/wiki/Efficient-market_hypothesis
(5) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1343063
(6) https://www.youtube.com/watch?v=iONlo9WcKgQ
(7) https://www.theguardian.com/technology/2017/feb/23/wikipedia-bot-editing-war-study
(8) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2740218


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 2: Current fund tactical asset allocation (TAA) target weights as of 31 March 2017 (prior month’s targets in brackets)

PE IL 24 - Table 2 - Current fund tactical asset allocation 31 March 2017

General

  • In the UK, prime minister Theresa May triggered Article 50, thereby formally starting divorce proceedings with the EU
  • The Fed raised short term interest rates for the third time this cycle, as inflation pressures continued to grow
  • FOMC committee members on average expect a further two increases this year, accelerating the pace of the last two years
  • Good results from several holdings, including Arrow Global, One Savings Bank, Polypipe and Ultra Electronics
  • Bovis Homes attracted takeover interest from Redrow and Galliford Try
  • We increased Doric Nimrod Air 2 due to the aircraft leasing vehicle’s valuation offering a lot of protection against a negative
    outcome on residual value on the A380
  • We reduced Ranger Direct Lending as we feel the risks of disappointment in US credit quality may not be fully reflected in the
    valuation

SDIF

  • Sainsbury’s was exited, in order to facilitate the 1% reduction in the TAA to UK equities
  • Positions in Royal London Short Duration Global High Yield Bond Fund and Muzinich Short Duration High Yield Bond fund were increased to maintain portfolio income as equity exposure was reduced

SDGF

  • Several UK equity holdings were reduced, in order to facilitate the 1% decrease in the TAA in the UK
  • Stewart Investors Asia Pacific Leaders Fund was exited, with the majority of funds reinvested into Pacific Assets Trust, a small-cap focused vehicle run by the same team at Stewart Investors
  • As part of the readjustment in Asia Pacific ex Japan, the Prusik Asian Equity Income Fund was also added to during the month

SIGT

  • Cullen North American High Dividend Value Equity Fund was reduced, following a decrease in the tactical asset allocation for North American equities
  • Royal London Short Duration High Yield Bond Fund was increased as a low risk alternative to holding cash

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/109

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Peter Elston’s Investment Letter – Issue 23: March 2017

20 March 2017

Fund objectives and the search for harmony

We think that over a ‘typical’ investment cycle, our income fund (LF Seneca Diversified Income Fund) and our two more growth-oriented funds (LF Seneca Diversified Growth Fund and Seneca Global Income and Growth Trust) can achieve returns in the order of CPI+5% and CPI+6% respectively (‘real returns’ of 5% and 6%).

During a ‘typical’ investment cycle, which I define below, we expect certain real returns from each asset class/market. For example, we expect developed market government bonds to generate real returns of 2% per annum over the long term, based on historical data that go back to 1849 as well as on some forward looking assumptions. If this is what should be expected over the long term, it is also what should be expected over a ‘typical’ investment cycle.

We also have a good idea of how much value our active management decisions relating to tactical asset allocation and holding selection (stocks and funds) can add, in light of each fund’s ex ante tracking error. For example, our investment trust’s tracking error in relation to strategic asset allocation is 5.1% as at 13.03.17, which gives it plenty of scope to add a decent amount of outperformance before fund costs. If tracking error was only 1%, this wouldn’t even cover fund costs.

 

SIM-Investment-Letter-Issue-23

Taking everything into account, we can therefore have a good idea of what each fund’s total real return should be over a typical investment cycle.

In the case of our income fund, we expect to get 4.3% annualised in real terms from strategic asset allocation and 1.9% from active decisions. This adds up to 6.2% before fund costs. Subtract fund costs of 1.3% and you get to 4.9%, close to 5%. This is not an exact science, and the 5% should not be thought of in precise terms; there are many independent variables involved that will affect the actual outcome. However, it is important that if you have an outcome-oriented objective such as CPI+5%, you must have a logical framework for it, as we do.

So, what is a ‘typical’ investment cycle?

Firstly, we think of an investment cycle as being in synch with a business cycle, which comprises a period of economic expansion and a period of economic contraction. According to the National Bureau of Economic Research in the US, the average business cycle since 1945 has lasted around 6 years.

A typical investment cycle is one in which real returns from asset classes and markets are in line with their long-term averages. From 1849 to 2016, US Treasuries have returned 2.1% per annum in real terms (this feels about right, given that with such safe haven bonds there is duration risk but minimal credit risk). So, in a typical investment cycle, we would expect US Treasuries and other developed market government bonds to generate a real return of 2.1% per annum, which we round to 2%.

An atypical cycle on the other hand might see US Treasuries perform much worse (or better) than their long-term average. For example, the period from 1940 to 1981 saw them fall by 2.7% per annum in real terms, which means that there would have been investment cycles during this period when returns were very poor indeed. Indeed, given where real interest rates and inflation are today, it is very possible that the next few investment cycles may see similarly challenged returns.

During such cycles, it would be hard to achieve real returns of 5 or 6%. Furthermore, rising inflation that causes the real returns of bonds to be poor will likely cause real returns from equities to be below their ‘typical’ cycle returns too. This was the case during the aforementioned period from 1940 to 1981, though US equities still achieved a decent 5.9% per annum in real terms, compared with their long-term average of 6.4%.

We are very committed to thinking in terms of “CPI+” objectives, but we think it is important that our investors know that a period of high and rising inflation would make them hard to achieve.

What we do believe however is that by understanding the behaviour of different asset classes in various inflation regimes, we have a better chance than others of achieving decent real returns, even if they fall short of some real return objective.

Another potential issue with CPI+ objectives is that funds employing them can be mistaken for absolute return funds. After all, a CPI+ objective is far more “absolute” than, say, a composite index comprising equity and bond indices (a common example would be 50% MSCI World/50% Barclays Global Aggregate).

However, although CPI+ is more “absolute” than a composite index, this does not mean that funds that use them are absolute return funds, particularly if they use clear qualifiers such as ‘over a typical cycle’. Our funds use CPI+ objectives because they are “outcome oriented” funds. They are absolutely not absolute return funds.

The difference is a significant one.

An absolute return fund is generally one that seeks to generate positive returns over short periods, at most three years. Our funds on the other hand are looking to achieve positive real returns over a ‘typical’ investment cycle, which means around six years.

Since equity markets are quite volatile over shorter periods, absolute return funds tend to employ all sorts of complicated ways to smooth returns. Such methods might include long-short strategies, pair trades, derivatives, momentum strategies, curve arbitrage etc. Furthermore, since equities and other risky assets that underlie these strategies tend to be unpredictable over shorter periods as well as volatile, you can see the difficulties that absolute return funds face.

When things are going well, it is easy not to be bothered about how returns are produced. When, however, things are not going so well, it’s a different story.

Excluding the two money market sectors, the IA Targeted Absolute Return sector has been the worst performing of 37 sectors over 1, 3, and 5 years to end December 2016. In real terms, it has returned -0.5%, 1.4% and 2.0% per annum over these periods, compared with 16.0%, 8.7% and 11.2% on average for the other 36 sectors. This is a tragic opportunity loss for investors, which sadly must be considered mostly a permanent one. A bear market might see the gap narrow but likely only marginally.

The point is that because equities, credit and commodities are unpredictable in the short term, it is very hard to use them to produce high and stable short-term returns. I know of only two investors who have been able to achieve this holy grail of investing: Bernard Madoff and Renaissance Technologies’ Jim Simons.

I remember attending a conference a few years ago at which a representative of Renaissance Technologies was talking about its supercomputer, which according to him was the largest in the world (at least the largest that was owned privately). It used this supercomputer to predict price movements over short timeframes, and it did this faster and more accurately than anyone else to produce high and stable returns.

And Madoff? Well, we all know why his returns were high and stable. They were faked.

Our funds at Seneca do not use any of the aforementioned complex investments and strategies. Nor are we trying to smooth short-term performance, other than that which is a natural result of our diversification, either within or across asset classes.

Take a look at our portfolios and you’ll see investments and funds that are easy to understand, whether UK midcap companies, fixed income and overseas equities funds, REITs, infrastructure funds, aircraft leasing vehicles or direct lending funds. We hope to be able to soften the blow of bear markets through the use of enhanced income funds that would enable our two income oriented funds to reduce exposure to equities while at the same time maintain their capacity to generate income (our growth fund, which has no income mandate, would shift towards cash or money market funds).

In summary, we think we sit nicely between, on the one hand, traditional balanced funds that invest only in bonds and equities and, on the other, complex structures that are hard to understand and indeed may not perform very well. In fact, we’d call our funds ‘harmonious’.

 


Current fund targets

The target weights in the table below are where funds should be positioned currently. Actual positions may deviate slightly from these target weights as a result of market movements or ongoing trades for example.

Table 1: Current fund tactical asset allocation (TAA) target weights as of 28 February 2017 (prior month’s targets in brackets) 

 

SIM-Investment-Letter-Issue-23-Graph-1

General

  • February was a good month for financial assets across the board, as economic growth in many key countries continued to improve
  • Sterling slipped slightly, following reports that the Scottish Nationalist Party was preparing for a second referendum on independence
  • Equities overweight reduced from 3%pts to 2%pts as recent strength in markets has made valuations less compelling
  • The 1% reduction came out of Europe ex UK where political risks are if anything still rising; the proceeds were moved into cash
  • Essentra rose 33%, after reporting full year results. New CEO and turnaround specialist, Paul Forman, is going down well with investors
  • National Express and Morgan Advanced delivered healthy results ahead of expectations, as did Senior, although the latter had a cautious tone
  • Invesco Perpetual European Equity Income Fund was reduced, following a decrease in the tactical asset allocation for European equities
  • BlackRock World Mining Trust announced a valuation uplift to its investment in a Brazilian based mine, which has moved from development to commercial production
  • TwentyFour Dynamic Bond Fund was reduced to keep overall fixed income exposure at close to 30% (SDIF only)
  • Blue Capital Global Reinsurance saw its significant discount narrow to some degree as it continues to deliver relatively stable NAV returns
  • UK Mortgages Ltd announced the completion of its third acquisiton of a parcel of mrotgages which fully commits their initial capital in assets that are demonstrating solid credit quality

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
LF Seneca Funds
These funds may experience high volatility due to the composition of the portfolio or the portfolio management techniques used. Before investing you must read the key investor information document (KIID) as it contains important information regarding the funds, including charges, tax and fund specific risk warnings and will form the basis of any investment. The prospectus, KIID and application forms are available from Link Fund Solutions, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the latest Annual Report for details of the principle risks and information on the trust fees and expenses. Net Asset Value (NAV) performance may not be linked to share price performance, and shareholders could realise returns that are lower or higher in performance. The annual investment management charge and other charges are deducted from income and capital.
Seneca Investment Managers Limited is the Investment Manager of the Funds (0151 906 2450) and is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP17/78

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