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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 (CF Seneca Diversified Income Fund) and our two more growth-oriented funds (CF 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.
CF 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 Capita Financial Managers, 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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Peter Elston’s Investment Letter – Issue 22: February 2017

20 February 2017

2017 Investment outlook

My job is to predict the future. This makes it fun as well as challenging. Some future events are very likely and thus easy to predict. You’re never going to make much money betting that the sun is going to rise tomorrow – only an idiot would offer you odds!

Where you will make money is when there is a difference between your perceived chance of an event occurring and the market’s perceived chance. If you were an astronomer and spotted an asteroid hurtling to earth you may well make money betting against the sun rising, though of course you wouldn’t have much to spend it on if you won! The difference between your odds and the market’s odds is known as ‘edge’ and in the financial world it is the basis of good investment performance.

What makes something predictable is whether it exhibits pattern as opposed to noise. Coin tosses are noisy, as one toss is not influenced by the previous toss. The swing of a pendulum on the other hand exhibits pattern – the time of one swing – also known as the period – is the same as that of the previous swing.

Interestingly, pattern and noise can live side by side, or indeed be part of the same thing. A tiny section of a photograph looks and is chaotic. Zoom out and a picture – a pattern – emerges. Zoom in and you’ll see the pattern of molecular structure. In other words, whether you see pattern depends on your perspective. Like the photograph, stock prices tend to exhibit pattern over very short time frames and over long ones, and are essentially noisy in between. Your perspective will determine whether you are able to profit from investment markets on a repeatable basis.

At Seneca, we have a long-term perspective, whether with respect to asset allocation, stock selection or fund selection. We allocate our team responsibilities in terms of the areas in which we are seeking to add value to our portfolios through active management decisions. Mark picks our UK equities, Tom our overseas equities funds, Alan our fixed income investments, and Rich our specialist assets. As for me, I do asset allocation. It is very much a team effort, with each member responsible in some way for the performance of each of our funds.

As asset allocation specialist, the main pattern that I continue to focus on is the relationship between business cycles and financial asset prices. What this pattern is telling me now is that in general you need to avoid safe haven bonds but that you can continue to enjoy decent returns from equities.

Why do I think this?

The business cycle has four phases or regimes: recovery, expansion, peak and recession. According to the National Bureau of Economic Research (NBER), the typical business cycle lasts around 6 years, with the recession phase lasting around 1 year. Business cycles can most easily be discerned in employment statistics. As can be seen in Chart 1, the increases and decreases in the unemployment rate in the US are fairly regular.

Why is this?

Following a recession in which businesses shed labour, they will at some point start to rehire. This is the recovery phase, during which monetary policy remains stimulatory and inflation pressures are subdued. At some point, hiring reaches the point at which upward wage pressures become more pronounced. This is the expansion phase, in which inflation rises and central banks start to tighten monetary policy. The peak phase sees economic growth fall – as tight monetary policy starts to bite – but remain positive.
This is followed by recession in which businesses shed labour and growth is negative.

Chart 1 U-3 US Unemployment Rate Total in Labour Force Seasonally Adjusted

PE 22 - Feb 2017 - Chart 1
In reality, the phases are not quite as neat as I have described them above. No two business cycles are the same. And some business cycles see prevailing economic conditions move back and forth between, say, recovery and expansion before progressing further. There may also be other non-coincident cycles relating to demographics, wealth inequality or debt that have some sort of influence on business cycles.

Nevertheless, if financial markets were efficient they would anticipate the various phases of a particular business cycle, exhibiting similar real returns in each. This is clearly not the case, evidenced by the well-established pattern of bull and bear markets in both bonds and equities.

The question is whether there is a pattern – a relationship – between the performance of equities and bonds on the one hand and the business cycle on the other. If there is, the asset allocator can have an edge.

As far as equities are concerned, the answer is a resounding ‘yes’. Chart 2 below shows the 1 year performance of US equities against the year-on-year change in the Conference Board’s coincident indicator (the generally accepted business cycle indicator).  It is not a perfect correlation by any means, but Chart 3 shows that it is significant, with a relatively high R-squared of 0.38 (Note: R-squared is a measure of correlation between two series of numbers. An R-squared of 1 represents perfect correlation, while 0 represents no correlation whatsoever).

Chart 2: US equities versus the US coincident indicator

PE 22 - Feb 2017 - Chart 2

Chart 3: How strong is the relationship between the US equities and the US business cycle?

PE 22 - Feb 2017 - Chart 3

If there is a strong correlation between equities and the business cycle, the next question to ask is whether there is an indicator which helps us to anticipate inflection points in the business cycle, namely the start of recessions and expansions.
Once again, the answer is ‘yes, there is’.

Chart 4 below shows the yield curve (10 year minus 2 year) versus the year-on-year % change in the coincident indicator.  Although the end of the 70s and early 80s were very turbulent, one can see that there was a “double dip” recession and that these were preceded by inverted yield curves (the middle of 1980 saw the yield curve steepen but not for long, and the 1982 recession followed soon after). The other three recessions since the early 80s (in 1991, 2001 and 2009) were all preceded by negative yield curves, with the lead time being around 2 years. Furthermore, there was no instance of a negative yield curve not leading to a recession.

In other words, we have a way of anticipating recessions and thus a way of predicting equity markets.

Chart 4: Yield curve versus the business cycle

PE 22 - Feb 2017 - Chart 4
So, what is the yield curve in the US telling us now about the prospects for the US economy and thus stock prices? Chart 4 above shows that although the yield curve is shallower than it was following the 2009 recession, it is nonetheless still positive. Furthermore, following the recent rise in long-term bond yields, the 10y-2y has moved from 0.8%pts in the third quarter last year to 1.2%pts currently. While not a huge move, this is indicative of an improvement in US economic prospects.

The astute observer will now ask why, if we are sanguine about economic prospects in the US, we are not overweight US equities. The answer is that we are more positive about equities elsewhere, notably Europe where the business cycle, as evidenced by the unemployment rate, is still in recovery phase (a phase when equities tend to perform better than in expansion phase). In other words, our US equity underweight is a relative call not an absolute one.

As for safe haven bonds, particularly those in the US, they tend to perform poorly during expansion phases. This makes complete sense of course given that expansion phases are ones in which inflation rises. I don’t need to tell you that rising inflation is negative for bonds.

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 January 2017 (prior month’s targets in brackets)

PE 22 - Feb 2017 - Table 1

General

  • The US dollar declined sharply in January and ended the month around 4% below its late December high
  • The fall was attributed largely to US politics which saw newly crowned president Donald Trump follow through on some of his controversial campaign promises in relation to immigration
  • Inflation expectations continued to rise, particularly in the UK
  • The funds remain overweight equities, though we did shift targets away slightly from Europe ex UK to UK in light of sterling’s decline since Brexit as well as concerns about EU politics
  • BT Group shocked the market by revealing false accounting practises within their Italian business. We felt the sharp share price fall was an overreaction, given that this should be an isolated issue and took the opportunity to add to the holding at a yield close to 5%

SDIF

  • The holding in One Savings Bank was added to on price weakness to build the position to its full target weighting
  • Emerging market debt exposure was increased with a further purchase of the Templeton Emerging Markets Bond Fund

SDGF

  • Invesco Perpetual European Equity Income Fund was reduced, following a decrease in the tactical asset allocation for European equities
  • Ranger Direct Lending Fund was reduced, due to concerns over the operation of one of the lending platforms used by the company
  • Position in International Public Partnerships was increased. The holding provides an attractive inflation linked income stream

SIGT

  • European Assets Trust, Invesco Perpetual European Equity Income Fund and Liontrust European Enhanced Income Fund were reduced, following a decrease in the tactical asset allocation for European equities

 


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.
CF 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 Capita Financial Managers, 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. FP17/44

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Peter Elston’s Investment Letter – Issue 21: January 2017

20 January 2017

A look at the relationship between return and volatility

It is generally agreed and understood that to enjoy higher returns over the longer term one must accept higher levels of volatility in the shorter term. One of the most interesting features of the last ten years has been the breakdown in this relationship.

The below scatter chart shows the relationship between volatility (x-axis) and return (y-axis) for a range of asset classes for two periods: the last year (CY2016) and the last ten years (2006 to 2016). It also shows the best fit line for both periods, together with the correlation statistics (R-squared) for each. Please note that each dot refers to a particular asset class. Also that I have not labelled each dot because a) it would clutter the chart and b) the emphasis is on the general relationship rather than the specifics (Table 1 further on presents the detailed underlying numbers for each of the asset classes depicted in the below chart).

Chart 1: return versus volatility for a range of asset classes

PE Investment Letter 21 - January 2017 - Chart 1 Return versus volatility

There are two key parameters to note for each of the two series (periods): the slope of the best fit line and the correlation. The slope defines the relationship between return and volatility (i.e. whether it is positive or negative) while the correlation statistic defines how well the data fits the relationship.

It is not too surprising that over one year there is neither a positive relationship between return and volatility, nor a high level of correlation (in fact the R-squared of 0.03 says that there is none whatsoever!) However, it is interesting to note that over ten years there is an inverse relationship between return and volatility and that the correlation is quite high. This is completely at odds with the aforementioned generally accepted positive relationship between return and volatility. What on earth is going on?!

The table below shows the return and volatility statistics for the various sub asset classes used in the above chart. They have been sorted by 10 year volatility-adjusted return (proxy for the Sharpe Ratio).

Table 1: Volatility and return statistics for a range of asset classes (sorted by 10 year “Sharpe” in descending order)

PE Investment Letter 21 - January 2017 - Table 1 Volatility and return statistics

Here are some observations:

  •  There are in total nine bond-related sub-asset classes and they are all in the top 10 by 10 year volatility-adjusted return
  •  Volatility of risky bonds has on the whole been lower than that of safe haven bonds
  •  US high yield has produced some very impressive volatility-adjusted returns over the last ten years
  •  US high yield had a fantastic 2016, generating a return of 36% with annualised volatility of just 7%
  •  Equity markets generally appear in the lower half of the table, with some markets such as Japan and Europe ex UK producing miserable volatility-adjusted returns
  •  Of all the equity regions, the US’s numbers are the most impressive, but they are still not great – the 6% return over the last 10 years is lower than the 9.5% one has seen over the last 30 years
  •  The bottom of the table is generally occupied by commodities and other “non-traditional” asset classes such as REITs, listed private equity and infrastructure

One important point to note is that neither FX exposure nor commodities are likely over the long term to produce high volatility adjusted returns. FX returns are essentially a zero-sum game – for example, when a Yen-based investor who is holding Sterling wins, a Sterling-based investor holding Yen loses. There is a small net positive utility in holding foreign exchange since a 10% gain for one investor is a 9% loss for the other – the average for the two is thus +0.5%. Once one takes account of the relatively high volatility of FX spot rates, one can understand that volatility-adjusted returns over time will be poor (one can also understand why FX hedging can make so much sense).

As for commodities, there is little reason why over the long term their prices should rise more than the prices of other goods and services. If you own Nickel for example and are not doing anything with it, you are firstly not generating an income and secondly you are paying for storage (not directly but via losses incurred at futures contract rollover). In other words there is little reason why commodities prices should rise in real terms over the long term (this is indeed the case in practice as well as theory). The volatility of commodities prices is even higher than for FX exposure (as can be seen in the above table) and so volatility-adjusted returns over time will tend to be even worse.

What this all means is that there are some sub asset classes which fail in both theory and practice to adhere to the aforementioned positive relationship between return and risk. Notwithstanding this, over the last ten years, weird things have been happening between risky bonds and safe haven bonds and between bonds in general and equities.

My own conclusions from the above observations are fairly simple: over the next ten years, returns from safe haven bonds will be poor, returns from risky bonds will be moderate, and returns from equities will be moderate to good. I might get excited about commodities or FX if they are close to long term lows on an inflation adjusted basis, but this is not generally the case at the moment (Sterling on a real effective basis is now trading close to all-time lows but it is possible nay probable that Brexit will keep it there for the time being). The inflation-adjusted oil price is well below its long term trend but as with Sterling there are structural issues that may keep it there.

In my next letter I will go into more detail with respect to our 2017 macro and market outlook.

Review of last year’s investment outlook

This time last year I wrote, “We believe on balance that the world will continue to grow in 2016, that equity market valuations by and large are low enough to make positive returns likely, and that western government bonds remain overvalued.”

Notwithstanding sterling’s weakness during the year, most equity markets around the world posted decent returns, with the MSCI AC World Net Local index itself returning 9.0%.

As for safe haven bonds, they proceeded over the first nine months of the year to become even more overvalued, with the yield on the Barclays World Inflation Linked Bonds index falling from 0.0% to -1.0%. The last three months of the year saw real yields rise, though only back to -0.7%.

I also wrote last year that, “High yield bond spreads have moved out, which given our expectation of future growth means this is an attractive area for us.” High yield spreads in both the US and Europe fell significantly during the year (in the US from 660 to 409bps and in Europe from 460 to 334bps). Returns will also have been boosted by the falls in government bond yields.

So, overall, I’d give our predictions a B+, which I would downgrade a notch or two for not gauging Brexit to be more likely. Nevertheless, our three public funds all had reasonable years, and all three now look very good based on volatility-adjusted total returns over five years (the income fund and the trust both look very good based on unadjusted total returns).

Our new investment process that we introduced in April 2015 is coming up to two years old, and it has undoubtedly been helping to improve our investment proposition. We remain completely committed to our unique style, Multi-Asset Value Investing, and its core principle that buying things cheaply will tend to produce good investment performance over time.

Current positioning versus last year

Our funds’ tactical asset allocation positioning is very close to where it was this time last year, which means our views on the various asset classes in which we invest have not changed much. This to a degree is to be expected – our asset allocation approach seeks to identify business cycle inflection points which don’t by their very nature come along very often. And although inflation is now rising in many countries, I think the end of the current cycle is some way off, though for some – the US being a good example – it is closer than others.

Table 2: Seneca funds’ SAA and TAA weights

PE Investment Letter 21 - January 2017 -Table 2 Seneca funds SAA and TAA weights

An interesting research paper about tactical asset allocation and the business cycle

I recently came across a paper written in 2008 by Robeco’s Pim van Vliet and David Blitz entitled “Dynamic Strategic Asset Allocation: Risk and Return across Economic Regimes”. Those of you who have been following us for the last couple of years (or longer!) will know that our approach to tactical asset allocation is centred around analysis of the business cycle. While van Vliet and Blitz make a distinction between tactical asset allocation and what they call “dynamic strategic asset allocation”, they can in this instance be considered the same thing (they are both seeking to optimise in relation to a static strategic asset allocation though in slightly different ways).

The paper’s analysis focuses solely on the US but considers a reasonably wide range of asset classes: equities (large, small, value & growth), Treasuries, credit, commodities, and cash over 60 years. The authors use four indicators to define the business cycle: credit spread (difference between the Baa and Aaa spreads), earnings yield (E/P ratio of the S&P500), the ISM manufacturers’ survey production index, and the seasonally adjusted U.S. unemployment rate. They then assign each month of the indicator to one of four phases of the business cycle (expansion, peak, recession or recovery) depending on whether it is high and rising (expansion), high and falling (peak), low and falling (recession). Finally, they consider the performance of each of the aforementioned asset classes in each of the four phases and build recommended portfolio weightings for each phase for each asset class in relation to a fixed strategic asset allocation (the objective of the Dynamic Strategic Asset Allocation is to optimise both return and volatility in each of the four phases). The results are summarised in the table below.

Table 3: Strategic asset allocation weights and recommended weights during each business cycle phase

PE Investment Letter 21 - January 2017 - Table 3 Stategic asset allocation weights

As for returns of each asset class in each of the four phases (as well as over all phases), they are summarised below. Note that returns are stated as excess returns in relation to cash.

Table 4: Excess returns of each asset class in each phase as well as over all phases

PE Investment Letter 21 - January 2017 - Table 4 Excess returns of each asset class in each phase

There are numerous interesting features of the above two tables as well as of other parts of the study:

  •  It appears that recommended weights do not differ that much from SAA weights. This is because the study imposes tracking error limits. Increasing tracking error limits would increase the size of positions in relation to SAA.
  •  Although equity returns are below average during expansion phases (3.7% during expansion versus 5.6% for all phases), the model still recommends overweighting equities (44% total versus SAA total equities of 40%).
  •  This is because returns from other asset classes during expansion phase are also below average (e.g. bonds negative 0.4% versus +0.6% for bonds during all phases).
  •  Although equity returns are best during the phases ‘recession’ and ‘recovery’, the model still recommends underweighting them in relation to SAA.
  •  In fact, the model also underweights equities during the ‘peak’ phase as well, so equities are underweighted in three of the four phases.
  •  This is because the model is seeking to optimise in relation to volatility as well as return (models that optimise for return only will overweight equities during the phases ‘peak’ and ‘recovery’).
  •  It should also be noted that the model makes material shifts between ‘large’, ‘small’, ‘value’ and ‘growth’ during the four phases, even though overall equity recommended weights do not move far from SAA weight.
  •  An allocation to credits is recommended in one phase only: ‘recovery’.
  •  The strong performance of credit in recent months and years on both sides of the Atlantic suggests that we may still be in ‘recovery’ phase, though inflation data suggests the US is closer to ‘expansion’ than Europe.
  •  It may well be time given the various conclusions of the paper to be moving out of credit, at least in the US (note the strong performance in 2016 of CCC credits mentioned earlier in this letter). The question is, what should one move into? Emerging market debt might be one option, particularly since there tends to be a positive correlation between emerging markets and commodities, which tend to do well during the ‘expansion’ phase that we may well be moving into in the next year or so.
  •  As the paper notes, “most assets exhibit above-average returns during recessions and recoveries and below-average returns during expansions and peaks”. Although in some ways this is counter intuitive, it is also generally understood that risky assets tend to anticipate good times (expansions and peaks) well in advance i.e. they perform well during recessions and recoveries (bad times).
  •  Many other studies use NBER data to define different phases of the business cycle which is problematic because such data is only available ex post. This study on the other hand uses four indicators that are available ex ante, and is thus one that has more practical application for asset allocators.

Those wishing to take a closer look at the paper can find it here

 


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.
CF 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 Capita Financial Managers, 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. FP17/14

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Peter Elston’s Investment Letter – Issue 20: December 2016

21 December 2016

Value investing is not the same thing as value indices

I’m thinking about launching a smart beta ETF called the “Smart Alpha Smart Beta ETF”. It would invest only in shares that go up. At the end of every month, the fund would be rebalanced into those shares that will go up the following month. “How do you pick the shares?”, I will no doubt be asked. “I don’t, the ETF will track an index of shares that go up”. “Ah, I see” may be the response, perhaps followed by “Sounds good. Where can I buy?”

There seem to be so many ways of systematically slicing and dicing markets nowadays in an attempt to beat them that I’m sure my idea might get some way before I was rumbled.
The first attempt to set out a framework for picking good-performers was that of Benjamin Graham and David Dodd in the 1930s. They never called it ‘value investing’ though that is what it later came to be known as. Many investors have since put their own slant on it, to the extent that now it is more a principle than a framework – the principle being that if you buy things that are cheap you have a better chance of beating the market and thus making good money.

The question of course is how you assess the cheapness of a stock.

For Graham and Dodd it was about calculating the intrinsic value of a company, then buying those whose market capitalisation was well below their intrinsic value. It took their bible, Security Analysis, 700 pages to explain how to do this.

In 1992, Eugene Fama and Kenneth French wrote a seminal paper entitled “The Cross Section of Expected Stock Returns”. They found that a stock’s market capitalisation and price-to-book ratio tended to determine its price performance over subsequent periods (smaller and cheaper stocks often did better than larger and pricier ones).

They called these two factors ‘size’ and ‘value’, with the latter quickly coming to be associated with Graham and Dodd’s ‘value investing’. Indeed, index providers such as MSCI and S&P subsequently constructed indices based on ‘size’ and ‘value’ – and others such as volatility, high dividend yield, quality and momentum. According to MSCI, it created ‘seven factor indexes based on these six factors (with two indexes for Low Volatility: the Minimum Volatility index and the Risk Weighted index).’

As with Fama and French, indices based on ‘value’ have also become associated with Graham and Dodd, and it would appear there are now many who think they are the same thing.

They are not.

While stocks identified using Graham and Dodd’s framework or a variant thereof may well have low price-to-book ratios – or low price in relation to the various other metrics that value factor indices also seek to capture such as earnings, sales, cash earnings, net profit, dividends, and cash flow – there is a lot more to ‘value investing’ than a few simple calculations. It is the difference between on the one hand a system of analysis that took 700 pages to set out and on the other a few simple calculations that would take a couple of minutes to perform. In other words, the difference is a big one.

Put simply, there are stocks that might look cheap but which in reality are not. A stock may have a low price to book ratio but it may deserve to have a low price to book ratio. Such stocks are known in the trade as ‘value traps’, and they should be avoided.

How?

By considering in detail all sorts of other aspects that drive a company’s longer-term performance, such as industry trends, barriers to entry, balance sheet strength, free cash flow, to name just a few.

In a later edition of Benjamin Graham’s second classic, The Intelligent Investor, first published in 1949, Graham noted that IBM was a wonderful investment opportunity. “Smart investors”, he wrote, “would long ago have recognised the great growth possibilities of IBM”, but “the combination of [IBM’s] high price and the impossibility of being certain about its rate of growth prevented
[investment funds] from having more than, say, 3 per cent of their funds in this wonderful performer”.

There are two key things that one can learn from this.

First, a value stock does not have to be cheap in absolute terms. IBM wasn’t, and Graham even uses the term ‘growth possibility’ to describe it – but ‘growth’ is supposed to be the antithesis of ‘value’! I hear you say. Second, even smart investors can be too timid when it comes to portfolio concentration – 3 per cent can hardly be called ‘high conviction’.

At Seneca, we are value investors, but we are not scared of buying stocks that are not cheap in absolute terms. We consider various other factors such as balance sheet strength, return on capital, and industry trends, and if we determine that a stock is cheaper than it should be – in other words, has a dividend yield that is higher than we think it should be – that is good enough for us. Nor are we scared of being high conviction – we only hold around 20 stocks in the UK equity portion of our portfolios.

As a pure multi-asset fund manager, we are trying to add value to our portfolios not just in UK equities, but also in overseas equities, fixed income, specialist assets and indeed tactical asset allocation. We do this by taking the central principle of ‘value investing’ – buying things cheaply – and applying it to these other areas. We call this ‘Multi-Asset Value Investing’ and I will be writing about it in more detail in later blog posts.

(This article is reproduced with kind permission of Trustnet. First published 2 December 2016)

Fund performance review

The table below sets out our fund performance as well as that of comparators during periods ending 7 December.

Fund performance review - PE IL20

In summary, we think investors should be pleased with our fund performance, though the longer term numbers for our growth fund still have room to improve. Readers will recall that it took a little while to align the growth fund with our multi-asset value investing style, and this was completed in September this year.

There are four things that differentiate all three of our funds.

  • First, we have a mid-cap focus with UK equities (mid-caps tend to outperform large-caps over time and there is less research coverage so there are more stock picking opportunities).
  • Second, we do not hold any safe haven bonds (with low or negative real yields they are very expensive).
  • Third, our funds we think have less foreign exchange exposure than many of our peers (FX exposure adds a lot in the way of volatility but little in the way of return over time, so is not a risk that we believe our investors should be exposed to).
  • Fourth, around a quarter of each of our funds is invested in what we call ‘specialist assets’, much more than many of our peers (these are generally London-listed investment trusts specialising in areas such as property, asset leasing, infrastructure and direct lending many of which offer high yields with stable, index-linked income streams and thus add something of real value to the portfolios).

We have great confidence in the logic of these positions and believe they will enhance returns over the longer term. The first three of them however worked against us this year (mid-caps underperformed large-caps, sterling fell, and safe haven bonds became even more expensive) and in light of this we are pleased that we kept up to the extent that we did. Over one year, the income fund is ahead of its peer group average, the IA Mixed Investment 20-60% Shares sector. As for the trust, it is also over one year ahead of its more appropriate peer averages, the Flexible Investment sector and the IA Mixed Investment 40-85% Shares sector (formally, the trust sits in the Flexible Investment sector in which it gets compared to pure equity funds). The growth fund had a tricky first quarter, due to some remaining legacy holdings, and so is behind its peer group over one year.

Five year numbers however look excellent for all our funds, particularly when one considers FE Risk Scores of funds and their sectors (for example, our growth fund’s performance is bang in line with its sector average but its FE Risk Score of 58 is much lower than the sector median score of 65.

Finally, I have included the relevant Vanguard LifeStrategy fund as a comparator for each of our funds. The passive option is one that we are very aware our investors have, and we think that the Vanguard funds are probably the most popular of these. Over five years, our investment trust and income fund stack up well against their relevant Vanguard fund, with the growth fund a little
behind.

As an investor in the Vanguard funds, I would be very concerned about their high exposure to expensive investment grade bonds in what we think will be an environment of rising inflation and rising real interest rates, as well as the high FX risk (sterling is now cheap on a real effective exchange rate basis and thus may well appreciate rather than continue to depreciate). With our additional competitive edges in relation to mid-caps and specialist assets, we very much look forward to the next five years.

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 November 2016 (prior month’s targets in brackets)

Current fund TAA - PE IL20

SDIF

  • UK equities target increased by 1% to realign with other funds
  • This increase came out of fixed income, where target was reduced from 31% to 30%
  • UK mid-caps resumed their post-Brexit recovery in relation to large caps, following a pause in late-September and October
  • Profit was taken on Kier Group, Intermediate Capital and Legal & General following good rallies from their post Brexit lows
  • Position in TwentyFour Dynamic Bond Fund was top sliced due to the reduced tactical asset allocation to fixed income
  • New investment in Civitas Social Housing. Company floated mid- November to provide a pure-play on Social Housing by acquiring fully occupied residential property portfolios from housing associations and local authorities. The company is targeting a yield of 5% from quasi-government backed cash flows, which are index-linked
  • Funding for the Civitas purchase was largely provided by the sale of GCP Student Living, which had been a good investment but where the yield of just under 4% was, we felt, now offering less value

SDGF

  • No asset allocation target changes during the month
  • UK mid-caps resumed their post-Brexit recovery in relation to large caps, following a pause in late-September and October
  • The US dollar was strong on the back of expectations that Trump government would boost growth and thus increase need for interest rate hikes
  • Sterling also recovered somewhat, following four months of weakness
  • Inflation expectations and bond yields continued to rise
  • New position in One Savings Bank (OSB), a specialist mortgage lender to predominantly professional buy-to-let landlords. OSB is a high return on equity business, on a depressed valuation, with a healthy dividend yield, well covered by earnings
  • New investment in Civitas Social Housing. Company floated mid- November to provide a pure-play on Social Housing by acquiring fully occupied residential property portfolios from housing associations and local authorities. Company is targeting a yield of 5% from quasi-government backed cash flows, which are index-linked

SIGT

  • No asset allocation target changes during the month
  • UK mid-caps resumed their post-Brexit recovery in relation to large caps, following a pause in late-September and October
  • The US dollar was strong on the back of expectations that Trump government would boost growth and thus increase need for interest rate hikes
  • Sterling also recovered somewhat, following four months of weakness
  • Inflation expectations and bond yields continued to rise
  • New position in One Savings Bank (OSB), a specialist mortgage lender to predominantly professional buy-to-let landlords. OSB is a high return on equity business, on a depressed valuation, with a healthy dividend yield, well covered by earnings
  • IShares FTSE UK Dividend Plus ETF sold to finance OSB purchase
  • New investment in Civitas Social Housing. Company floated mid- November to provide a pure-play on Social Housing by acquiring fully occupied residential property portfolios from housing associations and local authorities. Company is targeting a yield of 5% from quasi-government backed cash flows, which are index-linked
  • Funding for this purchase was largely provided by the sale of GCP Student Living, which had been a good investment but where the yield of just under 4% was, we felt, now offering less value
  • Overseas equity fund consolidation continued with sales of Schroder Oriental Income being used to increase the existing holding in Aberdeen Asian Equity Income, which was bought on a discount to NAV

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.10.2016 unless otherwise stated. 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.
CF 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 Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. 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. FP16/215.

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Peter Elston’s Investment Letter – Issue 19: November 2016

28 November 2016

The most interesting question in the world?

Here’s an interesting question: do the low or negative long-term real interest rates that prevail around the world signify a bleak economic outlook or are they what is required to stimulate spending and investment, and thus a bright economic outlook?

Both theories are supported by their own coherent reasoning. And yet one of them must be wrong. You cannot have both a bright and a bleak outlook.

Which is correct?

The argument in favour of the suggestion that (low) long-term real bond yields reflect (poor) long-term economic growth prospects is simple. As an economic agent, one has a choice; one can either invest in financial assets, the benchmark of which is a riskless bond, or in the economy via real assets that will provide a return commensurate with broad long-term GDP growth. Theory says that both should track each other. If economic growth falls, bonds become relatively more attractive. As investors buy them, their prices rise and their yields fall, thus redressing the balance.

There are a number of commentators, some more respectable than others, who believe we are about to enter an economic ice age. In other words, they believe that current low or negative real yields do indeed portend a bleak future.

Or do they?

Economic theory also says that the long-term interest rate is the rate required to keep saving and investment in balance. If you want to live within your means i.e. save, you need there to be someone, somewhere in the world, who wants to live beyond his i.e. invest. Oscar Wilde had great disdain for the former, saying “anyone who lives within their means suffers from a lack of imagination.” While one may not like Donald Trump, he and like-minded individuals who over the centuries have persuaded banks to lend them vast sums should be thanked for helping to boost economic activity and thus prop up savings rates.

It must be infuriating for many that their savings accounts are not yielding much (anything!) at the moment (even more infuriating for those who take inflation into account and realise that their savings are being eroded in real terms). However, these low yields reflect an abundance of those wishing to save and a dearth of those wishing to invest. The best way for savers to get better yields on their savings accounts would be to stop saving and start investing. This would boost the economy, and force central banks to put up interest rates!

The situation is not helped by governments that are worrying about their balance sheets when the clear message from bond markets is that they needn’t. Furthermore, large swaths of sovereign bonds are owned by central banks, and arguably should not be included in debt-to-GDP calculations.

Governments should instead be taking advantage of the low or negative long-term interest rates. As renowned economist Paul Samuelson famously observed, at a permanently zero or subzero real interest rate, it would make sense to invest any amount to level a hill for the resulting saving in transportation costs (1)

To be fair, there are tentative signs that the UK government is getting the message. In 2013 the Treasury issued a 65-year linker with a coupon of 0.125%, receiving a price at auction of 99.37% of par. In March of this year it issued a new tranche of £350 million at a price of 184%. The bonds are currently trading at 249%!

If the proceeds are spent on useful (or even useless!) public works projects, the benefits will be clear. First, there is a multiplier effect attached to public works spending that will boost economic activity well beyond the value of the projects themselves. Second, there will be a boost to private sector confidence. If companies and households see the government stepping in to support the economy, they should themselves be encouraged to invest.

However, it seems to have taken interest rates falling to where they did for the government to have woken from its slumber. In other words, low interest rates are what has been required to stimulate spending and investment and thus secure a rosier outlook.

While both theories about the relationship between growth and interest rates can be argued logically, the debate can be decided once and for all by looking at real world experience. If prevailing real interest rates reflect future economic prospects, there should be a strong and positive statistical correlation between real interest rates and equity returns.

There isn’t.

Regressing forward 20-year real total US equity market returns against prevailing US real bond yields, one finds no correlation at all. In fact, if anything, the correlation is very slightly negative (see chart). This is exactly what one should expect if bond yields tend to do whatever they need to in order to keep growth going.

Chart: The relationship between bond yields and equity returns

Chart 1 - PE Investment Letter - November 2016

Source: Bloomberg, Seneca IM

The implications of this are far reaching. First, one perhaps needn’t be as bearish about the longer term prospects for equity markets as safe haven bond yields suggest one should be. Second, one needn’t be so worried about companies with large pension fund deficits if they are using Gilt yields to discount liabilities, as is common practice. After all, why should a pension fund’s equity holdings be expected to grow in real terms in line with the current long-term real Gilt yield of -1.6% if there is no evidence that they should?

That’s also an interesting question.

 


(1) http://larrysummers.com/2015/04/01/on-secular-stagnation-a-response-to-bernanke/


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 October 2016 (prior month’s targets in brackets)

Table 1 - PE Investment Letter - November 2016

  • Funds remain overweight equities in relation to strategic asset allocation in the belief that global credit cycle has further to run as well as valuations that remain below historic peaks
  • Tentative signs of economic growth stabilising or picking up, both in developed and developing countries

SDIF

  • Reduction in UK Equities target for the income fund related to reconciliation with actual position rather than a change of view
  • The position in Liontrust Asian Equity Income Fund was sold and switched into Aberdeen Asian Equity Income Fund, a closed end fund trading on a discount to net asset value
  • Pictet Emerging Currency Debt Fund was sold and reinvested into the existing holding in Templeton Emerging Markets Bond Fund, which offers a higher yield
  • The position in LondonMetric Property, a UK listed REIT, was increased following price weakness post the Brexit vote; we believe the active property management approach pursued by the manager remains attractive and is likely to add value in a more difficult market environment
  • The holding in SQN Asset Finance Income Fund was reduced due to our concerns over the quality of certain assets held and with the shares trading on a premium to net asset value

SDGF

  • Oxford Instruments exited – balance sheet is manageable, but more levered than desirable in post Brexit world with limited forward order visibility
  • Increased weighting to Twenty Four Monthly Select Income at a discount to NAV and reduced Royal London Short Duration Bond Fund. Potential for stronger absolute returns from former, given dislocation in credit markets, post Brexit, and defensive nature of short duration strategy.
  • SQN Asset Finance Income Fund was significantly reduced, due to our concerns over the quality of certain assets held within its portfolio and because the shares trade at a substantial premium to NAV

SGIT

  • Several UK equity mid-cap holdings were ‘topped-up’ including International Personal Finance, Senior, Ultra Electronics and Britvic
  • The position in Liontrust European Enhanced Income Fund was increased to maintain exposure to European equities
  • Japanese equity exposure was reduced via a top slicing of the Goodhart Michinori Japan Equity Fund; the fund had returned over 30% over the past year
  • Some switching was carried out within Asian equity fund holdings to consolidate positions
  • Property exposure was increased, primarily by adding to the position in LondonMetric Property, a UK listed REIT, where the manager’s active approach to property management will, we believe, add value in more difficult market environments
  • The holding in SQN Asset Finance Income Fund was reduced due to our concerns over the quality of certain assets held as well as the shares’ premium to net asset value

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.10.2016 unless otherwise stated. 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.
CF 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 Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. 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. FP16/200.

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Peter Elston’s Investment Letter – Issue 18: October 2016

26 October 2016

It’s time to do something about high wealth and income inequality

High wealth inequality is being increasingly cited as one of the main causes of the structurally lower growth that much of the world, particularly the developed world, is currently experiencing. There is both good empirical as well as theoretical support for this relationship, suggesting that policymakers would be wise to start finding ways to lower wealth inequality.

Economic inequality has tended throughout history to be the number one cause of uprisings and revolutions (1) which are not on the whole great for incumbent elites (though they have been great for the likes of inventor of the guillotine, Antoine Louis! (2) ).

In the modern day of course, it is the ballot box that politicians fear. In this, the rise in anti-establishment sentiment around the world is something political and economic elites should take note of.

Why is economic growth currently so slow?

Secular stagnation thesis proponents such as former US Trade Secretary Larry Summers suggest that the low growth currently plaguing the world is due to factors such as falling population growth and the decline in demand for debt-financed investment. With respect to the latter, he noted in a speech entitled Secular Stagnation, Hysteresis, and the Zero Lower Bound (3) , “Ponder the fact that it used to require tens of millions of dollars to start a significant new venture, and significant new ventures today are seeded with hundreds of thousands of dollars. All of this means reduced demand for investment, with consequences for equilibrium levels of interest rates.”

He also suggests that high wealth inequality is a major reason for the low growth. In the same speech, he noted that, “changes in the distribution of income, both between labour income and capital income and between those with more wealth and those with less, have operated to raise the propensity to save, as have increases in corporate-retained earnings.”

The point here is that when wealth becomes concentrated in the hands of a small number of individuals, companies or countries,you get a glut of savings. The flipside of a savings glut is a shortage of demand, which means weak economic growth.

Economic growth relies on there being as many people, companies and governments willing to live beyond their means as there are those wanting to live within theirs. Right now, vast surpluses have been accumulated by an increasing number of billionaires (4), and companies such as Apple, Microsoft and Alphabet (5), as well as countries such as China, Germany, Japan and South Korea (6).

Turning to the empirical evidence linking wealth inequality with weak growth, it may be useful to look at the link between levels of indebtedness and economic growth. Arguably, it is more intuitive that high levels of indebtedness impede economic activity. At an individual level, the more debt you have, the less able you are to spend, and the less you spend, the less you contribute to economic growth.

This works at a country level too. As can be seen from the chart below, over the last one hundred years or so, there is a reasonably close inverse relationship between the level of debt to GDP in the US and the long-term (20 year) average of real GDP growth.

Graph 1 - PE Investment Letter - October 2016

The rising level of debt to GDP in the 1920s seems to have preceded the very low growth experienced in the 1930s, while the sharp fall in the 30s and 40s appears to have enabled the higher growth of the 40s and 50s. Furthermore, the rise in debt to GDP seen since the 1970s has gone hand in hand with GDP growth falling from above 4% towards 2%.

The relationship between levels of indebtedness and wealth and income inequality is somewhat less intuitive but just as strongly supported by actual experience, as can be seen in the chart below.

Graph 2 - PE Investment Letter - October 2016

Together with the first chart, one does not need to be Sherlock Holmes to deduce that there is an empirical link between income inequality and growth.

For me, the best way to better understand issues like income and wealth inequality is to put them in the context of a system made up of two people, then make extreme assumptions (I remember in my younger days watching Warren Buffett do this to explain trade and it left a lasting impression.)

So, imagine an economic system (society) made up of two agents (people) named Thrifty (T) and Spendthrift (S). There are only five economic activities undertaken in their society: house building, farming, papermaking, ink manufacturing and fishing equipment making. However, T is the sole provider of all of them. He provides shelter (including roof repair services) and food to S, and in return receives IOUs (yes, using T’s paper, T’s ink and a quill made from a feather kindly donated by one of T’s chickens).

Why S is so inactive could be for a number of reasons. It could be because T is so much better – more efficient – than S is at the aforementioned activities. It could be because T would rather hoard IOUs than buy from S. It could be because S is somewhat indolent, very tempting if you can just sign bits of paper then go fishing (yes, you got it).

Whatever the reasons for S’s inactivity, the upshot is that T becomes very wealthy, having amassed piles of IOUs. Wealthy on paper that is. Literally.

As for S, he ends up heavily indebted. The wealth inequality could not be more extreme! The question is, what happens when T starts to wonder what his IOUs are worth?

He can’t spend them because there is nothing to buy (S doesn’t have anything to sell). Instead, he reduces his sales to S so he can reduce the rate at which he is amassing what he has realised are effectively worthless bits of paper. Reduced sales of course mean reduced production. And another word for ‘reduced production’ is ‘recession’. Indeed, since the whole process of rebalancing this two agent economy – providing S with skills needed to start being productive – is such an involved one, it could even mean ‘depression’.

In the real world, while there are pockets of economic egalitarianism such as Germany and Japan, there are many large countries, both developed and developing, that have seen wealth and income disparity rising at a fast pace in recent decades and reaching what may well be unsustainable levels. Furthermore, while a number of developing countries have been catching up with their developed counterparts in terms of GDP per capita, there are others that have gone backwards.

It is possible, however, that it is hard to reverse wealth and income inequality that has risen to unsustainable levels. History has taught us that while the free market system is not perfect, is has tended to produce stronger and more sustainable growth than in other systems. Allowing the abler and more enthusiastic members of society to get richer than others has on the whole lifted standards of living for the less able too.

But, there is a flaw.

If you acquire wealth, you are very likely to want to do anything within the law to increase your wealth further.

Indeed, why wouldn’t you, either as a company or an individual, make political donations or employ lobbyists in the hope of for example encouraging favourable changes in tax codes? Oxfam head of research Ricardo Fuentes-Nieva, notes that the wealthy “get more resources to influence even more on how the tax code is modified, and thus lock the gains and protect the trend that mostly benefits them” (7).

Now, it can be argued that as long as quality of life is at least maintained for lower income groups, it doesn’t really matter how high inequality rises. We live in a world in which the time it takes to make a billion is declining rapidly – I imagine it took Mark Zuckerberg a tenth of the time it did John D Rockefeller. As long as our quality of life is maintained, should we care how many billionaires there are on this planet?

Yes, we should. And not only because rising inequality means too much debt which leads to lower growth. Human nature is such that we care more about relative wealth than absolute wealth. It doesn’t matter if our quality life is maintained if we see others doing better than us – also known as ‘not keeping up with the Joneses’. This phenomenon has been observed in studies such as that by Prof Christian Elger and Prof Armin Falk at the University of Bonn (8).

The dissatisfaction that results from feeling left behind economically is what is behind the rise in support for non-mainstream politicians such as Donald Trump, Jeremy Corbyn and Marine Le Pen. The so-called political elite would be well advised to start finding ways to reduce inequality.

The big question is, can they?

 


(1) https://www.reference.com/history/common-causes-revolution-history-d022271ee8d15436
(2) https://en.wikipedia.org/wiki/Guillotine
(3) http://larrysummers.com/2014/06/23/nabe-speech-u-s-economic-prospects/
(4) http://www.forbes.com/sites/timworstall/2014/10/30/oxfams-new-report-number-of-billionaires-has-doubled-since-the-crash/#551edd7dfbd5
(5) http://www.usatoday.com/story/money/markets/2016/05/20/third-cash-owned-5-us-companies/84640704/
(6) https://en.wikipedia.org/wiki/List_of_countries_by_current_account_balance
(7) http://policy-practice.oxfam.org.uk/blog/2013/09/tax-rates-and-the-top-1-percent
(8) http://www.telegraph.co.uk/news/science/science-news/3315638/Relative-wealth-makes-you-happier.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 - PE Investment Letter - October 2016

  • No changes to top down target asset allocation in September
  • Funds remain overweight equities and underweight safe haven bonds, in the belief we are generally at the point in the business cycle when inflation rises (bad for bonds) but employment continues to rise (good for equities)
  • SDGF’s holding in the Bellevue African Opportunities Fund was sold, with the proceeds being allocated to existing holding Somerset Emerging Markets Dividend Growth Fund; this change was last within overseas equities that related to the restructuring of the fund away from specialised funds towards more general fund
  • GCP Student Living was sold from both SDIF and SDGF on the basis that share price strength had pushed down the yield to less attractive levels; proceeds were allocated to Aberdeen Private Equity Fund
  • In UK Equities it was decided to sell Ashmore and move the proceeds into Ultra Electronics; Ashmore had risen 75% from its January low and as a result its valuation had become unattractive while Ultra Electronics, already held in SDGF, was generating a dividend yield that made it appropriate for SDIF and SIGT
  • Towards the end of the month, our UK Equity specialist Mark recommended the purchase of Phoenix Group, already held elsewhere, for SDGF, believing that the Abbey Life deal was transformational and leaves the shares
  • Units of the iShares UK Dividend ETF were sold to finance the purchase

 


Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.09.2016 unless otherwise stated. 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.
CF 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 Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may 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. FP16/182.

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Peter Elston’s Investment Letter – Issue 17: September 2016

6 September 2016

An interesting essay by San Francisco Fed President, John Williams

Having written about secular stagnation and the natural rate of interest in my August letter, it was interesting to see San Francisco Fed President, John Williams, write about low natural interest rates in his latest Economic Letter. I’m no expert, but it seems to me that Williams is the leading authority on the subject, having written a seminal paper (1) alongside colleague, Thomas Lauback, back in 2001. Therefore, I think he’s worth listening to.

Indeed, his conclusion is an appeal to central banks and governments to “share responsibilities” [for boosting growth]. He goes on to invoke Machiavelli, suggesting that “we can wait for the next storm and hope for better outcomes or prepare for them now and be ready” (one wonders to what extent his essay swayed opinion at the Jackson Hole Symposium).

To recap, the natural rate of interest is essentially the rate that keeps inflation stable. It has nothing to do with monetary policy and everything to do with structural factors such as demographics, trend productivity and economic growth, emerging markets reserve accumulation as well as general global demand for savings. Williams points to the decline in the natural rate of interest to what are now very low levels over the past quarter century and considers what can be done to increase it. As should be evident, the prevailing natural rate of interest reflects future economic growth prospects, which is why it is so important for investors.

It is a shortage of private investment demand in combination with an oversupply of savings that has caused the natural rate of interest as well as long-term real bond yields to fall as far as they have. In the developed world, it seems to me, private investment is weak either because population growth is low, because economies are already advanced, or because there is no new productivity busting technology out there (past examples include the plough, the steam engine, the internal combustion engine and the computer). There isn’t much we can do about the first two, but governments should be doing everything they can to encourage the commercialisation of new productivity-busting technologies (please excuse the pun, but driverless cars should be getting a smoother ride). Furthermore, in the absence of strong private investment, surely there is a strong case for a big increase in public investment, particularly in infrastructure.

In a critique of Williams’ essay (2), former US Treasury Secretary and proponent of the secular stagnation thesis, Larry Summers, suggests that Williams does not put enough emphasis on infrastructure investment as a means of stimulating growth and thus raising the natural interest rate. Summers is convinced that debt-financed infrastructure investments pay for themselves, essentially as a result of multiplier effects (economist Philip Milton received rapturous applause when he suggested similar on BBC’s pre-Brexit Question Time (3)). Williams does write that, “returns on infrastructure and research and development investment are very high on average”, though it seems Summers wanted him to be much bolder.

As for the savings glut, while developing countries seem intent on accumulating safe haven bonds, this is not the only problem. Take the savings industry in the developed world, for example. In many respects, allowing companies to close defined benefit pension schemes was one of the biggest mistakes ever made by governments. If you are saving for yourself rather than in a pool with others, you are naturally going to over-save. I am guilty of this myself as I believe I have to assume that I and/or my wife are going to live to 110. We are both hopeful that we will be gone by 90, but we have to assume the worst. Scale this behaviour up, and the resulting increased demand for savings is a huge drag on economic growth. As Oscar Wilde said, “Anyone who lives within their means suffers from a lack of imagination”.

To illustrate just how damaging the abandonment of pooling with respect to pension savings has been, imagine if we did the same for another industry where pooling is central: insurance. The idea of insuring yourself is of course absurd.

Let’s hope that in the not too distant future governments can start applying some common sense either with respect to infrastructure investment, putting more incentives in place with respect to new technologies, or discouraging over-saving.


(1) Measuring the natural rate of interest https://www.federalreserve.gov/pubs/feds/2001/200156/200156pap.pdf
(2) http://larrysummers.com/2016/08/18/6937/
(3) https://www.youtube.com/watch?v=0dUUDFTFzOo


 

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 August 2016, prior month’s targets in brackets)

Table 1 - PE Investment Letter - September 2016

  • We reduced the equity targets for all three funds by 2 percentage points in light of recent strong market performance
  • Reductions came entirely out of Europe ex UK; although the region has underperformed over the last year or so, our level of conviction has decreased somewhat following the Brexit vote and the political difficulties it exposed
  • We remain 3 percentage points overweight in Europe which reflects the decent yields on offer both in absolute terms and in relation to history
  • Furthermore, Europe’s business cycle has further to run than in the UK and US, thus there remains better potential for earnings to rise
  • As for use of target proceeds, 1 percentage point went into cash and 1 percentage point to Specialist Assets
  • We will consider uses for the 1 percentage point cash in the coming weeks as opportunities arise
  • As for the increase in Specialist Assets, the 1 percentage point was spread across eight existing holdings within REITs, Specialist Financial and Infrastructure

SDIF

  • Profit was taken on several UK equity holdings bought at much lower levels in the market falls post the Brexit vote
  • The Essentra position was increased following price weakness on CEO leaving announcement
  • The position in Schroder European Alpha Income was sold to reduce overall exposure to European equities
  • Baillie Gifford High Yield Bond Fund was sold – switched into Muzinich Short Duration High Yield to improve portfolio income
  • We increased investment in Royal London Sterling Extra Yield Fund, Royal London Short Duration Global High Yield Fund and Twenty Four Select Monthly Income Fund, to further consolidate holdings

SIGT

  • Several UK equity holdings were top sliced – taking profit on purchases made in the market sell-off post Brexit
  • The holding in Essentra was increased following price weakness on announcement of CEO departure
  • Schroder European Alpha Income Fund was sold to reduce exposure to European equities
  • We purchased Invesco Perpetual European equity Income Fund to increase emphasis on Value managers, which was partly funded by reduction in Blackrock Continental Income Fund
  • US equity holdings were consolidated with sale of IShares MSCI USA Dividend ETF – switched into existing holding in Cullen Global North American Dividend Value Fund

SDGF

  • Consolidated European and Japanese holdings down to two in each geography, thereby increasing weighting to Invesco Perpetual European Equity Income Fund and Goodhart Michinori Japan Equity Fund
  • We significantly reduced our holding in the Polar Capital Biotechnology Fund on strength, with a view to ultimately exiting sector specific funds. The proceeds were invested in the iShares MSCI USA Dividend IQ UCITS ETF, pending the completion of due diligence on a new active manager

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.08.2016 unless otherwise stated. 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.
CF 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 Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may 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. FP16/155.

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Peter Elston’s Investment Letter – Issue 16: August 2016

8 August 2016

Secular stagnation and the natural rate of interest

One of the most interesting features of global financial markets over the last 20 years has been the inexorable decline in long-term real interest rates (see chart below of yields of index linked bonds of maturities over five years across various developed markets). As is evident, this is a global trend, though not all countries have 20 years of history.

Chart 1: Index linked bond yields (maturities over 5 years)

Chart 1 - PE Investment letter - August 2016 Source: Bloomberg, Seneca Investment Managers

The decline has reignited the debate about ‘secular stagnation’, a term coined in the late 1930s by American economist Alvin Hansen to refer to the feeble recovery in the US economy that followed the Great Depression. Hansen argued that weak trends in population growth and technological innovation meant that the low growth would continue for many years.

That there is a vibrant debate about whether global growth is stagnating or not is itself instructive, as it suggests the study of economics has not advanced much in recent decades – surely we should know the answer to this question! Earlier this year, Prospect Magazine (1)  ran a series of four articles on the subject, two by proponents of the stagnation thesis and two by opponents. They were all written by well-respected economists, and consequently all were persuasive.

The economists arguing in support of the stagnation thesis were former US Treasury secretary Larry Summers and Northwestern University professor Bob Gordon. Representing the other side of the debate were GaveKal co-founder Anatole Kaletsky and University of Illinois at Chicago professor Deirdre McCloskey.

Of the four articles, I found Anatole Kaletsky’s the most convincing. Here is an excerpt:

“Cuts in public spending and tax hikes, motivated by irrational paranoia over public borrowing, have been so severe that it has not been possible to offset their effects through low interest rates. Inadequate demand, combined with labour deregulation and globalisation that would have been healthy if conditions had been normal, have squeezed wages downwards, reducing incentives for investment and aggravating inequality, which in turn has exacerbated the weakness of consumer demand. 

“To make matters worse, inflation is systematically exaggerated in official figures. If the true level of inflation since 2008 has been negative, as appears quite likely, then even zero interest rates were too high to stimulate rapid growth.”

In Kaletsky’s world, the fall in long term real interest rates in recent years was indeed the result of lower growth but this lower growth, particularly since the Great Financial Crisis, was due to cyclical factors (poor monetary and fiscal policy) rather than structural ones.

On the subject of structural factors such as innovation, Kaletsky sees evidence of technological progress everywhere. Robert Gordon, on the other hand, “assumes that the weak economic statistics are proof that, however much new technology we see around us, progress has slowed down.” I can’t help but side with Kaletsky, seeing as I do the extraordinary ways in which our lives continue to be made better, whether with respect to medical advances, battery storage, energy production, car and airline safety, or online shopping.

That being said, it does not appear likely that governments are going to change course with respect to public spending policy any time soon, and instead will continue to pander to growing protectionism within their electorates. This may well mean that economic growth in the medium term continues to weaken.

In such a world, one can either accept the resulting lower returns from bonds and equities, and the lower future consumption that they imply, or one can try to achieve higher returns by investing more actively – seeking out those areas of equity markets such as smaller companies or certain emerging markets that are likely to perform better over time. We would strongly espouse the latter.


(1)     http://www.prospectmagazine.co.uk


A proposal for the British government

I have a proposal for the British government. It’s not complicated: sell vast quantities of 50-year debt and buy vast quantities of UK equities.

In late July, the Treasury sold £2.5 billion of debt for £5.1 billion. During the lifetime of the bond it will have to pay a total of £0.2 billion in interest but this isn’t much in the grand scheme of things. Let’s say the Treasury sensibly puts this to one side and is left with £4.9 billion. Surely it can find something to do with this over the fifty years. If it can make a return on investment of at least -1.4%, then it will have the funds to repay the £2.5 billion par value.

You may have realised that I am referring to the most recent tranche of the 0.125% 2065 inflation linked Gilt that was sold on 26 July for 201.335% of par. In other words, the aforementioned return of -1.4% required to pay back the bond at maturity is a real return. You could just as easily use a nominal bond and a nominal required return. However, using the inflation linked Gilt makes it easier to understand the point at hand, namely that current yields imply the government cannot make a real return on investment of even -1.4%. (At this point I am reminded of economist Paul Samuelson’s famous remark that at a permanently zero or subzero real interest rate it would make sense to invest any amount to level a hill for the resulting saving in transportation costs.)

Back to my proposal: surely a basket of UK equities will return more than -1.4% per annum over the next fifty years?

They are already yielding 4.1%, so you’d need corporate earnings – and thus dividends – to fall 5.5% per annum in real terms over the long term for total annual real returns to equate to -1.4% (note: this derives from a mathematical truism that says that total return is equal to the dividend yield plus the growth in dividends, otherwise known as the Gordon growth formula). Even if we say that dividends are currently twice the sustainable level, and start with a 2% yield, we’d still be left needing earnings growth of just -3.4% per annum.

Now, earnings and dividend growth over time tend to be around two percentage points per annum less than GDP growth (note: this is because listed companies are generally the larger ones and thus have less propensity to grow than the average company). So, even if we assume an immediate and permanent 50% cut in dividends, GDP growth for the next 50 years could shrink 1.4% per annum and the British government would still break even.

Can economic prospects really be that bad? It’s possible, I suppose, but unlikely.


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 July 2016, prior month’s targets in brackets)

Table 1 -PE Investment Letter - August 2016

  • No changes to tactical asset allocation during the month.
  • Both Sterling and Gilt yields stabilised, following June’s sharp falls.
  • Equity markets around the world performed well, with markets responding well to strong July payrolls in the US that suggested the US economy was still growing at a moderate pace.
  • It is becoming clear that Brexit has impacted household and business confidence that will likely merit a response from the Bank of England.

SDIF

  • The holding in the AXA US Short Duration High Yield Bond Fund was sold to further consolidate holdings, with the yield on the fund having fallen to a less attractive level.
  • The fund’s position in the TwentyFour Dynamic Bond Fund was reduced to provide funding for an increase in the TwentyFour Select Monthly Income Fund, which offers a higher yield.

SIGT

  • Royal Dutch Shell was exited following a significant re-rating which led to a premium PE and yield compression.
  • New investment in IShares FTSE UK Dividend Plus which maintains UK equity weighting pending further work being carried out on a new direct investment.
  • Added to position in Polypipe following Brexit related sell-off.
  • Top sliced Asian equity holdings to maintain weighting following strong performance this year.
  • New investment in International Public Partnerships in order to broaden the exposure across a range of infrastructure sectors. This was funded with a managed exit from Bluefield Solar Income Fund which has a narrower mandate.

SDGF

  • Initiated a position in Intermediate Capital, manager of alternative credit strategies. Strong growth in permanent capital AUM. Yield over 4%.
  • New investment in Dairy Crest. Cathedral City increasing market share. Yield over 4%, improving cash flow and returns, post disposal of dairy business. Premier Foods being exited.
  • Royal Dutch Shell exited. Significant re-rating – premium to NAV and yield compression.
  • Atlantis China Healthcare Fund exited, favouring regional manager, Stewart Investors.
  • New investment in Aberdeen Private Equity Fund on unwarranted discount to NAV as well as strong NAV growth.

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.07.2016 unless otherwise stated. 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.
CF 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 Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may 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. FP16/137.

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Peter Elston’s Investment Letter – Issue 15: July 2016

18 July 2016

Recent fund performance

Since the referendum, our funds have slipped down the peer group rankings. This does not mean that their absolute performance has been particularly poor, just that the funds have underperformed their respective peer groups in recent weeks. While many will understand that poor short-term performance relative to peers – as well as in absolute terms – may happen from time to time, there may be others who are not so comfortable. The following will I hope provide reassurance.

Our funds are diversified in that they are spread across equities, bonds, and specialist assets. However, we are value investors and so are trying to capture the medium- to long-term price appreciation of financial assets that results from their value being under-appreciated. This is why we have a mid-cap focus in the UK – investors tend not to fully understand the scope for smaller companies to grow, so their share prices as a group tend to perform better.

As value investors we are also seeking to avoid financial assets whose value we think is being over-appreciated. This is why we do not hold developed world government bonds, which even before recent events were expensive – buy the 30-year inflation Gilt today and hold it to maturity and you are certain to lose a third of your real capital at today’s rates.

While we continue to have absolute confidence in our positions with respect to mid-caps focus and government bonds, both have hurt our peer-relative performance over the last 2-3 weeks. It should also be noted that we have other positions that have performed well or held up over the same period.

Many of our competitor funds own expensive Gilts or US Treasuries and avoid under-appreciated smaller companies. Such positioning will naturally – and indeed did – aid short-term performance but it will also very likely lower their longer-term returns. We think it is longer-term performance that is more important. In fact, given increasing longevity, paucity of value in bond markets, as well as low growth generally, we think it is more important than ever to focus on longer-term performance. The harsh reality of this however means having to accept the odd period of poor short-term performance, whether in absolute terms or relative to peers.

Our mid cap focus in the UK has been the major cause of the recent poor short-term fund performance in relation to our respective peer groups. However, we are very careful about what we buy, placing great importance on balance sheet strength and profitability. This we believe will help to produce good performance over time in relation to both mid-cap and large-cap indices and thus counter the impact of periods such as the last few weeks when mid-caps fell off sharply. Furthermore, we don’t own too many mid-caps, so we know them extremely well. Here are a couple of examples.

Kier Group is a conservatively managed vertically integrated construction and services company. Despite the fact that 85% of revenues in its two largest divisions are already covered by existing orders out to June 2017, the shares have been weak and now yield 7%. The dividend is well covered by earnings and supported by a strong balance sheet. Recent acquisitions of May Gurney and Mouchel provide considerable scope for further expansion, as cross-group revenue synergies are explored. Meanwhile, the company should also benefit from rising infrastructure spend which has cross-political party support. Specifically, the Highways Agency’s £17bn ring-fenced budget for its Road Investment Strategy and the National Infrastructure Commission’s £100bn budget out to 2020 provide tailwinds.

Victrex manufactures polyether ether ketone (PEEK), a high performance polymer that possesses unique qualities, such as being ultra-lightweight, extremely strong, resistant to chemicals and extreme temperatures, and is also electrically conductive. The company has dominant market positions and is frequently finding new uses for PEEK, due to its constant drive for innovation and ongoing collaborative work with its customers. Over 90% of Victrex’s revenues are from outside the UK, therefore it is a big beneficiary of sterling weakness. The shares yield over 3% and the dividend has grown by over 13% p.a. over the last 10 years. The company has net cash on the balance sheet and has stated that it intends to return surplus cash back to shareholders by means of special dividends.

Elsewhere in the funds, while we have some currency-hedged overseas equities funds, most are unhedged so have performed well as a result of the weakness in the pound. As for our fixed income funds, their prices have generally remained stable, though they have not of course performed nearly as well as safe haven bonds.

Of interest we think is the performance of some of our specialist assets. As a reminder, these on the whole are investment trusts that invest in income generating assets such as aircraft, property, medical equipment, loans, mortgages, and infrastructure. Again, we are very careful what we buy and, because we don’t own too many of them, we monitor them closely. We are looking for income streams that are stable and index-linked. We are looking for decent yields. These attributes have served some of our specialist assets holdings particularly well in recent weeks. Here is one example.

Primary Health Properties is a REIT invested in predominantly UK based purpose built modern GP surgeries and medical centres. It has a very secure tenant (NHS plus ancillary services), a visible and growing income stream, and resides in a property sector that requires substantial increases in investment.  The attractions of such low volatility tangible value are thus clear. The investment pays us a fully covered and growing dividend yield of 4.6%. At the time of writing (5th July) the shares are trading where they were prior to the referendum vote and have displayed none of the stresses experienced elsewhere in the property sector.

To conclude, we continue to have complete confidence in our process and in the capacity of our funds to generate value over the longer term. We place a great deal of importance on the quality of businesses we own and making sure that third party managers we engage have a similar mindset.


Brexit

There is much that can be written about the referendum result. Indeed, much already has been. I shall try to keep this simple and focus on what, I believe, are the two key questions for our investors and ourselves. One, what were the prospects for the UK and global economy before the referendum? Two, what has changed since?

For the last few years, growth in the UK and globally has been OK but not great. My view was that things were likely to continue in this vein rather than growth recovering to pre-crisis levels or on the other hand it slipping into negative territory.

I had a number of reasons for believing the global economy would continue to grow. First, that is its tendency. Despite the tiny minority who would like to return the human race to the Stone Age, most of us conduct our daily lives in a constructive way, both providing as well as consuming products and services. Aggregate that at a systemic level and you have what is called growth. And it’s quite hard to stop that in its tracks because, well, it’s what we like to do.

Since we quite like being constructive, we tend to do it more and more until economies overheat and central banks feel the need to step in and end the party. Looking at inflation prior to last Thursday, it seemed clear that economies on the whole were far from overheating. Agreed, some were closer than others, but at a global level it was obvious that there was a still a chronic shortage of demand rather than an excess of it.

Former US Treasury Secretary Larry Summers has written about this “chronic” demand shortage. He refers to it as secular stagnation – a term coined by Alvin Hansen in 1938 to describe what he feared the US economy was experiencing in the aftermath of the Great Depression. In fact, I was going to write about Summers’ deliberations on the subject in detail in this investment letter. Alas, Brexit has rather overtaken events and that shall have to wait. Nevertheless, Summers’ key conclusion is that secular stagnation is real but that it can be countered with public investment in areas such as infrastructure. Since fiscal austerity has not generally resulted in a strong recovery in private sector confidence, he argues, it should be stopped. Furthermore, econometric models suggest, he says, that although government borrowing as a percentage of GDP would at first rise, over time it would fall as the multiplier boosted the denominator, GDP.

I have had increasing sympathy with this argument and as a result felt more optimistic about the prospects for the world economy. That said, it will likely be a while before key policymakers listen to Summers – and the many others who share his views – and consider his proposed solution.

In the meantime, I believed that ultra-loose monetary policy would prevent demand from falling off a cliff while workforce slack would prevent inflation from rising to uncomfortable levels.

My somewhat hopeful view was supported by generally positive leading indicators, yield curves that were steep rather than inverted, as well as the aforementioned low inflation and labour force slack.

Then on 23 June Britons voted to leave the EU. What has changed as a result?

The most obvious and incontrovertible thing that has changed is that the referendum is now behind rather than ahead of us. This matters because the UK and European markets had been weak over the preceding year or so, arguably because the referendum lay ahead and represented uncertainty (in the 12 months to May 2016, outflows from all IA sectors totalled £38 billion). True, there are now other uncertainties that have taken its place but at least they are not binary in the way markets hate.

Another equally incontrovertible fact is that the ‘leave’ camp won the referendum. The market’s violent reaction suggested this result was both unexpected and perceived as negative for the UK economy, though equities have since recovered. It seems the most likely outcome is that at some point the British government triggers Article 50 of the Lisbon Treaty, thereby setting in motion the process to leave the EU. But it is far from clear when – and perhaps even if – this will happen.

In the meantime, there is scope for all sorts of developments. One of these must be for Brits to ponder whether the UK should seek to remain in the single market. If yes, we would have to accept free movement of people as Norway and Switzerland have. If no, we would have to accept tariffs on trade in goods and services with the EU. New UK Prime Minister, Theresa May, has said, “It must be a priority to allow British companies to trade with the single market in goods and services — but also to regain more control of the numbers of people who come here from Europe.” This is all very well, but the EU has made it clear that the UK cannot have both.

The pound has fallen sharply. In some respects, this is a good thing as the UK’s current account deficit as a percentage of GDP had reached an unsustainable 7% 1 (see chart 1). That said, the initial effect of the pound’s weakness will be to widen the deficit even further as imports cost more and exports are worth less. Longer term, the fall in the currency will be stimulative, though how much spare capacity the UK economy has to absorb this stimulus is unclear. Although wage pressures remain relatively subdued, Bloomberg Intelligence’s estimate of the UK’s output gap suggests that much of the excess capacity that prevailed after the Great Financial Crisis has now been removed (see chart 2).

Chart 1: UK current account deficit as % GDP

Chart 1 - UK current account deficit as a % GDP

Chart 2: UK output gap (%)

Chart 2 - UK output gap %

Bond yields have fallen sharply. As of 4 July, the yield on the 10-year Gilt stood at 0.83% compared with 1.37% on the day of the referendum. Interestingly, this was not due to a fall in inflation expectations. Quite the opposite in fact – the inflation rate expectation embedded in 10 year yields actually rose following the referendum, from 2.31% to 2.34%. In other words, it was a fall in real yields rather than inflation expectations that drove the fall in nominal yields.

Putting this fall in real yields in a longer term context as well as in the context of equity market yields is particularly interesting (see chart 3). The yield of -1.503% on the 10-year inflation protected Gilt as of 4 July suggests that if you bought it and held it to maturity you would make a total real return of -14% (for the 30-year the number is -33%).

Chart 3: Long term yields

Chart 3 - Long term yields

Bank of England governor Mark Carney has hinted he’ll loosen monetary policy over the summer. Furthermore, former Chancellor, George Osborne, backtracked on his longer term budget targets. It is clear therefore that both the Bank of England and the Treasury expected the impact of Brexit on the UK economy to be negative, perhaps considerably so. At the same time, evidence of an immediate impact is sparse. As of 4 July there were only 22 items on the FT’s Brexit Business Impact Tracker, a log of the expected impact of Brexit through company announcements and similar. Given all the warnings from UK companies ahead of the vote, it is perhaps surprising there have not been more announcements of cuts of some sort.

Chart 4: Citi WGBI GBP hedged (inflation adjusted)

Chart 4 - Citi WGBI GBP hedged (inflation adjusted)

There are many other things that have changed since the referendum that I have not mentioned. However, the point of those that I have chosen to highlight is that it remains very unclear what the longer term economic impact will be of the vote to leave the EU.

What we do know is that developed market government bonds are even more expensive now than they were prior to the referendum (the chart above suggests that the great bond bull market is running out of steam but taking a long time to end!) We also know that equity market yields are generally well above long-term historic averages. Therefore, as far as the big asset allocation call between bonds and equities is concerned, this suggests pretty clearly that one should underweight the former and overweight the latter. We are thus sticking with our current positioning.


1  Average of Q4 2015 and Q1 2016


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 2016, prior month’s targets in brackets)

Table 1 - Current fund tactical asset allocation target weights - 30 June 2016a

  • No asset allocation changes in June
  • SDGF: we switched Prudential into Legal & General, after material outperformance by the former
  • Ocean Dial Gateway to India exited, following strong performance and a preference going forward for regional, rather than country specific exposure within Asia
  • Thomas Cook was exited to fund a new investment in Essentra, a global manufacturer and distributor of small but essential components, e.g. plastic screw caps, as well as health and personal care packaging
  • SDIF: we introduced two new names: Essentra and Arrow Global
  • The relative strength of fixed interest assets enabled us to fund the equity purchases with reductions in our two Royal London fixed interest funds. These sales followed reductions earlier in the month in emerging market debt (Pictet and Templeton)
    Strong performance through the month enabled us to take some profits from specialist assets, thereby releasing capital for other areas of undervaluation
  • SIGT: Holding in BHP Billiton was sold due to uncertain outlook for commodity prices and following recent cut in dividend
  • A new holding namely Essentra was introduced to the portfolio with the company having seen a significant derating following a profit warning in early June
  • Asian equity holdings were reduced following strong performance over recent months – bringing overall exposure back towards target weightings
  • Several specialist asset holdings were top sliced to provide funding for UK equity purchases

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Important Information

Past performance is not a guide to future returns. The information in this document is as at 30.06.2016 unless otherwise stated. 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.
CF 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 Capita Financial Managers, the Authorised Corporate Director of the funds (0345 608 1497).
Seneca Global Income & Growth Trust plc
Before investing you should read the Trust’s listing particulars which will exclusively form the basis of any investment. Net Asset Value (NAV) performance is not linked to share price performance, and shareholders may 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. FP16/118.

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Peter Elston’s thoughts on the Brexit vote – June 2016

24 June 2016

A comment on the Brexit decision

We wake up today to the extraordinary news that Britons have voted to leave the European Union. The immediate question is what the implications are for financial markets and for our funds.

First, although we did not discount the possibility of this outcome, nor did we think it the more likely. We believed that although the polls were close, undecided voters would tend to vote to remain. We were wrong.

Our funds are multi-asset funds so have some natural defensiveness built in via exposure to fixed income investments and what we call specialist assets, some of which are denominated in foreign currencies that will be rising today against a sharply falling pound. But within our multi asset framework we are still exposed to investments, principally equities, which will fall sharply today.

We have always communicated the message that we are long-term investors so our hope, and indeed our expectation, is that our investors will remain calm. As the saying goes, if you are going to panic, panic first. We certainly think it unwise to join any stampede and indeed at some point would like to take advantage of the lower prices.

Right now it is unclear how far and for how long markets will fall though it is quite possible that markets today will end the day well off their lows. Markets have a tendency to overreact. We will be watching very closely but remaining calm.

Further out, it will be the implications of voting to leave the EU for the UK economy that will continue to occupy our thoughts. It was patently clear from the debate that even those campaigning to leave the EU did not know precisely what a post-Brexit world would look like. The financial markets are sending a clear message today that it could well be bleak, though that is by no means a certainty. Indeed 52% of the electorate believes that the UK’s prospects are now brighter. They and their flag bearers should now be listened to.

 


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Important Information

The information in this document is as at 24.06.2016 unless otherwise stated. The value of investments and any income may fluctuate and investors may not get back the full amount invested. 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.

Before investing in the CF Seneca Funds you should read the key investor information document (KIID) as it contains important information regarding the fund, 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 Capita Financial Managers, the Authorised Corporate Director of the Fund (0845 608 1497). Seneca Investment Managers Limited, the Investment Manager of the Fund (0151 906 2450) 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. FP16/107

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