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

24 October 2017

Five points about active management in the multi-asset space

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

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

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

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

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

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

Simple.

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

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

High tracking error is bad but low tracking error is worse

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

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

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

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

Anything less, beware.

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

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

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

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

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

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

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

Shame to miss out on such a great opportunity.

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

We’ve all seen the headlines:

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

Source: FT.com

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

Why?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

(4)  Source Bloomberg


 

Current fund targets

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

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

Table 1

General

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

SDGF

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

SIGT

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

(1)  Source Bloomberg

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


 

Download this investment letter as a PDF


 Important Information

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

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

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. FP17/420

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

29 September 2017

More great news

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

Yet more shocking findings about active management

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

Cartoon - Active management PE IL 28 - September 2017

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

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

Not, that is, until now.

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

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

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

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

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

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

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

For this, please welcome Ross Miller.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Chart 1 PE IL 28


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

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

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

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


Current fund targets

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

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

Table 2 PE IL 28

General

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

SDGF

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

SDIF

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

SIGT

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

Download this investment letter as a PDF


Important Information

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

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

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. FP17/401

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

25 August 2017

Stop press: Awards announcement

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

An attack on poor active management

I abhor poor active management.

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

Small & interesting PE IL 27 - August 2017

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

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

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

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

This has to be wrong.

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

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

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

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

So, I have a different approach.

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

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

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

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

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

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

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

Interesting anomaly with respect to global fund managers’ AUM rankings

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

What revealed itself was fascinating.

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

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

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

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

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

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

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

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

PE IL 27 - Chart 1

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

PE IL 27 - Chart 2

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

PE IL 27 - Chart 3

Wealth creation from US equities since 1926

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

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

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

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

Table 1: Lifetime Wealth Creation

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

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

PE IL 27 - Table 1

Chart 4: Cumulative % of wealth creation, all companies

PE IL 27 - Chart 4

 


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

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

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

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

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

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

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


Current fund targets

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

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

PE IL 27 - Table 2

General

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

SDGF

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

SDIF

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

SIGT

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

Download this investment letter as a PDF


 

Important Information

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

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

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. FP17/342

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

26 July 2017

Preparing for the next downturn

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

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

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

Cartoon 2020 vision - PE IL 26 - July 2017

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

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

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

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

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

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

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

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

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

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

Chart: Unemployment rates in the developed world (%)

PE IL 26 - Chart 1 - unemployment rates

Source: Bloomberg, Seneca IM

 

Our tactical asset allocation framework

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

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

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

PE IL 26 - Graphic - business cycle

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

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

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

 


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

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


Current fund targets

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

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

PE IL 26 - Table 1 - TAA weights 06 17

General

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

SDGF

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

SDIF

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

SIGT

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

Download this investment letter as a PDF


 

Important Information

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

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

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. FP17/258

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

21 June 2017

Beware dividend concentration among UK large caps

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

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

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

 

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

 

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

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

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

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

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

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

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


 

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

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

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

 


Current fund targets

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

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

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

General

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

SDIF

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

SIGT

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

Download this investment letter as a PDF


 

Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
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. FP17/188

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

18 April 2017

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

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

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

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

PE IL 24 - Cartoon3

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

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

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

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

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

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

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

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

Chart 1: US unemployment rate

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

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

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

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

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

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

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

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

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

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

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

How does all this relate to investing? Simple.

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

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

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

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

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

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

 


 

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


Current fund targets

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

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

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

General

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

SDIF

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

SDGF

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

SIGT

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

Download this investment letter as a PDF


Important Information

Past performance is not a guide to future returns. The value of investments and any income may fluctuate and investors may not get back the full amount invested. This document is provided for the purpose of information only and if you are unsure of the suitability of these investments you should take independent advice.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca and do not constitute investment advice. Whilst Seneca has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
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. FP17/109

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

20 March 2017

Fund objectives and the search for harmony

We think that over a ‘typical’ investment cycle, our income fund (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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