Home / Peter Elston’s Investment Letter – Issue 14: June 2016

Peter Elston’s Investment Letter – Issue 14: June 2016

Active management and the problem with “passive”

My attention was drawn last month to a recent McKinsey report entitled, Diminishing Returns: Why Investors May Need to Lower Their Sights.1

The thrust of the report was that investors’ current expectations for future returns have been shaped by actual returns enjoyed over the last three decades. Since these were unusually high, expectations for the future are now too high. The report notes that high returns over the past three decades were due to sharp declines in inflation and interest rates; high GDP growth that was the result of positive demographics, productivity gains and rapid growth in China’s economy; and even stronger corporate profit growth due to such factors as declining corporate tax rates. Some of these trends, the report argues, have now either stalled or gone into reverse, meaning that future returns will be lower, perhaps considerably so, than they were in the past.

I have sympathy with the conclusion, and in fact would add the cost of climate change to the list of factors that will increasingly impact growth – and indeed aggregate corporate profits – in the decades ahead.

As an investor, one has two choices: one can either accept the lower returns or one can do something about it. Or, to put it another way, you can either ‘be’ the market by investing in passive funds that will simply provide you with these lower returns, or you can seek to ‘beat’ the market by investing actively, thus enhancing your returns if done successfully.

It is therefore ironic that flows into passive funds appear to be accelerating (see FT article, Passive funds grow 230% to $6tn 2) at a time when market returns are in decline. Furthermore, if you need to make your savings pot last longer because you are going to live longer, you are effectively doubling your problem by going passive.

This is not to say that I think beating the market is straightforward. It clearly isn’t, as the plentiful evidence that most actively managed funds fail to beat their benchmark indicates.

I am thus dismayed that, as the FT article cited above notes, active managers have been “attacked by academics and consumer groups for not offering value for money.” Of course active managers do not as a group offer value for money! The reality is that active investing is not like Blackjack in which it is possible for everyone to win, but Poker, in which some win necessarily at the expense of others. The above attack is the equivalent of criticising lotteries on the basis that the vast majority of participants win less (i.e. nothing) than they spend to play.

This analogy is not a perfect one, because winning lotteries is about luck. If financial markets were efficient, and it was thus impossible to beat the market, I can assure you my savings pot would be stuffed full of passives.

But they’re not.

The prices of financial assets do not move randomly but exhibit pattern, meaning that price movements are a function of previous movements and are thus predictable (unlike random movements which are by definition independent and thus unpredictable). This assertion is not opinion but fact – there are plenty of statistical tests that have found pattern in financial markets. For example, when real interest rates are high, real returns from bonds will tend to be high (the converse is also true). Another one: when the dividend yield of a higher quality company’s stock is higher than the market average, the stock’s total return tends to be higher than the market average. (Another name for the pattern at work here is mean reversion.)

However, taking advantage of these patterns is harder than it might appear.

First, it requires a contrarian mindset. The reason why dividend yields or interest rates become too high in the first place is generally that the companies or economies in question get into difficulty (think about falling oil prices over the last couple of years that drove up yields of oil majors or the high inflation of the 1970s that drove up interest rates). It takes a strong mind to see such difficulties as opportunities rather than as things to fear. Such strength is rare in any walk of life – most humans prefer to be part of a group rather than to stand apart from it. And of course we humans are emotional beings – being fearful is a natural trait that we evolved to protect ourselves from genuine threats such as sabre toothed tigers and disease. Human nature will per se always be hard for humans to counter.

Second, spotting patterns in markets requires a fair grasp of mathematical concepts that is also fairly uncommon. Computers are now bypassing humans in this endeavour, enabling the emergence of so-called smart beta funds that seek to take advantage of patterns such as value, quality and momentum. But there will always be some scepticism about putting your savings in the hands of computers, and thus mathematical nous will remain a valuable skill for so endowed active managers. Furthermore, smart beta funds themselves will likely by virtue of their buying and selling create other patterns that the skilled active manager can take advantage of. After all, any fund that invests according to a strict, and public, set of rules, whether traditional passive or smart beta, is essentially flagging to the world what it is about to do. It should be possible for active managers to work out how to profit from such knowledge.

Third, funds may become too big to be able to take advantage of market inefficiencies. Peter S. Kraus, chairman and chief executive of AllianceBernstein, recently wrote that, “Active equity managers as a group made two mistakes: one, as we grew quickly, we got complacent about our ability to effectively manage larger pools of assets. Then, with bigger portfolios to invest, many managers over-diversified their holdings as a way to reduce risk and preserve those assets.”3

I am reminded of Warren Buffett’s comment in a 1999 interview for BusinessWeek: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”4

Now, I have an awful lot more to prove than Buffett, and I’d be thrilled if I had a fraction of his ability, but I do know three things:
1. our Seneca funds are sufficiently small to be able to take advantage of investment opportunities that are out of reach for our bigger competitors,
2. I suspect they can grow several-fold before this advantage begins to wear off, and
3. if and when we reach that point, I will be very conscious as to any trade-off between further growth on the one hand and capacity to produce good performance on the other to prevent us growing further.

After all, my duty of care is to our investors as well as our shareholders.

1  http://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/why-investors-may-need-to-lower-their-sights
2  As at May 29, 2016
3 FT article, Why the era of the ‘closet benchmarker’ has to end
4 As quoted in “Wisdom from the ‘Oracle of Omaha’” by Amy Stone in BusinessWeek (5 June 1999) https://en.wikiquote.org/wiki/Warren_Buffett

The UK referendum

First it was David Cameron, then it was Gordon Brown, now it seems the markets have taken over the lead role of campaigning to stay in the EU. As the likelihood of Brexit has risen in recent days and weeks, sterling and equity markets have tumbled while safe haven Gilts have risen, presumably an indication of just how awful a vote to leave would be. The question is, how many people will this message from the markets sway?

This is not about facts any more, though I’m not sure it ever was. No one knows whether it would have been better to have been outside the EU these last few decades. And no one knows whether it will be better or worse to stay in. No, it is now down to pure psychology: the extent to which voters are either scared of the unknown or prepared, enthused even, to leap into it.

At the time of writing, the betting markets have the probability of a vote to stay at just over 60%. This is despite recent opinion polls putting the leave campaign ahead by a couple of percentage points or so. In other words, the betting markets are saying that the polls are wrong.

It wouldn’t be the first time. Despite adjustments that the polling companies make to ‘raw’ polling data, there are certain things they can’t account for, at least not accurately. For example, which way will the large number of undecided voters swing? Second, as alluded to above, to what extent will voters take note of the fears that are being very clearly expressed in financial markets? Third, voters may well express an opinion that is based on principle when polled that they may well not adhere to in the austere atmosphere of the polling booth. Fourth, it is not clear how voter turnout might upset the polls.

I can appreciate both sides of the argument – it would be stupid and reckless of me to say otherwise when the polls are so close. I can understand that many Brits are disillusioned by and mistrustful of politicians and the members of the so-called economic elite with whom they often fraternise. They may not care about the risk of being financially worse off if they can feel personally empowered in other ways. On the other hand, there are many who believe that while the club that is the EU is not perfect – in any club there are always going to be rules that members find irritating – it is better to be in one than not in one. (It’s more complicated than this of course but I think this summary captures the essential sentiments on both sides, if not the formal arguments of those leading the campaigns).

As far as the psychology is concerned, the 2014 Scottish independence referendum provides a good guide. There was a very similar pattern in that, in the lead up to the vote, the polls and betting markets narrowed sharply and as a consequence financial markets got the jitters. When the time came, the vote to stay (“No”) won comfortably, 55.3% to 44.7%. Furthermore, the turnout was a very high 84.6%.

In the UK referendum. the remain campaign is not hindered by the “No” label, the negativity of which may well have made the Scottish vote closer than it would otherwise have been.

My view is that the aforementioned psychological considerations will favour the ‘remain’ campaign more than the ‘leave’ campaign and that, like the Scottish referendum, the outcome will not be as close as the polls are currently suggesting.
If I’m wrong, what then?

Even in the event of the ‘leave’ camp winning, I suspect sterling and equity markets will bounce in the immediate aftermath of the vote. This is the nature of markets. The situation is akin to Pascal’s wager, in which the great 17th century mathematician argued that there was no downside to believing that God exists – if you were wrong, it didn’t really matter. Similarly, there is one can argue no downside today to investors taking the view that the ‘leave’ campaign will win and selling their shares. Yes, you might not capture upside, but you won’t lose money. The utility of not losing it seems is far greater than that of winning, also known as loss aversion.

The logic of this argument is flawed, but then reason has rarely been the driver of markets in the short term – that role has been taken jointly by ‘fear’ and ‘greed’. The fact is, it is always more dangerous to sell than to not sell. If you sell and you are wrong, you incur a permanent loss, albeit an opportunity loss. If you don’t sell and you are wrong, you just have to wait for things to recover, as they almost always do. The loss is very likely temporary, and thus not permanent.

This is the view we have taken at Seneca. We are slightly overweight equities because we think they are generally cheap and the economic outlook, while not great, is OK (and in the case of our UK companies we think they can thrive either way). We are prepared to ride out short term volatility to the extent our already diversified multi-asset funds are exposed to it, and we would strongly encourage others to do the same.

Strategic asset allocation (SAA) review

We have just concluded our annual review of our funds’ strategic asset allocations. We have made some small changes to the underlying assumptions but not to the weights themselves.

To recap, our strategic asset allocation for a particular fund is constructed so as to achieve a particular real return – once fund costs and expected value added are accounted for – over the long term, as well as good diversification. Ultimately, we believe that by achieving a certain real return, the fund in question will attain top quartile status over the medium to long term in relation to its respective peer group. The inputs to the calculation for a particular fund are thus: (a) the long-term expected real returns we expect each of the asset classes in which our funds invest to achieve; (b) the real return objective of the fund; (c) the value added we expect to generate from active management and (d) fund costs. While we are aware of the volatilities of and correlations between asset classes, we do not use complex optimisation models. We do however model the SAAs to check that they have achieved in the past what we want them to achieve in the future.

Changes to the long-term return assumptions can be seen in the table below:

Table 1: Asset class long term real return expectations

Table 1 - Asset class long term real return expectations

The changes relate only to equities and within equities to all regions/countries other than North America (for which read ‘US’).

The rationale for the changes is simple: we think that economic growth is likely to be lower over the long term across the globe. At the same time, we acknowledge that US companies are probably more dynamic than in other parts of the developed world, and also that a negative adjustment should be made for the poorer governance of companies in emerging markets. In sum, this means a 1 percentage point reduction everywhere other than in North America.

We have not made any changes to expected returns within fixed income or specialist assets.

As for assumptions about the value added we can generate through active management, we have increased our targets for UK equities and overseas equities from 2% to 3% and from 1% to 1.5% respectively. This is an acknowledgement of our mid cap focus in the UK (mid cap stocks over time have beaten large caps by a significant margin, something we expect to continue). As for overseas equities, we are making more use of our capacity to be more concentrated as well as our capacity to invest in smaller, more dynamic funds. Both of these we feel increase our scope to add value.

Inflation watch

Inflation has such an important bearing on real and financial asset prices, that it deserves its own section.

Core inflation rates in the developed world have been fairly stable in recent months at around the 1.3% per annum level (see Chart 1). This is certainly an improvement compared with a year or so ago when the average was slightly below 1%, but is still short of where central banks would it to be. That said, core inflation in the US is around 2% which is where the Federal Reserve would like it to be (and hence why it has started to increase interest rates). In recent months, core inflation has started to trend downwards slightly in Europe and Japan – something the ECB and BOJ will be watching closely no doubt – but is still well above zero. Despite headline inflation numbers which are much lower as a result of food and energy price declines, central banks should be commended for maintaining price stability in recent years (with the exception of Japan whose success is more recent).

In the emerging world, the inflation picture continues to improve, with rates continuing to fall in Brazil and Russia, and stabilising around 2% in China (see Chart 2). India’s inflation remains a little higher than policymakers would like it to be, but it remains much lower than levels seen back in 2012 and 2013.

I have included this month a chart of year over year wage growth in developed economies (see Chart 3). As with core inflation rates, it is encouraging to see that wage growth in the US, the UK and Europe has remained in the 1.5-2.5% range, while in Japan it has risen from around -1% in 2013 to close to 1% currently. The assertion that Japan prime minister Abe is losing the battle against deflation is perhaps unwarranted.

Chart 1: Core consumer price inflation – developed economies

Chart 1 - Core consumer price inflation

Source: Bloomberg

Chart 2: Consumer price inflation – emerging economies

Chart 2 - Consumer price inflation - emerging economies

Source: Bloomberg

Chart 3: Wage growth – developed economies (YoY%)

Chart 3 - Wage growth - developed economies Source: Bloomberg

Employment watch

Most if not all central banks are tasked with maintaining price stability and full employment. This section looks at recent employment trends and what they might mean for monetary policy around the world.

May’s non-farm payrolls of 38,000 came in well below expectations of 160,000. Furthermore, April’s payrolls were revised downwards from 160,000 to 123,000. The unemployment rate fell from 5.0% to 4.7% as the workforce shrank (having been rising since September last year, the participation rate has fallen back in April and May). Chart 5 below puts these numbers context. While the poor payrolls are of some concern, it is too early to say that they are the start of something more pronounced. There have been several months during the last six years when payrolls have come in well below 100,000 but did not signal the start of a downward trend. That said, we are now closer to the point at which employment is more likely to start to fall, so these numbers should be taken more seriously.

One conclusion that can be drawn from the data is that the probability of a June or July rate rise from the Fed is now much lower.

Elsewhere, unemployment rates in Japan, the UK, and Europe continued to fall. As can be seen in Chart 4 below, the average of the four countries/regions still has some way to fall before it hits the low point in the previous cycle.

Chart 4: Unemployment rate – developed economies

Chart 4 - Unemployment rate - developed economies

Source: Bloomberg

Chart 5: US employment indicators

Chart 5 - US employment indicators

Source: Bloomberg

Corporate sector indicators

Sales per share is often an interesting indicator to look at. Charts 6 and 7 below do just that, the first by geography and the second by industry. While the first suggests that the decline in the total (world) sales per share is fairly broad, the second suggests the decline is concentrated in four sectors: energy, materials, financials, and utilities (indeed this pattern can also be seen in Chart 8 which shows operating profit margins by industry). Nevertheless, it is clear that sales growth in the current cycle has been much weaker than in the previous two cycles. This is a reflection of the weak economic growth posted since the crisis. Why growth has been weak is a hard question to answer. Renowned economist Larry Summers has put forward a number of arguments as to why growth has stagnated in the US, many of which may also apply in other major developed economies.

I shall be looking at Summers’ research in more detail in next month’s letter.

Chart 6: Sales per share by geography (trailing, Dec 1995 = 100)

Chart 6 - Sales per share by geography (trailing, Dec 1995 = 100) Source: Bloomberg

Chart 7: Sales per share by industry (trailing, Dec 1995 = 100)

Chart 7 - Sales per share by industry (trailing, Dec 1995 = 100) Source: Bloomberg

Chart 8: Operating profit margin by industry (%)

Chart 8 - Operating profit margin by industry (%) 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 31 May 2016, prior month’s targets in brackets)

Table 2 - Current fund tactical asset allocation - as of May 2016

      • No asset allocation changes in May for the OEICs
      • Minor asset allocation changes for the investment trust – fixed income increased to 7.0% from 6.6%, cash reduced to 1.0% from
      • SIGT: Introduced Britvic (target increased from 0% to 1.5%) and exited Aberforth Smaller Companies (target decreased from 1%
        to 0%)
      • Britvic’s yield of 3.3% offers good value in the context of stability of business and strength of brand
      • Aberforth exited on basis that the yield was not sufficiently attractive; also the holding did not align with our broad intention to invest directly only in UK
      • SDGF: introduced GCP Student Living (target increased from 0% to 1%), Aberdeen Private Equity Fund (0% to 0.7%), and exited
        NB Distressed Debt (1.7% to 0%)
      • GCP Student Living provides exposure to a niche and growing area of the property market and an attractive dividend yield of
      • Aberdeen Private Equity Fund continues to grow its NAV at a decent pace; it trades at a 33.3% discount to NAV
      • NB Distressed Debt exited on the basis that it does not provide the stability of returns that we seek from our specialist assets
      • SDIF: introduced Arrow Global Group (target increased from 0% to 1.0%), and reduced Fidelity Enhanced Income (2.0% to
      • Arrow Global is a market leader in acquisition of consumer debt; the company is growing earnings and dividend rapidly, yet its stock trades on a single digit P/E
      • Fidelity Enhanced Income reduced in line with move to replace indirect UK equity holdings with good value direct investments
      • SDIF: increased Royal London Sterling Extra Yield Fund (target increased from 4.0% to 4.6%), Royal London Global Short Duration High Yield Bond Fund (4.0% to 4.6%), and exited M&G Global High Yield Floating Rate Note Fund (1.2% to 0%)
      • The increases in the two Royal London funds were part of a further consolidation of fixed income positions, and also improved the income generation within SDIF
      • The M&G fund was exited as we felt the running yield of around 3% was unattractive given our view that a rise in UK interest rates that would benefit the fund is still some way off

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Important Information

Past performance is not a guide to future returns. The information in this document is as at 31.05.2016 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.
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