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

15 January 2018

Looking back…

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

cartoon snip

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

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

Table 1

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

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

Table 1.1

Table 1.1

Table 2.1: 2017 performance attribution for LF Seneca Diversified Income

Table 2.1

Table 2.2: 2017 performance attribution for LF Seneca Diversified Growth

Table 2.2

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

Table 2.3

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

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

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

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

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

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

…and forward

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

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

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

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

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

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

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

Monthly review and outlook

Review

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

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

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

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

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

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

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

Outlook

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

Current fund targets

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

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

Table 3

General

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

SDGF

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

SDIF

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

SIGT

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

Download this investment letter as a PDF


Important Information

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

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

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

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

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

 

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

19 December 2017

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

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

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

Cartoon

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

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

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

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

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

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

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

Chart 1

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

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

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

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

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

Chart 2: Low concentration/short term

Chart 2

Chart 3: Ultra high concentration/very long term

Chart 3

Chart 4: Very high concentration/very long term

Chart 4

Chart 5: Low concentration/very long term

Chart 5

Chart 6: Ultra high concentration/short term

Chart 6

Chart 7: Very high concentration/short term

Chart 7

Chart 8: Very high concentration/medium term

Chart 8

Chart 9 Very high concentration/long term

Chart 9

Chart 10: High concentration/long term

Chart 10

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

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

Table 1

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

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

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

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

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

Table 2: Active-ness scores after data normalisation

Table 2

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

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

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

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

Happy Christmas everyone!

Macro and Markets Monthly

Review

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

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

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

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

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

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

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

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

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

Outlook

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

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


(1) Bloomberg

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


Current fund targets

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

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

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

Table 3

General

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

SDGF

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

SDIF

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

SIGT

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

Download this investment letter as a PDF


Important Information

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

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

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

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

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

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

28 November 2017

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

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

I think not.

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

Cartoon

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

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

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

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

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

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

The results are shown in the chart below.

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

Chart 1

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

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

Back to simple asset allocation.

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

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

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

Chart 2

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

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

Chart 3

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

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

Simple refinements of course, not complicated ones.

Macro and Markets Monthly

Review

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

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

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

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

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

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

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

Outlook

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

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

Source for all data: Bloomberg


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

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

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

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

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

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


 

Current fund targets

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

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

TAA table

General

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

SDGF

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

SDIF

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

SIGT

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

Download this investment letter as a PDF


 

 

Important Information

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

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

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

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

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