Luke Newman and Ben Wallace on falling correlation and why the time is right to look again at absolute return funds
Fear and greed have been powerful motivators over the past few years, with investors in turn gripped by panic about the health of the global economy and optimism that central banks have done enough to promote growth. From concerns about the burden of government debt in the Western world, to European Central Bank chief Mario Draghi's 'whatever it takes' support for the euro in the summer of 2012, whichever way the pendulum has swung, investors have followed.
The past few months, however, have seen the steady emergence of a different trend. We first saw it at the start of 2012, when shares were being priced almost entirely on market sentiment. At that time, the importance of economic newsflow far outweighed the detail of individual stocks. Since then, share price correlations have steadily fallen. The dominant macroeconomic themes that have driven investors to buy or sell over the past few years are no longer overshadowing stock-specific drivers to quite the same degree.
There is also evidence that insiders, such as company chief executives, are growing in confidence. It is perhaps no coincidence that merger and acquisition activity has perked up recently (34 per cent higher in the first six months of 2013, versus the same period in 2012) and private equity has been particularly active.
Stock selection matters again
A market where prices move in tandem, such as we saw in the period prior to 2012, limits the opportunities for stock-pickers like us to generate performance for investors. The lower the correlation in share price movements, the greater the opportunity to find stocks capable of generating higher or lower returns than the market average. This gives room for independent stock characteristics to play a bigger role, providing more opportunities to generate profits from long and short stock-picking ideas.
It can be something of a challenge to overcome some investors' ingrained preference for bond funds, particularly for those who lost money in the post-Lehman Brothers crash towards the end of 2008 and into 2009. In recent months, however, bond markets have come under abnormal and sustained pressure, driven by uncertainty over the tapering of the US Federal Reserve's US$85 billion per month bond-buying economic stimulus programme.
This has left investors looking for other options for their money in a low growth, low interest rate world. Absolute return funds, which are generally considered to sit somewhere between a bond fund and an equities fund in terms of potential risk are, in our opinion, an attractive halfway house. For our absolute return strategies, the key is getting the right mix of holdings. It is an intrinsic part of our management style to be very proactive in scaling positions on the fund. The portfolio is divided into our core (long) book and a tactical (short) book, which allows us to move quickly when responding to market events, or when looking to exploit what is a diverse investment universe.
Strong market potential
January 2013 marked the first time in some years that we had moved the fund's gross exposure above 100 per cent (the sum total of our 'long' and 'short' holdings in the portfolio). This was a statement of confidence that we believed it was a sensible time to put investors' capital to work. At the time, we increased our exposure to more defensive areas of the market that displayed very safe and secure dividend-paying characteristics, such as HSBC and Vodafone. HSBC, in particular, seemed well positioned, with a recent dividend increase suggesting strength in future earnings.
Financials has also been a busy area for us in 2013, across both long and short books, given the sector's sensitivity to economic data and monetary policy. Central banks have taken extraordinary measures in the past couple of years to help restore confidence in the economy. Rising asset prices are helping to restore balance sheets. While we would not ordinarily choose to go long in miners, a number of resources stocks also seem unduly out of favour, given management changes and improvements in how companies are spending their money.
The fall in share pricing correlations hopefully marks an end to what has been a lingering hangover from the financial crisis, at least for the time being. In a perfectly efficient market, all investment decisions would be based on rational and measurable factors, with share price volatility driven primarily by the fundamentals of individual companies. Markets are not perfect, but in this environment we believe that our absolute return strategy can play an important role for investors.
Is the US economy strong enough to cope in the absence of Federal Reserve stimulus?
Five long and eventful years now separate us from the acute phase of the financial crisis, when a severe liquidity crunch, unprecedented mortgage foreclosures, and the prospect of prolonged unemployment triggered a major global recession. Extraordinary central bank measures, extensive financial reforms and deleveraging have coaxed economies through the twilight phase between zero growth and weak expansion. But, as the Federal Reserve manages its exit strategy from quantitative easing, investors are questioning whether the US economy is ready for a new dawn.
Although the potential for external shocks remains, we are cautiously optimistic about economic growth; in part due to the natural cycle of recovery, but also due to longer-term economic shifts and investment in cutting-edge technologies. Not least, the US is transitioning to a new era of energy abundance through the shale gas revolution. This is helping to reduce the dependence on foreign oil imports, shrinking the budget deficit and contributing to jobs growth. Research suggests that five million new jobs could potentially be created over the next seven to eight years, directly in industry and indirectly as falling household energy bills increase discretionary spending.
Furthermore, lower energy input costs for businesses are coinciding with the rising competitiveness of US labour. America's innovation within manufacturing is arguably unmatched globally. These smarter products are harder and costlier to replicate overseas. While lower-end production - e.g. mass-market clothing - is unlikely to come back from emerging economies, high-tech areas look poised to grow domestically. An added boon for US manufacturing are signs that a portion of the jobs that were lost overseas during the outsourcing decades are returning. General Electric is bringing water heating manufacturing back from China to Kentucky, while Whirlpool is making mixers in Ohio.
Where there are goods, however, there must be buyers: consumer spending accounts for roughly 70 per cent of US GDP. We believe a confluence of factors could trigger another leg up in overall consumption. The considerable deleveraging that has occurred means households are in a better position to spend or borrow, as confidence improves. Total consumer debt is now 12 per cent lower than its 2008 peak. Wealth effects from the recovering property market and the rise of US equities to above their 2007 levels should also contribute.
That said, investors will have to re-acclimatise as the Fed tapers. The removal of stimulus is likely to have uneven effects throughout the market. For example, the lowest quality companies, those with proportionately larger debts and less predictable earnings, have outperformed those of the highest quality over the past four years. Lower quality stocks could therefore be among the casualties as market mechanisms normalise. There are already signs that a return to fundamentals-driven investing is occurring. The tendency for all stocks and most asset classes to move in sync has reached multi-year lows, and volatility is subsiding. With the return of stock-picking to the market, this could presage robust returns from active managers.
Rose Jacobs canvasses for views on the extent to which the outlook for Europe has improved in the second half of 2013
By some reckonings, this has been a heady season for Europe. In August, second-quarter growth figures showed the Eurozone emerging at last from its double-dip recession; a month later, fund flow data suggested that investors had abandoned their aversion to European equities, pouring more money into pan-Europe funds over the summer than at any time since 2008. Nor did German elections spoil the party. The country's two eurosceptic political parties - the FDP, junior partner in the current government, and the newcomer Alternative for Germany - both failed to earn the five per cent of votes that would have given them seats in the Bundestag, leaving Angela Merkel's Christian Democratic Union (and its Bavarian sister party) to form a coalition government with the Social Democrats or the Greens. Observers believe this will result in a Berlin more willing to grant bail-outs and less devoted to austerity.
A fragile recovery
And yet not even Merkel, who was backed by 41 per cent of the German electorate, is breaking out the champagne. Compromises that her coalition partners might force through, such as a national minimum wage, could dent competitiveness in Europe's powerhouse. And while the Eurozone's economy is growing, that growth is anaemic and patchy: in addition to the usual suspects - Greece, Ireland, Cyprus - countries including the Netherlands and Italy remain in recession.
"We're certainly not seeing a V-shaped recovery," says Sarah Gordon, Europe business editor for the Financial Times. "The danger is that we get an L-shaped recovery, as was seen in Japan in the early 1990s." She also warns against reforms backsliding, particularly at the Eurozone's periphery. "We know there were structural reasons for the crisis, as well as cyclical. How do you maintain the political will for national reform when people have extreme austerity fatigue, and when they see growth coming back?"
Indeed, Sebastian Dullien, a professor of international economics at university HTW Berlin, points out that "no one is asking for more austerity at the moment". But he and other experts see this as a positive rather than negative development, warning that a return to stricter austerity measures could well lead to "an extended period of weak growth".
Macro vs micro
John Bennett, Head of European Equities at Henderson, doesn't doubt the precarious nature of the recovery; in fact, he argues Europe hasn't yet emerged from a recessionary environment. Still, he has long been bullish on European equities, and remains so. He points out that European markets bottomed out in June 2012; if anything, investors have been slow to rebalance their portfolios back towards the continent. "In extreme macro periods, people take their eye off the micro," he says.
And the micro story is compelling for a number of reasons. First and foremost, valuations are attractive, both in historical terms and compared with the US. Second, European companies have by and large faced the macro crisis head on. "They've lived with austerity and recessionary markets," says Bennett. "The US devalues, the UK devalues, but Europe has lived with a hard currency for a long time, so these companies have restructured. They've thinned out their cost bases, which has made them much more operationally geared to any recovery. You don't need three per cent, five per cent, seven per cent top line growth. You just need it to stop falling."
Finally, Bennett points out, many of the companies are global businesses, and many have very significant market shares. "Maybe it sounds daft to say this is going to be one of the top asset classes of the next decade, but I stand by it. Maybe it's just the least ugly."
A third leg to the global crisis?
The Eurozone's existential crisis may be receding, but Bennett questions whether that really marks an end to the global economic crisis, or whether problems might simply flare up elsewhere - specifically, in the East. The FT's Sarah Gordon agrees that "a third leg to the global financial crisis” centred in the developing world is not unfathomable. The US Federal Reserve may have delayed its initial plan for tapering, but money will eventually, inevitably become more expensive again. "If that coincides with an end to the supercycle in commodities, that's a toxic mix for emerging markets," Gordon says.
She is not certain this would necessarily hurt Europe: "Currency crises are awful for the countries experiencing them; but we've learnt from the past that they don't tend to tip the global economy." Sebastian Dullien agrees, so long as China remains out of the frame.
Bennett is less sanguine. He points to what appear to be competitive currency devaluations in Asia, and wonders whether China might eventually be pulled into that loop - thereby exporting deflation to the West. "I would never forecast macro because it's a mug's game," he says. "But my biggest worry is that we haven't won the battle against deflation."
John Bennett is Head of European Equities at Henderson Global Investors and the Manager of the Henderson European Focus Fund
Mike Kerley argues that Asia can prosper as the West normalises
Asia has benefited in recent years from favourable growth relative to other regions and strong capital inflows. The latter has been driven by the implementation of ultra-loose monetary policies in developed economies. Now that plans are in place to slowly withdraw that stimulus, some market commentators are asking if certain Asian economies could be victims of the West's reforms and policies.
The US Federal Reserve's talk of tapering its asset purchase programme has caused some pain and asset price adjustment across the region. Certain smaller market constituents within the MSCI Asia Pacific ex-Japan Index, such as India and Indonesia, which have weak currencies and underlying economic issues, fell significantly following the Fed's announcement and have seen some foreign investment repatriated. However, the withdrawal of liquidity and the fact that developed markets are starting to ‘normalise' will lead to a greater emphasis on growth. From an income perspective, this is where Asia has an advantage.
China's still growing
From a country perspective, China offers the best combination of value and income growth in the region. Despite Chinese economic output losing some momentum during the first half of the year the country is still expected to achieve its 7.5 per cent growth target for 2013. Supportive manufacturing, services and export data released over the summer suggests China's economy is showing signs of a recovery stimulated by a policy shift towards domestic consumption.
Middle-class structural growth is what underpins Asian domestic demand, and should also mean the region is better placed to withstand external shocks. As Asian consumers in developing countries move up the income ladder, a desire to raise living standards is leading to greater consumption of higher-quality goods and services. According to the Brookings Institution, Asia will be home to three billion middle class people by 2030, ten times more than North America's middle class. This would be 64 per cent of the expected global middle-class population, accounting for over 40 per cent of global middle-class consumption.
Putting savings to use
Moreover, rising levels of wealth have led to Asian consumers hoarding a huge pool of bank deposit savings. For example, the amount local investors in China have saved is equivalent to US$16 trillion or 192 per cent of the country's gross domestic product (GDP). Therefore, the potential for investors across the region to mobilise their savings into higher yielding assets, such as equities, is huge.
Infrastructure enhancements are also being implemented due to demands for better standards of living and governments laying the foundations for further foreign investment and business development. Rather than being victimised, the rebalancing of the global economy may actually be going in Asia's favour.
Chris Burvill tells Cherry Reynard why it may be wise to take a cautious approach to investing in the UK's
Chris Burvill has managed the highly regarded £1.33bn Henderson Cautious Managed Fund since its launch (at Gartmore) in February 2003. He has more than 25 years' experience in running cautious multi-asset investment strategies.
Q: Is the UK entering a period of sustained economic growth?Chris Burvill: After five years of below-trend gross domestic product (GDP) growth there is a lot of ground to make up and we could easily confuse this recovery period with sustained growth. That being said, providing we don't become too reliant on the outlook for the housing market there is a good chance that the economy can grow steadily for some time to come.
Q: How will we know if the economy is normalising?CB: A rise in short-term interest rates would be my clearest sign that the economy was normalising. I would also be encouraged by a looser fiscal regime; lower taxes would signal that the government thought the economy was on the mend. Also, recent economic weakness has been characterised by the dearth of real capital expenditure from companies. To some extent, this has been good for stock markets, in that it has kept capacity tight. The next wave of recovery may come from capital expenditure, investment in R&D, plant and machinery. The market could take that very positively.
Q: Can equities still go up in a rising interest rate environment?CB: It may make a dent in the bullish equity argument, but to date that has been largely based on valuations. When interest rates are rising, the valuation argument is not as strong and instead there needs to be a focus on corporate earnings growth, which I believe could well come through. As we have seen with the sale of Vodafone's stake in Verizon Wireless, corporate activity is starting to pick up, much of which is shareholder-friendly and could be positive for earnings.
Companies are returning cash to shareholders, for example, and rising rates may actually encourage them to take on more, rather than less, debt. In this way, counter-intuitively, higher interest rates can be positive for equities.
Q: Where are the strongest valuation opportunities in the market at the moment?CB: As each investment cycle passes, mega caps fall further out of favour. They experience short-term rallies, before getting knocked again. This would include oils and pharmaceuticals, which have reached very low valuations. BP has shown itself willing to return cash to shareholders when the opportunity allows, and wants to be more aggressive with its balance sheet. This is what investors should be looking for in other sectors. We have been buying banks and oil, and are likely to revisit pharmaceuticals in the coming months.
Q: What is your current position on UK government bonds (gilts)?CB: I am short duration. I am worried that gilts look very unsteady and that one rogue inflation report may hit them hard. Nevertheless, I do have a small weighting as a means to balance the portfolio. There is always risk around the corner.
Q: What has particularly contributed to the fund's outperformance over the past year? CB: It has come from a variety of areas rather than any individual position. Stocks across the portfolio have performed well, particularly some of our mid-cap and smaller FTSE 100 names. M&S, for example, was utterly unloved a year ago and has now become a very interesting recovery stock. It is an example of an attractively priced stock that has been re-rated as investor confidence has grown.
Asset allocation positioning has also contributed to fund performance; our positive view on equities and sterling has been a significant boost.
Q: When do you decide to shift out of a company or an asset class in general?CB: I rely more than most on straightforward valuation techniques, which provide a good indicator as to those companies we need to re-examine. In general, I prefer asset allocation to come from the bottom up, finding enough stocks that the equity component reaches its own natural level.
Q: Do you find that the fund's UK focus is a constraint?CB: Yes, but I believe that is a good thing. It enables me to concentrate on the areas where I have the deepest knowledge.
Q: Why would investors choose to buy a cautious fund in the current environment?
CB: If markets rise - and I certainly believe that they will move higher from here - the Fund is nicely positioned, but because I have cash - at around 10 per cent of the Fund - and other short-duration assets, I retain flexibility. This may be to shift into gilts at higher yields next year or to buy more equities if opportunities arise. We are not out of the woods yet and it is good to be able to adapt.
Chris Burvill is Director, UK Equities and Co-Manager of the Henderson Cautious Managed Fund
Matthew Beesley discusses how the financial landscape has changed five years after the global financial crisis
Following the fifth anniversary of the collapse of Lehman Brothers and the ensuing Global Financial Crisis (GFC) - arguably the most calamitous event to hit financial markets and economies since the Great Depression of the 1930s - it seems appropriate to ask two questions: have things got better? And, could this happen again?
In the years prior to the GFC, both domestic and international banks ramped up lending, driven by an abundance of low-cost funding, rising profits and asset prices, along with surging economic growth. For too long, banks were running unsustainable business models, masked under the so-called safety net of risk diversification known as securitisation, or ignored under the term 'off-balance sheet'. Many were overleveraged, overdependent on wholesale short-term funding and significantly more interconnected than their risk models showed, rendering them more vulnerable to systemic shocks.
A changed landscape
Five years on, the global financial landscape has changed for the better. Since the beginning of 2013, conditions in the financial markets have improved markedly, primarily owing to the unprecedented monetary easing in the US, UK, continental Europe and Japan. Other initiatives, such as the Funding for Lending Scheme in the UK, have started to boost credit availability for homeowners and businesses.
To improve the robustness of the financial sector, global regulators and policymakers have made huge efforts to overhaul supervisory mechanisms and the international regulatory framework. Banks are undergoing more regulation and are under more scrutiny than ever, with the introduction of the 'Volker Rule' limiting proprietary trading activities, the Dodd Frank Wall Street Reform and Consumer Protection Act, reforming oversight and supervision, and the more conservative Basel III capital requirements.
In the UK, the Banking Reform Bill aims to separate retail operations from the more risky investment arms, so even if a bank fails it can continue essential operations. There are also greater efforts to coordinate standards and promote effective regulation internationally, via the Financial Stability Board.
In this new environment, financial institutions have realigned their business models by focusing on attracting core deposits as a funding source, boosting capital ratios (see chart) and curbing excessive lending practices. Capital, however, is only one part of the equation. Amid the significant asset writedowns following the GFC, many banks had huge loan losses. The US is further ahead on writing down the value of these assets, while in peripheral Europe, especially in Spain, the process is ongoing. In the UK, however, banks have generally taken a conservative stance to reserving for losses.
The healthier outlook
In our view, therefore, things are definitely getting better. In the immediate aftermath of the GFC, the US injected billions of dollars into the banks to help recapitalise balance sheets and stop many of them failing through the Troubled Asset Relief Program (TARP) and forced some of the weakest institutions to merge with stronger banks.
A few years later, the European Central Bank introduced its Longer-term Refinancing Operations (LTROs) to lend to banks at attractive rates, again to support their balance sheets. Several of these financial institutions have sufficiently recovered and are starting to repay these bailouts as well as resuming dividend payouts.
Amid this backdrop, our global funds' financials weighting has risen as high as 30 per cent, although it currently stands at 17 per cent. We purchased UK-based Lloyds Banking Group as we believe its earnings power is underestimated. The UK mortgage market continues to rebound, while profit margins are improving, as broader demand for loans from individuals and businesses grows; this is being supercharged by Lloyds' aggressive focus on reducing its cost footprint.
Lloyds, like the Belgian lender KBC Financial, is benefiting from its dominant position in its home market, which is still growing and where competition remains relatively benign.
As bottom-up investors, we look for change in the companies we invest in. There is continuing evidence of restructuring and transformation in many Southern European banks such as Italian bank UniCredit. Conversely, our weighting to US financials is minimal, having sold the position in Citigroup earlier in the year. In the US, we do hold Charles Schwab, which stands to benefit from higher US interest rates as many of its clients move funds away from low-yielding, low-margin cash and fixed income into higher-margin products, such as equity funds. We also own Sumitomo Mitsui Financial Group in Japan, which is well positioned to benefit from Prime Minister Abe's reflationary efforts.
Could the crisis recur?
Although the likelihood of another similar financial crisis is now less likely, risks remain. The process to realign the banks' business models and comply with stricter international regulatory requirements will take years rather than months. Meanwhile, European banks are not making as much progress compared to their US and UK counterparts in terms of deleveraging and balance sheet strength. However, for diligent investors, this may be where some of the best investment opportunities lie.
Matthew Beesley is Head of Global Equities
John Pattullo and Jenna Barnard on controlling the taps of duration and default risk throughout economic cycles
The bond markets offer a huge diversity to investors with a smorgasbord of different types of bonds, each suited to a different economic environment. For example, in a recession government bonds tend to perform well as interest rates are cut to spur on the economy, while in a growing economy high yield corporate bonds tend to do well given their equity-like nature and low interest rate sensitivity. The key to a successful investment strategy in the bond market is, therefore, active asset allocation. We are currently at an unusual time in the economic cycle. Going forward, traditional bond funds may not perform as they have historically, making a selective approach through active asset allocation even more crucial.
A glance at the returns on different types of bonds since the beginning of the year reveals the sharp differences; while gilts and investment grade corporate bond returns are down five per cent and one per cent respectively, European high yield bonds have returned just over five per cent. Since the chairman of the US Federal Reserve (Fed) talked of tapering bond purchases in May, core government bond prices have fallen sharply and yields have risen as markets, so used to the extra liquidity of quantitative easing, began to fear its removal and anticipate imminent interest rate hikes. It follows that a selective approach to fixed income investing is needed to generate good returns.
The taps of duration and default
The moment one buys an asset that yields more than the risk free rate (government bond yield) one is introducing ‘risk’ into the portfolio — getting paid for this risk, after all, is how returns are generated. The question is how to control the risk and maximise returns.
There are two primary risks in bond investing. One is default risk (credit risk), the borrower’s ability to pay back on a timely basis, and the other is the interest rate risk (duration). Duration is an important measure that defines how the bond price will fluctuate, as interest rates change.
In a strategic bond fund, the manager endeavours to preserve capital by essentially turning the taps of duration and default in varying degrees to generate the best returns from the two variables. Given the flexibility of a strategic bond fund, to invest across a broad spectrum of fixed income assets, the manager can move between different types of bonds at different times of the economic cycle to achieve his goal.
Interest rate risk is dictated by the interest rate cycle, which is closely related to the global economic cycle. By keeping duration low when rates are on the rise and raising duration when they are falling, it is possible to mitigate the effects of interest rates. In theory over a full cycle, the capital effect should be neutral for a bond portfolio: in good times it is possible to make capital gains while in bad times capital may be lost. As an illustration, over the years the duration of our portfolios has moved between one and ten years (in extreme cases), but in general varied in the range of three to eight years.
Default risk has a different effect. If a bond defaults, that investment capital is lost forever regardless of the economic cycle. However, this risk can be greatly reduced by active asset allocation, and good credit selection.
By anticipating changes in the economic cycle, one can select bonds that would perform best under the given conditions. To illustrate, over time and according to different economic cycles, our allocation to high yield corporate bonds has ranged from 20 per cent to 80 per cent. The figure is presently around 50 per cent as the prevailing economic environment remains supportive for high yield credit.
Good credit selection is equally essential to enhance returns and lower the odds of a capital loss. We are very selective in this regard and tend to invest in core companies, in core countries. Our thematic bond investing approach identifies large defensive names within well-established and consolidated industries where, given their reliable revenues, one can expect reasonable returns (such as five to eight per cent yields) without taking excessive risk.
Overly bearish on bonds?
Given a fairly benign picture of growth and inflation in most developed countries, the bearishness on bonds seems somewhat exaggerated. Although the withdrawal of quantitative easing can further dampen returns from government bonds, today's environment can lend support to corporate bonds.
The current climate is in fact favourable for corporate bonds. Company default rates are historically low (see chart) and expected to remain so. This is in part due to quantitative easing policies of recent years helping companies to borrow easily at lower rates, thus reducing default scenarios. While investment grade corporate bond supply is broadly shrinking, the supply of new issues in high yield is modest (on a net basis as most are just refinancing). The conditions are further underpinned by the recent Fed decision, which helps keep US Treasury yields below three per cent.
A dose of reality
Going forward, however, as we near the end of the 30-year bull run for bonds it will become harder to make capital gains. Instead, assuming that inflation and growth expectations remain where they are today, the majority of returns from bonds will come from their coupons.
The physical cash payment going into investors’ accounts on a regular basis can be relied upon provided one looks for sensible yields, without taking excessive risks. Hence, greater flexibility is needed in the approach to bond investing in the future. A strategic bond fund can offer just such flexibility.
John Pattullo and Jenna Barnard manage the Henderson Strategic Bond Fund
After the financial crisis, how did investors react, and what does the latest data tell us about the industry and market five years on.
Jonathan Lipkin, Director, Public Policy, Investment Management Association (IMA)
Q. How did UK investors react as the global economy slid into crisis in 2008?
The IMA observes changes in investor behaviour mostly through its monthly fund statistics. In 2008, retail flows were volatile - there were net inflows in some months and significant outflows in others.
After the shock of the Lehman collapse, retail flows turned strongly positive. However, the direction of flows suggested a 'flight to safety', with strong bond fund sales.
This set the theme for 2009 and 2010, which saw record retail investor inflows. In part, this may have been new monies, but we believe there was a significant redirection from bank and building society deposits into funds. These flows went heavily into fixed income, but also absolute return funds.
Q. As 2013 has progressed, what data trends are evident?
There have been strong flows into authorised funds so far in 2013 with net sales totalling £14.4bn in the year to August (our most recent data). The majority of these flows came from retail investors.
Equity funds have been particularly popular among retail investors, suggesting increasing appetite for risk assets amid recovering developed markets worldwide.
Mixed asset funds were the second most popular fund type. The Mixed Investment 20-60% Shares sector has been the best-selling IMA sector in four out of the eight months to August. The Targeted Absolute Return sector has also been popular.
Q. Are you concerned that there appears to be growing concentration in net fund flows?
We observe that in terms of net retail flows in 2012, about half of the fund operators that we collect data for took money in and the other half reported net outflows. We see this pattern most years and it highlights an important point; even when industry sales are strong, not all managers are benefiting.
In measuring concentration, we usually focus on funds under management because this is the main determinant of the industry's revenue stream. On this basis we find that the industry remains a highly competitive environment with a Herfindahl-Hirschman Index (HHI) of only 308. A reading of over 1,000 on this index (out of a maximum of 10,000) indicates only moderate concentration.
We have also considered the gross flows at the fund level. We find that gross flows have become somewhat more concentrated in recent years with the top 100 funds taking 56 per cent of total flows in 2012 compared to 48 per cent in 2005.
It should be noted that flow analysis is susceptible to intermittent large inflows and the 2012 figure was partly driven by very significant inflows into a small number of funds. This is another reason why we believe funds under management are a more representative measure of industry concentration.
Q. In terms of this data, has investor behaviour evolved during the last few years?
Fund data shows significant changes in terms of investor behaviour. The record fund inflows seen over 2009 and 2010 have fallen off rapidly, confirming our belief that the inflows were strongly influenced by a redirection of existing savings.
The past few years have also made it possible to observe several patterns in retail investor behaviour. First, there has been a continuation of the 'hunt for yield' as interest rates and returns on deposits continued to be low. Faced with volatile equity markets, some investors have also looked to funds where managers focused on achieving a particular outcome (eg. absolute return).
For others, the chosen approach was to try and overcome the uncertainty characterising the markets during that period by investing in funds where managers could exercise greater discretion over asset allocation.
Q. How has the investment industry reacted to these changes?
IMA Survey interviews this year suggest that firms increasingly believe the shift in investor behaviour is more permanent than cyclical. In other words, going forward, retail and institutional clients are likely to expect a different kind of product set than in the past.
There is an expectation that many firms will focus more explicitly on client-centric product offerings, such as target-date funds or liability-driven investment (LDI). The overall asset allocation is expected to be more diversified than the equity dominance that characterised the 1990s, although 2013 data reminds us of the ongoing importance of the equity culture in the UK retail market.
At the same time, there is a recognition that firms need to focus increasingly on building and sustaining investor trust. A lot of work has been done on greater transparency of costs and charges, where firms have been working with the IMA on the development of a simple, all-inclusive cost figure. But industry efforts go beyond information disclosure to a focus on better client communication to ensure that materials are accessible and engaging for different types of investors.
Crossing the line
Kathryn Scott, Project Manager, Henderson Global Investors
Asset managers do not want to delay their applications to register as alternative investment fund managers, a key element of the Alternative Investment Fund Managers Directive (AIFMD).
Q. Surely AIFMD only affects the hedge fund industry?
It's actually a lot more far reaching. Investment trusts, private equity, real estate funds and Non-UCITS retail funds (NURS) are all caught up in this legislation. For example, a lot of Henderson's multi-asset funds are NURS vehicles so it is very important that we meet the deadlines.
Its aim is to bring higher regulatory standards via a UCITS-style European Union-wide regulation to non-UCITS funds. It was prompted by the financial crisis and the general shift towards better regulation.
Q: How rigid are the implementation deadlines?
UK Asset managers have until 22 July 2014 to become authorised to perform the activities of an alternative investment fund manager (AIFM). Failure to do so by this deadline means that all action on non-UCITS funds must cease, so no investment decisions on the funds can be taken, and no marketing of the funds. It is very serious stuff.
Q: In reality, fund managers need to get their act together before then?
That's right. Firms that need to be authorised as full scope UK AIFMs, or need to be registered, need to submit a complete application no later than 22 April 2014, although the FCA strongly advises to do this earlier. In fact, firms seeking an authorisation or variation of permission under AIFMD are encouraged to apply no later than 22 January 2014 in case the FSA needs a full six months to determine the application.
Smaller fund managers are not subject to the full scope of AIFMD but will still be subject to registration and monitoring requirements. Small fund managers are deemed to be those whose total assets in open-ended funds are below €100 million or whose total assets in closed-ended funds are below €500 million.
Q: What will change under AIFMD?
For some fund managers the changes will be quite fundamental. For larger fund managers it tends to formalise activities they were already undertaking. Key changes include:
Q: Can you elaborate on what a European passport means?
Well, authorised AIFMs will be able to market and manage AIFs throughout the EU from 22 July 2013. This should help create a level playing field for funds, fostering efficiency and creating more cross-border competition.
Q: So this sounds like quite a lot of work behind the scenes?
It is. In particular, the governance requirements are quite specific and additional reporting and disclosures mean fund managers need to ensure data is collated in a way that meets the new rules. It is a bonanza for IT specialists and lawyers as firms strive to meet the deadlines. To put it into perspective, research by BNY Mellon estimated institutions would end up paying one-off costs of between US$300,000 and US$1 million to meet the AIFMD regulations. 1
Q: That's a lot of money. Is it worth it?
It is hoped that by raising the regulatory standards this will increase investor confidence, so in the long run, more people will be encouraged to invest in AIFs. The EU-wide passport should also make funds more accessible.
1 Source: Hedgeweek.com, 23 July 2013
Then and now
In 2008 the world slid into the great financial crisis. Several hundreds of billion dollars later, nationalised banks still remain largely nationalised but things could be looking up
From September 2012, the US Federal Reserve began buying $40bn worth of mortgage-backed securities a month, and in January 2013 added $45bn a month of longer-term Treasury securities. This was on top of $900bn of security purchases (2009 to 2011) (Source: US Federal Reserve)
The European Central Bank has instituted a range of liquidity measures to aid sovereign and financial institutions: LTRO - longer-term refinancing operations; CBPP - Covered Bond Purchase Programme; and OMT - Outright Monetary Transactions (Source: ECB)
The level that the Bank of England's quantitative easing policy reached in July 2012. The Bank's analysis of the effects of QE found that it had boosted the value of household wealth, but this largely benefited the top 5% of the population (Source: Bank of England)
From signs of a looming crisis in 2007 through to the precipitous events of the autumn of 2008 when the financial system began to unravel, significant dates in the crisis and response are many. Here's a snapshot through to September 2013's sale of Lloyds shares.
"Five years ago, the markets plunged into an Alice-in-Wonderland world. For when Lehman Brothers collapsed, the repercussions were so violent investors were faced with confronting 'six impossible things before breakfast' each day, to paraphrase Lewis Carroll."
Gillian Tett, Financial Times, Sept 2013
Outstanding amount owed to the UK government by UK Asset Resolution, managing the liabilities of Bradford & Bingley and Northern Rock (Source: UK Asset Resolution, 30 June 2013)
The proportion of US Treasury funds provided to US banks under TARP (Troubled Asset Relief Programme) that had been repaid at September 2013 (Source: US Treasury)
The part - 34.5% - of the €1,018bn obtained in the two three-year Longer Term Refinancing Operations (LTRO) that has been repaid (Source: ECB September 2013 Monthly Bulletin)
Is the sunny outlook for the UK economy all it seems?
The economy has rebounded strongly in 2013, surprising the pundits but vindicating 'monetarist' optimism. The Chancellor, among others, suggests that the economy "is turning the corner", implying a return to "normality". Normal, of course, is a subjective concept but, to the average person, probably means an environment in which the economy grows steadily, inflation is contained, living standards gradually rise and the real interest rate on savings is positive. Such a scenario, sadly, still seems distant.
First, the good news. Solid economic growth is likely to continue well into 2014. This is suggested by strong money supply expansion in mid-2013 - monetary trends lead the economy by six months or so, according to the monetarist rule. The 'best' money measure for forecasting the economy is the narrow aggregate M1, comprising physical cash and instant-access bank deposits. M1 holdings of households and private non-financial firms rose by an annual 11 per cent in July - the fastest since 2004, when the economy was growing by three to four per cent per annum.
Reasons for doubt
So why doubt that the economy is 'normalising'? There are three reasons. First, inflation is likely to rebound later in 2014 and in 2015 - a lagged response to faster monetary expansion in 2012-13. Depending on commodity price and currency moves, it could return to more than three per cent in the second half of next year. Market interest rates would probably rise in anticipation of this pick-up, in turn causing money supply growth to slow.
Second, the MPC should be acting now to head off inflationary risks by lessening the degree of monetary stimulus but, instead, has locked itself into a policy straitjacket in the form of its convoluted forward guidance. By mid-2014, with inflation picking up and the unemployment rate at or close to its seven per cent 'threshold', the Committee may be forced into belated - and significant - restraint. This would compound a market-led tightening of monetary conditions and could lay the foundations for another economic downturn in 2015-16.
A third reason for refusing to don the rose-tinted spectacles is the UK's continued dismal productivity performance. The MPC expects output produced per hour worked to resume respectable growth as the economy revives but the lesson of the last major productivity slowdown - in the 1970s - is that weakness can persist for many years in the absence of policy change. Sluggish productivity implies that solid economic growth may run swiftly into capacity and inflation constraints, while real wages may continue to languish.
Chancellor Osborne may be enjoying the current economic boomlet but the odds are that it will burn out before the 2015 election - partly because of the excessively loose stance of his hand-picked monetary policy general.
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