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By Cantab Asset Management

The last decade has seen significant asset price appreciation, accommodated by expansionary monetary policy. Alongside this, periods of uncertainty have led to spikes in volatility. Whilst recent levels of Quantitative Easing are unprecedented in historical terms, volatility and market corrections are not. This note considers the relationship between active management and market volatility in the context of achieving strong long-term performance. The main takeaways from the following analysis are:

Analysis

The VIX index is used by investors as a measure of implied volatility in financial markets. It is based on S&P500 option prices and is commonly referred to as the “Fear Index”. Between 2018 and 2021, the VIX has breached level 20, which is considered to be ‘high’, on four occasions, as illustrated below.

Each of the four highlighted periods captures a date range in which the index level moved from low-to-high-to-low and is used as a proxy for short-term market volatility. Performance during these periods is illustrated below, alongside commonly-used risk metrics for three actively managed funds and their respective passive alternatives.

Summary

These findings may or may not be representative of the entire active universe of funds; to test them is beyond the scope of this analysis. What is clear however, is that within the universe of actively managed funds, there are options that provide significant outperformance on a risk–adjusted basis during periods of heightened volatility. It is our role as advisors to identify and monitor these.

When applying the same analysis to the actively managed Cantab multi-asset portfolio, not only did the portfolio outperform its passive equivalent over the full period but also achieved relatively similar volatility and max drawdown metrics overall. The analysis also found that after a material peak-to-trough movement, the actively managed Cantab portfolio recovered considerably faster to previous highs when compared to the passive equivalent.

The results from the analysis not only highlight the importance of taking a long-term view, but also demonstrate that there are two sides to volatility: downside and upside. Volatility is usually calculated using variance or standard deviation, by summing the square of the deviation of returns from the mean return and dividing by the number of observations in the data set. By definition, upside and downside deviations are treated equally. Whilst higher volatility implies higher risk, due to less predictability of asset pricing, investors are typically in favour of upside volatility in practice. By pursuing a passive strategy, investors avoid the downside risk of underperforming a benchmark index; unfortunately, they also miss out on the upside potential of outperformance.

Periods of short-term volatility have been common throughout history and will continue to be common in the future. However, during such periods, investors tend to focus on the negative side of volatility rather than directing their focus to the bright side of volatility that is offered by good active management.

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Notes:

Risk warnings:
This content has been prepared based on our understanding of current UK law and HM Revenue and Customs practice, both of which may be the subject of change in the future. The opinions expressed herein are those of Cantab Asset Management Ltd and should not be construed as investment advice. Cantab Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. As with all equity-based and bond-based investments, the value and the income therefrom can fall as well as rise and you may not get back all the money that you invested. The value of overseas securities will be influenced by the exchange rate used to convert these to sterling. Investments in stocks and shares should therefore be viewed as a medium to long-term investment. Past performance is not a guide to the future. It is important to note that in selecting ESG investments, a screening out process has taken place which eliminates many investments potentially providing good financial returns. By reducing the universe of possible investments, the investment performance of ESG portfolios might be less than that potentially produced by selecting from the larger unscreened universe.

By Brooks Macdonald

Several major global events – including most recently the coronavirus pandemic and the Russia/Ukraine situation – have prompted investors to flee financial markets, but history shows this could have been a mistake. In this article, we discuss the importance of remaining invested and how missing the best performing days could have led to a portfolio’s significant underperformance over the long-term.

What potentially seems a distant memory, the stay at home orders and dystopian feel to everyday life sent shockwaves through financials markets at the start of 2020, as a result of COVID-19. More recently, Russia’s invasion of Ukraine has rocked markets. In such conditions, it may be tempting to consider exiting the financial markets or switching to cash, with the intention of reducing further expected losses.

Trying to time the market can seriously damage your investment returns

Amidst heightened volatility, it is understandable that many are concerned about the impact on the value of their investments. But, while sharp declines in markets can naturally be disconcerting, if you want to give your investments the best chance of earning a long-term return, then it’s a good idea to practice the art of patience.

When markets fall and fear dominates, it can be difficult to resist the temptation to sell out of the financial markets and switch to cash, with the idea of reinvesting in the future when feeling more positive about market prospects – trying to ‘time the market’. But this is a strategy that carries with it the risk of missing out on some of the best days of market performance. And this could have a devastating impact on long-term returns.

Remaining invested may be an emotional rollercoaster during times of market stress, but research shows time and again that this is the best investment approach over the long term. For example, one study of US equity mutual fund investors showed that their tendency to try and time the market was a key driver of their underperformance (Dalbar, 2019)1. In the current environment, it is understandable that many people are concerned about geopolitical risks, and how this is being reflected in the value of their investments. To give some context, the speed at which the market entered into ‘bear’ territory (typically a 20% decline) in response to the coronavirus pandemic was the fastest in history. The current sell off does not qualify as a bear market but has dropped 10% since recent highs as shown in the chart below.

1 Dalbar (2019). ‘Quantitative Analysis of Investor Behaviour

Despite temptations to switch into cash, data shows that missing out on just the 10 best market performing days can have a big impact on long-term returns.

Staying ‘fully invested’ during the ups and downs has resulted in an initial £100,000 portfolio, for example, having an ending value of £445,000, compared to £250,000 for those that missed the 10 best days in previous 20 years. This effect also highlights the powerful effect of ‘compounding returns’ over time. If, for example, the 50 best days are missed, the long-term returns are indeed negative.

A different way of delivering the same message, where staying invested over the 20-year period generates annualised returns of 7.9%, compared to 0.8% annualised returns if one misses the 30 best days:

One of the most common reasons investors lose money is when they try to time the market, trying to avoid the worst days of the stock market by cashing out and then re-investing when they think the market is going to pick up. However, as the chart shows, the best and worst days of the stock market cluster. Try to miss the lows and you’ll probably miss the highs too.

Missing the best days during the downturn and subsequent upturn can again have a large impact on the returns generated over the subsequent period.

With the benefit of hindsight, we are now fully aware of the global impact of COVID-19, and the rapidity in which it has hit equity markets. While markets rivalled the speed of the virus in trying to price-in the near-term damage, we expected they could also be swift to act when a tipping-point was seen to be close- at-hand. World equity markets returned to highs around 120 days following 2020 lows.

By keeping to an established and proven investment framework, we can look to take advantage of short-term volatility as we continue to seek out longer-term investment opportunities. We look to avoid behavioural biases that may result in decisions that negatively impact long-term return potential. Yes, the journey may not be smooth, but generally it is important to look through the noise, and remain invested during times of market stress.

 

Important information

Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a reliable indicator of future results. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets. The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others. The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

Brooks Macdonald is a trading name of Brooks Macdonald Group plc used by various companies in the Brooks Macdonald group of companies. Brooks Macdonald Group plc is registered in England No 4402058. Registered office: 21 Lombard Street, London, EC3V 9AH. Brooks Macdonald Asset Management Limited is regulated by the Financial Conduct Authority. Registered in England No 3417519. Registered office: 21 Lombard Street, London, EC3V 9AH.

More information about the Brooks Macdonald Group can be found at: www.brooksmacdonald.com

By Fidelity

Our investment team discuss how we are evolving and enhancing our sustainability research and ratings. Find out more about how we are moving away from solely using ESG as a risk management tool, with an increasing focus on delivering real world change.

In recent years, we have seen rapid growth in interest in sustainability and rising desire for sophistication from investors in how it is approached. Today, investors are increasingly looking to influence positive change by directing capital to address ESG problems, not least climate change.

As part of this evolution, we have developed the core tools within our sustainable research platform, making enhancements. We have evolved our ESG ratings and version 2.0 now makes more in-depth assessments of how companies are managing the impacts of their businesses and mitigating any negative effects on all stakeholders, including workers, society, the environment, etc. We are also measuring alignment with the SDGs and how companies are making positive contributions to these goals; as part of this, we try to disaggregate different activities to provide more granular information.

Broadly speaking, what we are doing is moving away from using ESG as a risk management tool that contributes solely to financial outcomes. Instead, we are moving towards an approach focused on delivering real world change. It means much more holistic assessments of the opportunities and risks faced by an issuer, as well as more forward looking.

The first stage in our process regards materiality mapping – we have developed customised materiality maps for 127 individual industry subsectors, each with a different weighting combination of 14 social and 26 environmental indicators. These maps are determined by our research analysts alongside our dedicated sustainable investing team on the basis of each company’s operations, but also the context of their impact on other stakeholders, such as suppliers and broader society. For example, we would include Scope 3 emissions linked to airports, whereas other ESG ratings might not.

Our extensive corporate access enables us to engage with corporates to investigate sustainability issues in great depth. This is a key differentiator – we use a combination of qualitative and quantitative inputs, rather than relying on publicly-disclosed quantitative data as many external rating systems do. Our qualitative assessments are undertaken by our analysts, who have detailed knowledge of the companies in their coverage.

We are lucky to have relationships with and access to senior management teams all around the world that enable us to take this approach, it is not something that every firm can accomplish. Our local research teams are able to engage on ESG issues with countries in all cultures and languages in order to drive improvements in their behaviour.

Click here to read the full article and watch the webinar >

Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of an investment in overseas markets. A focus on securities of companies which maintain strong environmental, social and governance (“ESG”) credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security’s ESG credentials can change over time. Issued by Financial Administration Services Limited and FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited.

By Louisiana Salge, Senior Sustainability Specialist, EQ Investors

Whilst the number of investors who would like to make a positive impact to society and the environment continues to grow, we still encounter misconceptions that prevent some from taking the plunge. This piece dispels some of the common myths associated with sustainable investing.

Misconception 1: All sustainable investment approaches are the same

There are a variety of ways in which sustainability considerations can influence investment mandates and portfolio management. To summarise the three most common approaches:

Traditional ethical investing focuses on excluding a set of industries or companies based on controversial behaviour, often called the “sin stocks”. Investment strategies will apply a values-based negative screen on industries like tobacco, alcohol, or pornography. The rest of the strategy is then managed with traditional investments.

ESG investing introduces information on how well companies manage relevant operational Environmental Social and Governance (ESG) factors into the investment decision-making. Investment strategies can integrate this information differently. Common approaches may overweight or set inclusion thresholds based on company ESG performance, relative to peers. This approach usually overlooks the analysis of companies’ products and services.

Impact investing focuses on creating material, measurable positive impacts on people & planet. Instead of being a relative assessment, such as ESG, the focus here is on maximising the absolute positive impact associated with investments. Investment strategies can do this by positively targeting sustainable themes like clean water, renewable energy, or accessible healthcare. This approach puts a very strong emphasis on companies’ products and services and the solutions they bring to the many challenges we face.

Misconception 2: Sustainable investing will sacrifice investment returns

There is mounting evidence that sustainable investing does not sacrifice performance, in fact, incorporating ESG factors into investments can help boost financial performance. Overall, businesses that demonstrate greater operational sustainability (ESG) and sustainable products & services, can perform better.

Evidence indicates that the positive correlation between sustainability and performance holds both at the corporate accounting, and investment performance level. The reasoning is that businesses managing E, S and G better than peers demonstrate better risk control and compliance, suffer fewer severe incidents (for example, fraud, environmental spill litigation) and ultimately carry lower tail risk. ESG leaders invest more in Research and Development, foresee future risks and plan ahead to remain competitive.

Impactful companies are those that have turned the largest societal challenges into profitable business opportunities. These companies benefit from the growing global demands for their products and services, greater regulatory support and from avoiding reputational and stranded asset risks.

Misconception 3: Sustainable investing is too risky

It is true that many high-impact investments can be in more volatile markets (such as emerging markets), but real opportunities exist across all asset classes, from small to large companies located in the US, in the UK and all regions of the world – and risks vary between these. For example, social housing investments can provide reliable government backed income streams while providing significant societal benefits. Water utilities prevent industrial wastewater from polluting natural ecosystems and provide defensive investment characteristics.

Therefore, portfolio managers like EQ Investors can adhere to normal risk categories and create portfolios for different ‘risk appetites’, as well as tailor these to sustainability preferences.

Misconception 4: It is a narrow investment universe

There is no single defined investment universe for impact investors. Investor preference defines the opportunity set by deciding on risk, return and impact theme targets. The amount of companies eligible for investment can depend on the impact or ESG standards set by investors.

While this means that we can’t give a reliable impact universe estimate, opportunities are larger than some might assume. For example, the EQ Positive Impact Balanced Portfolio has exposure to about 1,000 unique companies and organisations globally.

This universe is also expanding. As much as investor interests are turning to sustainability, companies’ business models are too. In 1999 Impax Asset Management had an investment universe of 250 companies which generated more than 50% of their revenues from environmental solutions. This universe has now grown to about 1,400 companies. The same would apply to the healthcare, financial inclusion and education universes.

Misconception 5: Sustainable investing cannot make a positive impact

When investing through traditionally managed portfolios, disregarding the impact of investments on people & planet can contribute to business activity that actively works against the client’s values. On the other hand, investing a client account through a positive impact mandate, the output of companies and that associated with an investment can align with the client’s values.

Even in listed markets, allocating equity capital or investing in bond issues of businesses that create positive sustainable impact, will support their share price, and provide easier access to capital thereby producing a license to operate. Using capital to invest for positive impact will signal to the market that such non-financial impacts are valued and nudge laggards in the right direction.

Sustainable investors will use their company relationships to engage boards on any sustainability weaknesses and thus create change. They are also able to use voting rights to back or block strategic decisions that concern the company’s ESG performance.

The dual objective to create financial and sustainability outcomes means that the investment reporting that private clients receive should not solely cover the financials.

At EQ Investors we invest significant resources to bring the impact that our portfolios have “to life” and demonstrate that we are delivering on our clients’ positive impact objectives. For example, we have created an interactive impact calculator that shows the investments’ associated positive impacts, like renewable energy generated or hours of education provided. We also transparently disclose alignment with the UN Sustainable Development goals, and how portfolios are aligned to climate change scenarios.

Canada Life Asset Management Portfolio Funds offer a straightforward and cost-effective solution to the challenge of choosing a mix of investments to suit the investment needs of a broad range of clients. They offer you simplicity, significant time savings and – crucially – the reassurance that the funds will remain appropriate for the risk appetites of your clients over time.

The range comprises five globally diversified fund of funds aligned to Dynamic Planner’s risk profiles 3 to 7. The Portfolio Funds access the investment expertise of Canada Life Asset Management in-house fund range, allowing the funds to offer competitive charging structures.

They are available within a wide selection of wrappers, which now includes OEICs, ISAs, ISA transfers, Pensions, offshore and onshore bonds.

Canada Life Asset Management has more than ten years of proven capability in risk-targeted fund management. Canlife Portfolio Funds 4 to 7 launched in March 2008, with Canlife Portfolio 3 added in March 2012. This capability was extended in November 2013, with the launch of OEIC fund versions, the LF Canlife Portfolio Funds III to VII and the Canlife Portfolio TRA Pension funds which were released in May 2018. Both the OEIC and Life & TRA Pension ranges share the same fund managers, investment process, philosophy, asset allocation and underlying holdings.

In December 2018 the Life portfolio funds directly invested into the equivalent OEIC funds. Prior to this, the Life funds invested through other Life funds through a fund of funds structure.

In March 2019 the Canlife Index Portfolio’s 3-7 were launched.

The risk-targeted portfolios at a glance

We have two ranges of risk-targeted portfolios – an active range and a passive range. Within each range, there are five portfolios. They are ready-made, cost effective solutions delivering ongoing suitability for your clients. Each portfolio invests in a range of geographies and asset classes and is closely managed to a defined risk/reward profile, aiming to align to Dynamic Planner’s asset allocation for risk profiles 3 to 7. Each portfolio is monitored daily to ensure it achieves its aims and Dynamic Planner Risk Profile allocations. If necessary, they are rebalanced.

By Sam Liddle, Director, Church House Investment Management

How will central banks respond to current global tensions? It’s one of the most important questions any market participant can ask right now.

The scene has long been set for an extended period of aggressive hiking to address rampant inflation resulting from years of ultra-loose policy. The Federal Reserve raised rates in March for the first time since 2018 and, at the time of writing, is anticipated to increase them further, while the UK’s Monetary Policy Committee has hiked rates three times since December 2021. Yet with market uncertainty and slowing growth, many are positing that policymakers will be more inclined to temper their approach in the second half of this year.

There’s no questioning the idea of prolonged pandemic levels of fiscal stimulus is likely to sound attractive to many. However, our belief is that the transition away from the ‘easy money’ era has become unavoidable and, as such, any temporary delays are essentially prolonging the inevitable¬.

In fact, with inflation set to continue rising amid current conditions, kicking the proverbial can when it comes to unwinding central bank balance sheets could even make things worse.

With this in mind, we believe it is becoming increasingly important for investors to move with the market cycle. And in real terms, this means placing less emphasis on maximising returns and more on preserving gains that have already been made.

A return to the norm

The fact of the matter is that it is has long been easy to overlook the concept of market cyclicality. Remember that?

For one thing, interest rates have been kept at incredibly low levels ever since the Global Financial Crisis. But alongside this, monetary policy has also been extremely accommodating, culminating in an extraordinary injection of capital during the pandemic.

As a result, it has been relatively easy for individuals to take on debt and service the costs of that debt for years now. Consequently, markets have been able to prosper and valuations have hit extraordinary levels as individuals have secured their stake in the global growth boom en masse.

Now, things are beginning to change in a big way. As mentioned, the tremendous injection of liquidity by central banks during the pandemic has pushed inflation to unsustainable, multi-decade highs in many economies.

As such, those same central banks are now being forced to increase rates in earnest to steer clear of hyperinflation territory. Likewise, institutions such as the Bank of England and the Fed are now moving away from their role as the de facto buyers of corporate debt and even unwinding their recent purchases back into the market.

Macro uncertainty, the likes of which we are currently experiencing, can only hold back the tightening of monetary policy for so long – it is now an inevitability.
And for many, this means a harsh reminder of the fact that markets do not stay in the growth phase indefinitely, and instead cycle through booms, slowdowns, recessions, and recoveries.

After all, the enormous concentration of risk present in markets, due, in part, to the rise of ETFs means the sell-off could be vast when the questioning of sky-high valuations really starts.

Just look at Meta – a bedrock of the modern-day, mega cap tech boom: the Facebook owner recorded the biggest ever daily loss for a US firm in February, slumping more than $230bn after its quarterly figures disappointed investors.

Where to turn

So, what’s the solution? Well, there’s no definitive answer. But where investors were long able to pile into the next big stock and benefit from its unstoppable escalation, the answer could now lie in taking a more demure approach and riding the market cycle until the next growth period begins.

The key here, then, is to shift from thinking about wealth creation and onto wealth preservation.

One multi-asset approach is to establish a large allocation to ultra-low risk “cash plus” investments like floating rate bonds and short duration corporate debt. These can help to take out the volatility presented by wider markets in a portfolio, and can be paired with a smaller allocation to higher risk assets that tend to perform well in times of rising interest rates–such as banks, property, or retailers with strong pricing power–to target an overall return in excess of inflation.

Moving with the times

Clearly, when the market begins to slow and monetary policy begins to tighten, minimising downside risk and preventing capital erosion becomes extremely important. However, many out there stand a very real risk of being caught out by the sudden change in pace after such a long period of euphoric stasis and support that has seen markets thrive.

The key to avoiding this is to move with the market. With central banks the clear focus of the market this week, now is the time to take stock and prepare one’s portfolio allocation for a marked change in dynamics.

Find out more about Church House Investment Management.

By Mark Harris, Head of DFM Solutions, EPIC Investment Partners

Worrying dynamics in the UK pension market have combined with a dearth of products to properly help clients in the decumulation phase.

Pensions are a long-term game but there’s a growing concern about the increasing number of people about to hang up their proverbial savings boots. There are worries about people entering retirement at both ends of the savings spectrum. The UK suffers from a worryingly low average pension pot, meaning many savers will have to make what they’ve squirreled away go further, while those with a larger bank of savings might still be exposing themselves to investments that are too risky for their stage in life.

To compound these issues, there appears to be a dearth of investment products specifically formulated for the decumulation phase, whereby investors begin to use their hard-earned savings to fund their retirement. An ageing population means larger numbers of people are entering retirement every year, making these issues increasingly urgent.

Precious savings

Everyone who saves into a pension works hard to do so, but it’s inescapable that the size of the average UK pension pot raises questions about the quality of life retirees can expect.

According to data from the Financial Conduct Authority, the average UK pension pot sits at around £62,000. This is not an insignificant sum of money, however, with life expectancy rising, it’s not inconceivable that a saver’s pension pot could have to last them 20 years.

That £62,000 only equates to £3,100 per year over that two-decade timeframe. Of course, the state pension (currently £9,339 per year) would bolster this, but probably not enough to provide a comfortable lifestyle.

Research from the Pensions and Lifetime Savings Association has estimated that to live a moderate lifestyle in retirement, a single person in the UK would need an average retirement income of £20,200 by today’s standards. That jumps to £33,000 per annum if you’re looking for an especially comfortable retirement. This gap between the average pot and what is deemed a ‘moderate lifestyle’ is something that an investment strategy needs to address.

Questionable quality

Retirees drawing on their savings don’t have as long as those who are years away from retirement to recoup losses if markets fall, meaning capital preservation is paramount. The chart below shows cumulative drawdown over the last 6 years with four drops below 10% since 2015. If you’re in your retirement, protecting against such periods, whilst drawing consistent income (i.e. without the ability to take riskier equity calls) is crucial.

Cumulative market drawdown – December 2014 – March 2022

Given the average size of pension pots reacting swiftly to protect capital against such periods is paramount

Unfortunately, the quality of many decumulation funds poses a worry, and there are legitimate concerns that if markets come under real stress that these products may not perform as they should.

Looking at the FTSE 100, equities have been a one-way trade since the market bottomed in March 2009, experiencing no real sustained period of stress. Even the Covid-19 drop appears to have been a short blip judging by the rebound in markets, while the bull market in bonds has been even more elongated.

It’s common for risk tolerance to be dialed down as a saver nears retirement, but there’s a potential that funds claiming they are decumulation products still carry too much risk, because returns from equities and bonds have been so easily achieved in the past decade that these asset classes are not treated with the caution they should be.

This is not just a finger-pointing exercise. We’ve putting our money where our mouth is after conducting extensive analysis to understand the specific risk-management needs of the decumulation fund market.

What it told us was that decumulation products should be built to be lowly correlated with traditional asset classes and to tilt more defensively if and when risk indicators are triggered.

Given the UK’s over-75 population is expected to pass six million for the first time this year, and grow by 50 per cent by 2040 to reach nine million in total, there’s a growing need for robust decumulation products for those coming to the end of their savings game.

By Jerry Wharton, CEO, Church House Investment Management

There have been significant losses for some bond investors so far this year and we have been asked how we have protected our holdings from the worst of the volatility in the Church House Tenax Absolute Return Strategies Fund.

We have always been very proactive about protecting our holdings, either through curve positioning (duration), credit quality, or explicit interest rate hedges. This has enabled us to embrace higher yields whilst avoiding the risks to capital values.

Government benchmark yields have indeed risen sharply and holders of too much duration have certainly paid the price. Bear in mind though the opportunities that this readjustment has created.

Only a few months ago, the short end of the Gilt curve was almost negative, now we have two-year Gilts offering a mighty 1.6%. Not that attractive in itself, but when you add a credit spread on top, you are now able to access a fair yield on a total return basis.

There are now a number of quality bonds, issued last year when yields were low, that are trading well below par. Remember that bonds are redeemed at par, 100p. A good example is a green bond issued by Berkeley Homes last year. The proceeds of this issue can only be used for the construction of new housing stock that qualifies for the highest rating of EPC (Energy Performance Certificate). These bonds are currently trading at 87 offering a yield to redemption in nine years’ time of over 4%. Given the current risk-free rate of return, this is a wonderful opportunity.

Another fine example is a sustainable bond from Tesco (well ahead on reducing their carbon footprint since 2015). These five-year instruments are investment grade and pay a coupon of 1.875%. We can buy them at around 93, which therefore gives us a yield of 3%.

The other weapon we have is using AAA-rated floating rate notes. These tend to be of the highest quality, mostly covered bonds secured by residential mortgage loans with loans-to-value of about 45%. The coupons of these bonds refix on a quarterly basis using a spread above SONIA (the LIBOR replacement) and therefore the capital value of these bonds actually increases as interest rates rise, providing a hedge against rising inflation.

At the end of Q1 this year, the Tenax Fund had 34% invested in Sterling corporate bonds with duration of 4.4 and an average yield to redemption of 3.75%. A further 37% was invested in AAA floating rate notes, providing a hedge against inflation, a higher return than cash, and helping to dampen volatility across the fund.

In conclusion, there is no need to sit there and take all the medicine in the way that some bond investors have. Whilst it is not possible to have completely mitigated the downside, we have contained it through judicious curve positioning and interest rate hedges. The opportunities now abound for achieving a decent yield from fixed or floating bonds.

Find out more about Church House Investment Management.

By Sam Liddle, Sales Director, Church House Investment Management

As rising inflation continues to grip markets, investors are looking for ways to protect their portfolios against the potentially damaging effects.

Whether inflation this time around is a short-term issue or something we all need to get used to the foreseeable future, its effect on cumulative returns can be long lasting if or when interest rates continue to rise in line with inflation.

Multi-asset investors, some with cash plus targets, face a dilemma in this scenario – how to beat inflation yet remain true to their investment process.

Do they simply move further up the risk scale increasing the potential of heavy losses if markets go against them? Do they buy ‘expensive defensives’, and at what cost? Do they move to cash or worse, negative-yielding bonds? What about derivatives – can asset managers justify and explain that position to investors who want to understand exactly where and how their cash is invested?

It could be that the investment instruments and tactics that portfolio managers employ to navigate through the potentially rough seas ahead will make all the difference.

No frills to avoid thrills and spills

Take, for example, the humble Floating Rate Note (FRN). “What on earth is a Floating Rate Note?” I hear you ask.

FRNs are debt instruments, typically issued by financial institutions, supranationals (e.g. the European Investment Bank) and governments, and, as the name implies, FRNs differ from other fixed income securities by having a variable (floating) coupon rate.

The coupon on a FRN is re-set every quarter to a specified level over the reference rate such as SONIA (Sterling Overnight Interest Average). When interest rates rise, SONIA, in turn, ratchets up and consequently, the coupons on FRNs increase.

Simply put, as interest rates rise, so does the coupon on FRNs.

They are therefore negatively correlated to, or provide a hedge against, a rise in interest rates, and unlike derivative hedging and structured products, the FRN hedge costs little.

Gilts and other debt instruments, such as investment grade and high yield corporate bonds are positively correlated to interest rate movements so will fall in value when interest rates rise.

For this reason, FRNs make up a significant component of the investment grade bond market and tend to be in high demand when interest rates are expected to increase.

For Absolute Return strategies, aiming for positive returns in excess of cash, FRNs provide a useful hedge against rising interest rates and help moderate volatility. They are also fully liquid so when volatility increases in other asset classes, creating mispricing, fund managers are able to sell FRNs to exploit those opportunities.

After decades of falling interest rates in the UK, the direction of travel might have changed, and rates have started to rise. James Mahon and Jerry Wharton, co-managers of our own Church House Tenax Absolute Return Strategies Fund are clearly placing a lot of faith in FRNs with a 38.3% allocation.

If rates now rise faster and further than most investors and commentators expect, gilts and corporate bonds will become more volatile – FRNs on the other hand will, much like the tortoise in Aesop’s fable, quietly and surreptitiously win the race against the inflation hare.

By Wayne Bishop, King and Shaxson Asset Management

King and Shaxson Asset Management’s sole focus is managing ESG and Impact portfolios. We have been doing so since 2002, long before the terms were first coined.

In the years leading up to the pandemic, interest and assets under management in ESG and Impact products had been growing at a rapid pace. This was fuelled by relative outperformance and client interest; the pandemic’s arrival then provided a perfect catalyst.

The reflation trade in 2021 led to a reversal in this relative outperformance for the first time in 11 years, presenting a window for opponents to criticise ESG and Impact. In particular, they took aim at funds’ exposure to the technology sector. Increased retail interest has added a number of new considerations and risks to the financial adviser’s process. In this article we seek to explain the main risks and considerations advisers need to understand.

Firstly, we need to understand what ESG and Impact investing really means. Put simply, it’s an additional step in the investment process. Non-financial factors, such as those associated with the environment, society or corporate governance are analysed alongside the traditional investment process.

Beyond this, a fund can have Impact considerations, where investments are identified as having a positive and measurable outcome on people or the planet. In many places, these outcomes are supporting solutions linked to the UN Sustainable Development Goals.

The considerations above will define where the product sits on the spectrum of capital (highlighted below).

For more information and details on funds identified in the spectrum of capital, please see our ‘Terminology Buster’ video.

Into the mainstream

No doubt we can attribute some of the growth in ESG and Impact investing to the desire of investors to ‘do good’. However, other factors have played a pivotal role in its growth.

The first is the maturity of sectors associated with ESG and Impact, and with that, its relative out-performance. Many of the technologies, such as renewable energy, electric vehicles, energy efficiency, environmental technology, medical Artificial Intelligence, fintech, and the internet of things have developed in the last 20 years.

The investment universe has grown alongside the growth of the sectors, albeit at a slower pace. Companies that were smaller and riskier some 20 years ago, are now large-cap companies. Other companies have repurposed themselves, or have been spun out of conglomerates to align. All of which have altered the size and structure of the universe.

What cannot be understated as perhaps the most significant factor is the growth in data. This enables the analysis of ESG and Impact factors, which had previously been a laborious process for asset managers. Now there are numerous services run by large rating agencies, providing scoring and supplemental non-financial information. At the same time, many companies today report on ESG or Impact metrics, albeit a process that’s in its infancy and will require further standardisation.

Importantly, it is not only asset managers who get this information. Internet sources and social media enable the underlying investor, who by their nature are more interested in their investments, to access both positive and negative information.

How the data is applied to the investment process is a key factor in investment selection. ESG data is an ever-growing source of information, but most ESG rating agencies process the data to determine an investment’s risk, rather than determine if the company is ‘doing good’. This may appear to be a small nuance in terms, but it is instrumental in the investment selection process.

Two ESG funds may sit alongside each other in terms of their label and risk profile, but have very different holdings as a result of the screen applied. A detailed understanding of how products are screened is essential. Our ethical screening policy explains some of the key areas we look at (click here to read).

This means that, for advisers, there is a risk of a clash between client expectations and the products offered. Understanding both client expectations and looking ‘under the bonnet’ of a product is therefore essential to ensure alignment. Experience has taught us that as clients become more interested, their views change over time. Therefore, this should always be regarded as a dynamic process.

Out of the woodwork

As mentioned, the recent reversal in relative performance for both ESG and Impact has provided a window for a number of critical comments (click here to read our recent comment on technology). Over the past years, we have cautioned about over-egging outperformance. Much of it boils down to lacklustre returns and higher volatility of sectors such as oil and gas, commodities, and large banks.

Whilst we have seen underperformance in the last 12 months, we call the longer-term nature of this into question. High commodity prices eventually lead to alternatives being used. We see high oil and gas prices as speeding up renewables and battery storage take-up. We still see major disruption from technology eroding older industries, from vehicles to finance.

Therefore, many of the longer-term structural trends associated with both ESG and Impact investments remain intact, and as efficiency and cost savings become a priority, we see these trends accelerating, rather than retreating. The much-needed decline in some valuations means that we see recent performance as a healthy correction after the pandemic.

Years of experience has helped us gain a healthy perspective on this sector, trends that come and go and those that stay and grow. As a team managing ESG and Impact portfolios, we are strictly discretionary and do not offer an advisory service. Our focus is helping financial advisers, not being one.

Boasting an 11-year track record, King & Shaxson Asset Management offers 11 model portfolios (Dynamic Planner Risk Profile 3-8), all of which incorporate a stringent negative and positive screen. To find out more and to request an MPS brochure, please click here.

Disclaimer: For Investment Professionals Only. The information contained in this document is for general information purposes only and should not be considered a personal recommendation or specific investment advice. Nothing in this document constitutes an offer to buy or sell securities of any type or should be construed as an offer or the solicitation of an offer to purchase or subscribe or sell any investment or to engage in any other transaction.