June 2007

Welcome to the 6th edition of our Financial Connection e-bulletin.

We hope that you enjoy these e-bulletins. If you have any queries, or would like to discuss any of the issues raised with one of our consultants, please call us on 0845 788 9933 and quote EM-4489.

130/30: A multitude of sins and the odd Saint?

A $50bn US industry is on the way over here.

130/30 funds blend the world of long-only investing with the techniques of a long/short equity hedge fund manager. A fund manager will have his usual portfolio of stocks, but now can "short" (sell) with an additional 30% of the fund, and use the proceeds from these sales to create another 30% of purchases. The end result is hoped to be a traditional long-only fund with some extra performance on top, but no change in net market exposure i.e. the end investor is 100% exposed to market movements.

The reality of these funds is that there is more than enough rope for a fund manager to hang himself, if only because a loss from a short position is theoretically unlimited. Shorting is a very different and difficult skill, and many talented fund managers have found this beyond them, when moving into the world of hedge funds. So, as a starting point a sensible investor will want to know that his 130/30 fund manager has a track record of adding value with his short positions.

Once satisfied that your manager has the skill and experience to make the technique work, the next question is, what is the structure of the fund? There are many ways to skin the 130/30 cat. A sensible approach might be to keep the 30/30 element separate from the long only "100" part, and run as a market neutral pairs traded fund. A good manager here, unleveraged, is only likely to be able to add a few percent at best, but this is still worth having as the risk taken is not huge. For example, he might go long of BP and short Shell, and long of Glaxo and short Astra.

But where could these funds go wrong? The chances are, as ever, that this will be in the realm of risk control and portfolio construction. Imagine a Focus fund manager, running a tight list of perhaps 25 holdings in his fund, and intentionally non diversified. He has, perhaps, decided that he thinks the oil price is going down, and in any case does not like BP and Shell. So he has no exposure. In his 130/30 fund, he could go long BP and short Shell, as it doesn't matter if they both fall in value, it is the difference between the two, in a pairs trade, that creates the return, and he might have a strong feeling that Shell will do the worse of the two. However, alternatively, he might decide to further back his conviction by shorting both stocks (by selling them) and reinvesting the proceeds into his best ideas of, say, Cable & Wireless and Next.

Clearly the risk in this instance is that the oil price rises significantly on geopolitical news (or whatever), and Shell and BP shoot up in price. The original portfolio is hurt by being underweight these stocks versus the market and hence badly lags its benchmark index. However, the real damage is done in the short positions where BP and Shell have to be bought back, at a far higher price to that which they were sold at. Consequently, the portfolio, rather than just missing out on a gain, actually has to contend with a large absolute loss, assuming a flat return from Cable & Wireless and Next, neither of which are likely to be beneficiaries of a higher oil price.

Therefore, under these circumstances, the 130/30 fund would under-perform even the underperforming traditional long only fund, and investors would be left wondering whether it is worth the extra risk?

So, the two key factors to these funds are going to be, the manager's track record in shorting stocks, and the way he uses that extra 30% on both sides of the trade. Is it used sensibly to add some extra value, with minimised extra risk, or is it deployed in an aggressive manner with the only guarantee being excess volatility and boom or bust?

In conclusion, 130/30 funds should be a tremendously useful tool for investment professionals in search of increased returns. Nevertheless, they have the potential to carry substantially more risk and more cost. Furthermore, we know that most active managers, on average, under-perform, so the suspicion remains that many 130/30 funds will actually end up returning less than a long only fund, and certainly the benchmark index, with greater risk and cost.

 

 

Andrew Wilson

Head of Investment management

 

UK Equity Income - Fire and Forget, or Evolving Sector?

The UK Equity Income sector has long been popular with both investors and financial advisers. It is not unknown for some advisers to go as far as recommending an equity portfolio predominantly, or even entirely, made up of Equity Income funds.

This could be justified by strong sector performance, and because the Equity Income sector is home to some of the best fund managers in the business, such as Neil Woodford, Bill Mott, and Colin Morton. Furthermore, we all know, if only from the Barclays Equity Gilt Study, that a large slice of take home return from the UK market comes in the form of dividends.

But the investment world rarely stays still for long, and, as the saying goes, you can never step in the same river twice. So, what does the future hold for a sector, which is widely used as a cornerstone of client portfolios?

Well, the first thing to say, controversially, is that the successes of the last ten years are highly unlikely to be repeated. There has been something of a meeting of lay-lines during this period, and without wanting to mangle too many metaphors, there seems little chance of UK Equity Income funds having such a following wind over the next few years.

The reality is that this sector would have been an excellent choice (in hindsight) for an investor ten years ago, almost regardless of the manager or managers selected. Equity Income funds, quite naturally, focus on high yielding stocks. These tend to be cheap, by dividend yield and often other measures, and so fall into the "Value" style of investing. Ten years ago the highest yielding stocks in the market also tended not to be amongst the blue chip mega caps, but were found more often in the mid cap and smaller company areas of the market, areas which went on to perform so well, and where active managers tend to benefit from reduced analytical coverage by major brokers.

As it happens, Value stocks have enjoyed an extraordinarily good run of performance in this period, and, in a happy coincidence, mega cap stocks have underperformed so badly that they are currently priced at a 20 year low relative to the rest of the market. So, the average UK Equity Income fund could hardly have failed - it has been like shooting fish in a barrel.

Now cheap stocks tend to outperform over time, and there is also an observable "small cap effect", so although this outperformance has been unusually pronounced and sustained, apart from a brief spell at the end of the 1990s, it should not have been a total surprise.

Investors in other sectors, styles, and asset classes may now be due their turn in the sun, however. In fact, pure smaller company or value investing would actually have bettered the Equity Income sector over the last ten years in any case, even though it benefited from both those two areas of strength. As an example, the JPM Strategic Value fund, which combines value metrics with other non correlated but still powerful factors, has outperformed the IMA UK Equity Income sector by 50% over the six years to end March 2007. The point being, you didn't have to be in the Equity Income sector to enjoy the benefits of value or smaller company investing, and there are more sophisticated ways to access those exposures, and in a more consistent manner.

However, overall, Equity Income has been amongst the top sectors to be involved in. Not only has it been a leading light of UK investment, but, partially due to the extraordinary strength of sterling, it has also outperformed most international sectors, such as Emerging Markets.

Mean reversion is an observable characteristic of financial markets and the UK Equity Income sector could now be vulnerable. Sterling is surely highly unlikely to continue appreciating at its current rate, while many overseas economies are growing faster and are in much better demographic shape than the UK. The virtual "free lunch" provided by the performance of value stocks in general, and the lack of performance from under-owned (by income funds) blue chips could also be over, and at least a pause for thought might prove worthwhile.

High yielding stocks stopped outperforming over a year ago, while the "small cap effect" is not known to persist at times of a slowing economy, and especially when the valuation differential with mega cap stocks is so extreme. We would never suggest trying to second guess or time the market, but a portfolio "health check" may be no bad thing, as even a diversified portfolio needs rebalancing back to target weights, and on a consistent basis.

Interestingly, the response of the experienced Bill Mott, as he launched his new PSigma Equity Income fund, has been to tilt the fund towards mega cap companies, and those with foreign earnings. Other Equity Income managers have not proved so pragmatic and flexible, and indeed recent work has shown that many funds are now yielding less than the All Share index, which is unlikely to be what their investors would like to hear.

In fact, as high yielding stocks have struggled in recent months, most UK Equity Income funds have held up remarkably well, which does raise the question of what exactly are they invested in? Mid cap M&A targets perhaps?

What is certain is that the UK Equity Income sector is becoming less homogenous, and at a time when returns may be tougher to come by, especially relative to other investment opportunities. Therefore investors will need to understand exactly where their Equity Income funds are investing, and then determine whether they are playing an effective role as part of a balanced and diversified portfolio.

Andrew Wilson

Head of Investment management

Market Commentary - Rolling 12 Month Review: June 2007

Overview

Multi asset class investors have enjoyed a strong 12 months of performance. This has been driven by exceptional returns from most equity markets while Commercial Property has continued to compound up in positive fashion, albeit, at a slightly slower pace than the last few years. Bond markets have been weak though, and therefore have been a drag on multi asset portfolios, especially for lower risk investors versus the more risk tolerant, although they have also suffered less volatility along the way and had more potential capital preservation characteristics (unused portfolio insurance). Also of significance has been the ongoing and surprising strength of sterling, which has temporarily depressed returns from international markets, when converted back into pounds.

Total gross returns should be in the 4.5% to 12% range, depending on the level of risk taken. Ethical investors would have been towards the top end, as these portfolios by necessity avoid some sectors such as Oil and Pharmaceuticals, which have been poor performers over this period. They also tend to have more of a sterling bias, which has been helpful this time. "All Equity" investors had the most returns, as well as the most risk, over the last twelve months, and were looking at between 15% to 16% returns. Many equity indices are now close to, or breaking back through, their old pre bear market highs of 2000. However, this particular bull market is now long in the tooth, and there may be more downside risks for equities.

Equities form a significant part of multi asset class portfolios. The positive performance we are witnessing at the moment has been primarily due to a wave of merger and acquisition activity, as well as private equity bids, which has served as a floor to many markets, and indeed provided an extra leg up to what had appeared to be a tiring bull market. It will be interesting to see how long this phase lasts, as the cost of corporate borrowing should increase as interest rates rise. Furthermore, Private Equity is now paying significantly more for companies than it was back in 2002 and it should be remembered that these companies are now also at peak earnings for the cycle, as opposed to five years ago. Hence, any bargains in the market may well already be long gone, and some private equity investors may yet be disappointed in the years to come.

The best performing markets over the last twelve months have been in Asia and Emerging Markets (Latin America leading the way). The Brazilian and Mexican indices appreciated by 62% and 58% in sterling terms, while the smaller Asian markets were also strong; the Philippines was up 66%, Indonesia 55%, and Malaysia 47%. India gained 48%, while the MSCI China index 56%. It was virtually impossible to select an equity market that fell in value, although some did lag, such as Taiwan and Russia, which crept up by not much more than 5%.

Developed equity markets also made good progress. FTSE All Share appreciated by 22%, the S&P 500 in the US by 23%, and FTSE Europe ex UK by 31% (Germany up an encouraging 37%). The Topix in Japan gained a more sedate 12%. However, these figures are in local currency terms. Once these gains are translated back into sterling, the figure on the S&P 500 falls to 16%, and the Topix suffers worst of all, actually recording a 2% fall, due to the weakness of the yen.

In terms of Industrial sectors, Telecoms was a strong performer across the board, which is not something you could have said many times in the last few years. They outperformed the broader market by 22% in the UK, 26% in the US, and 81% in India. A good example would be Vodafone which was up 55% over the period. Utilities also performed well, as did Industrial stocks which benefited from the ongoing and synchronised growth in the global economy. Technology stocks were global losers, especially in Asia, and investors focused more on the reflation of real assets. As a result, real estate was very much in favour around the world, although real estate shares do seem to have topped out and started rolling over, or at least in the UK, Europe, and US - the same can't be said of China where it continues to be the most profitable sector to invest into (for the time being).

Commercial Property is a crucial element in a multi asset portfolio, particularly when accessed as bricks and mortar as opposed to real estate shares, which tend to be more volatile and correlate more directly with equity markets. Commercial Property has been producing unrepeatably high returns for the last few years, which has driven down the yield on the asset class, although this has been offset a little by increasing rental growth over the last year. Offices continue to outperform, while the Retail sector is still the laggard, in terms of yield and indeed rental growth.

There is less "hot" money entering the asset class now, and performance has slowed down to more sustainable levels. Returns over the last year should still have made (just) double digits, although one would expect this to cool a little further too. The valuation mismatch versus bonds and equities has now been recovered, but property should still continue to compound up decent positive returns (especially where fund managers are adding value via actively managing their stock of properties e.g. refurbishments etc) and remains an excellent diversifier.

Long/Short Equity is used in pension and offshore bond portfolios. Managers here made high single digit returns, on average, over the last twelve months, which is fair performance in absolute terms, although one might have expected a little more given the strength of the markets. This may well be evidence of a growing bearish feeling in the hedge fund community, and a lack of desire to follow the current trends in the market.

All multi asset class portfolios have a material exposure to bonds (fixed interest investments). These can provide valuable portfolio "insurance" during turbulent times in financial markets, and also excellent diversification characteristics. Their insurance element has hardly been required in recent times, although there was evidence that it still exists, when equity markets had a small blip in February, and bonds, conversely, rose in value (as one would expect).

Central banks have been nudging interest rates higher as inflationary expectations rise. As a consequence bond yields have been going up, which is excellent news for new investors, but clearly less positive for existing bond holders. That said, active managers can take a defensive stance in shorter dated issues, which often perform better at such times, while multi asset class investors can at least take comfort that the equity portion of their portfolio is gaining much more ground than the bond element is giving up. We regularly and consistently re-balance the different parts of the portfolio back to target weights, to ensure the correct risk/reward level is maintained.

We are on the verge of seeing 10 year bond yields higher than at anytime since 2002. This does give multi asset class portfolios some "dry powder" and capital appreciation possibilities should there be stress in other parts of the financial markets.

Outlook

The US economy slowed dramatically in the first quarter of 2007, and as one commentator put it "the risks are virtually all to the downside". Alan Greenspan, the ex Chairman of the Federal Reserve has been placing a one-third chance on recession this year. The old cliche is that when Wall Street sneezes everyone else catches a cold, and so there have been serious concerns about the global economy, and whether stock markets can continue to appreciate.

However, there has never been a better chance of international markets de coupling from the US, as Asia and Emerging Markets have been generating their own growth, and indeed now own the vast majority of global currency reserves. They are certainly higher quality these days. Furthermore, although various economies have slowed a bit, corporate news has still been positive. And if that wasn't enough, it does look as though the US will rebound from the first quarter slowdown. Growth prospects in the US now look to have been underestimated, and there has been some evidence of bear investors capitulating; for example the put/call ratio that indicated negative investor sentiment earlier in the year is now describing near euphoria. Whether that euphoria is misplaced is another matter of course, the point here being that investors perceive the economy to be in good shape, the sub prime debacle behind us, and the market likely to go up (perhaps a contrarian signal?). Even US consumers, who have had to contend with rising interest rates and a falling housing market, declare themselves to be of positive sentiment regarding their economic well being.

So, what had appeared to be an end of cycle slowdown or recession, may now turn out to be just a mid cycle pause for breath. In fact, the jury is surely still out on this question and it is only over the summer months that some clarity and direction should return. Certainly it is apparent that investors are still happy to take on risk, in all its investment forms, in their portfolios, not wishing to be left behind by their peers. This has amazed some more fundamental analysts, and it should be remembered that large numbers heading for narrow exits is a recipe for disaster. On that note it is always worth watching when and if the "smart" money (and by that we mean the best hedge fund mangers and investment banks) is getting out of various investment products and themes, and when they are happy to give the last few percent of upside, and all the downside risk, to the likes of retail investors, who are reliably late to most stories. This is less a concern of JS&P Towry Law clients, as we do not attempt to time markets or call tops and bottoms, or rather we don't put our portfolios in harms way should one fail, as routinely one would, by trying to guess the future. We prefer to try and provide consistent returns through most market conditions, and with an eye to limited downside risk and capital preservation.

With so many markets at record highs, and financial and real assets having performed so well for so long, some caution in terms of future expectations might be in order. Corporate earnings are still impressive, but one never knows when these will peak, and valuations are starting to look a little stretched in some areas e.g. UK Mid Cap stocks. The return from commercial property is slowing, while no one knows when bond yields will finally stop rising. At such times it is comforting to be able to construct portfolios based upon the known correlation of asset classes, which should help provide consistency of performance, rather than following a gambler's hunch. This way investors can spread their risk, and, via sophisticated asset allocation software, in a statistically optimal manner. Thereby creating a portfolio for all seasons, and designed to perform over the longer term.

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