Ahead of the Curve, Tideway’s Portfolio Approach
Tideway Market Update, 22/01/2021
Tideway’s approach to Asset Allocation has differed significantly from the peer group over the years. We thought the start of a new year (close enough) was an appropriate time to reiterate why we have constructed portfolios the way we have, and why we think our approach will compare favourably to the more traditional 60-40 equity fixed income approach that the majority of the market has employed. Furthermore, the last ten years have seen a large increase in investors allocating to passive solutions, with passive fund houses such as Vanguard enjoying large inflows to their strategies as a result. We will also discuss some of the potential risks of investing your retirement savings in these strategies as well.
The most noticeable difference in our approach, from the peer group, is that we have never invested directly in government securities, apart from as a short-term store of cash, instead preferring to invest our fixed income allocation in credit markets where we have received incremental income over government equivalents. There can be no debate that investing in government securities over the last ten years would have been beneficial for any investor, both from a pure return perspective, but also in terms of portfolio hedging with government securities tending to correlate negatively with risk assets (move in the opposite direction) which is useful when markets are selling off. Credit securities have also performed very well over this period but have never enjoyed the same hedging properties that governments have provided, in the recent past anyway. To counteract this, we have held less equities than our peers whilst also being a long-term allocator to alternative investments such as Infrastructure and Global Property.
As you may or may not know from our communications, we enlisted the services of TS Lombard in 2019, who provide macro research and investment strategy analysis to their clients, to help refine our investment process and provide us with the necessary information in order to make the best possible decisions for our clients. TS Lombard have been immensely valuable resource for us, especially in 2020, with unprecedented volatility in markets as a result of Covid-19.
One particular piece of note, and of great interest to ourselves, was presented by Andrea Cicione, in TS Lombard’s recent two-day Macrofest webinar; “The end of 60/40 investing: the new era of asset allocation is here.” The main theme espoused during the presentation was that although 60-40 portfolios have worked well in the previous 40 years, there were certainly no guarantees of the same in the future: After a forty-year bull run in bonds and with Global equities currently trading above their long-term historical average, it is likely that future returns are going to disappoint and therefore to achieve the same returns going forward it would most likely be necessary to take increased risk via equities.
Even more worrying for the 60-40 investor is that in addition to lower forward-looking returns in fixed income, government bonds were also losing their insurance or portfolio hedging properties with correlations trending towards their longer-term positive relationship and would no longer help dampen portfolio volatility in a sell-off. The thesis continues, that although no other asset class has a negative correlation with equities, alternative investments such as gold, real estate and infrastructure would play an important role in portfolio construction going forward.
It was pleasing to see our overriding philosophy towards portfolio construction put so succinctly with evidence to support the various assertions. We therefore feel that we are somewhat ahead of the curve, though we might have benefitted from holding more government bonds historically, when it comes to managing portfolio volatility. As mentioned at the start of this piece, we have no exposure to government securities preferring to invest in Credit markets; Investment Grade, High Yield (at the short-dated end) and Hybrid Capital, a subordinated form of capital which sits below senior debt and above common equity in the capital structure. We have also been quick to embrace investments in the alternatives space with all our multi-asset portfolios having an allocation between 15% and 20%. Currently this includes infrastructure (Legg Mason Clearbridge Global Infrastructure), listed Real Estate (Schroder Global Cities) and private assets including access to renewables and alternative credit (Sanlam High Income Real Return).
Hybrid Capital provides competitive returns from a range of investment grade issuers with an emphasis on regulated businesses, such as utilities, insurers, and banks. Infrastructure provides investment in long term assets with highly regulated stable cashflows providing a high degree of inflation protection as well as a higher-than-average income. For exposure to property, we prefer funds which invest in listed REIT securities rather than direct property, due to the liquidity mismatches in the daily traded open ended fund space. Tideway is always looking at ways to improve risk adjusted returns and are monitoring the alternatives space closely for additional opportunities.
To add to the potential shortcomings of the 60-40 portfolio in addressing investors future investment and retirement needs, low-cost passive strategies have been increasingly been offered as solutions for investors. Leaving aside the majority of the well-trodden active versus passive debate we believe there is one additional major limiting factor in these solutions; we do not believe there is a coherent argument to invest passively in fixed income when you compare the quality of active fixed income strategies at low cost to the investor.
Although we are willing in acknowledge there are arguments for investing passively in equities in certain circumstances, we do not think the same holds for fixed income. We have made these views clear before, but below is a reminder of the key points which Stephen Snowden, lead manager of the Artemis Corporate Bond fund (Investment Grade Credit) which we are invested in, put best. Key reasons summarised below:
– A passive approach is not as effective due to regular bond issuance, investor redemptions, and the need to reinvest cashflow from coupons
– Index eligibility is determined by analyst decisions at the three rating agencies with stock and sector index weightings a function of corporate borrowing needs; those with the most debt have a larger weighting in the index
– The presence of index-based investors creates large valuation dislocations around the investment grade/sub investment grade boundary which can be exploited by active management
– Furthermore, closed ended ETFs trade at a premium or discount which is heavily correlated with the market, they can often trade with a bid to offer spread making them more expensive to buy and sell.
With both government and passive credit securities totalling up to 40% of total portfolio exposure in your traditional 60/40 portfolio, this would seem like a less than ideal solution from where we are sitting, even if total strategy returns have been competitive thus far.
Furthermore, unlike with equity strategies, the cost differential between active and passive is not even that great. The aforementioned Artemis Corporate Bond fund is priced at just 0.40% whilst passive competitors such as the Vanguard Global Bond Index and Vanguard UK Investment Grade Bond Index are priced between 0.12% and 0.15%; an active solution is available for just 0.25% more. See below the 1 year returns courtesy of FE Analytics.
1-year returns to Jan 20th:
Artemis Corporate Bond: 11.06%
Vanguard US Investment Grade Credit hedged: 6.17%
Vanguard UK Investment Grade Bond Index: 5.23%
Although bordering dangerously close to the traditional active versus passive debate we will finish up with a few other points we would be remiss not to highlight concerning passive strategies. As most of you will know US markets have dominated market returns in the recent past with S&P500 delivering exceptional returns for those who were lucky enough to have been invested over any period of time. Upon further analysis, again nothing new to those who have been following events this year, a large proportion of those returns have been driven by just five companies, known in some circles as the ‘S&P 5’ or the ‘Fab Five’ (Apple, Microsoft, Amazon, Google, Facebook) which are now worth roughly one quarter of the entire index according to TS Lombard. With earnings increases no longer explaining the increase in share price (down to multiple expansion) we think it extremely unlikely similar future returns will be achieved by investing in these companies, and as a result the associated indices. Even the more geographically diversified such as the FTSE Developed World, has an allocation of 65% to the US, again meaning your returns are potentially limited if the US and the S&P 5 does not continue to lead returns.
We are of the opinion that 2021 will provide opportunities for and reward the old-fashioned stock picker, especially in areas such as Emerging Markets and smaller companies, where volatility amongst the universe of stocks is higher and less well researched.
To summarise we believe our portfolios are well positioned for the future in comparison to traditional 60-40 strategies, especially those of a passive nature. We hold no government securities and have focused on the Hybrid Capital and alternatives space to help provide diversification to your portfolios. To add to this Tideway portfolios have a higher average yield, both useful for those who need an income in retirement, whilst also providing a buffer for short term expenses and any income needs that you may have without disrupting the portfolio.
Please be aware that past performance should not be taken as a reliable indicator of future performance.
The value of investments, and the income you may receive from them, cannot be guaranteed and may fall as well as rise.
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Tideway Market Update, 08/01/2021