What can the last six months teach us?
A rising tide floats all swimmers, but it’s only when the tide goes out that you can see who is wearing a swimming costume. Markets that consistently trend upwards – which they mostly do – make most investors look smart. It generally requires the shock of a bear market to embarrass those who lack a robust investment process.
Heightened volatility offers trustees and asset owners much greater insight into the quality of their investment managers. With markets having recovered virtually all their ground after the collapse witnessed in February and March, this summer is an excellent moment to reflect on what has and hasn’t worked well.
Moreover, we have always found that the best preparation for the next bear market is carried out immediately after the one. Memories are fresh with what can go wrong and not dulled by the ease of making money. High portfolio values today mean we are still looking back on a decade of exceptional returns; any changes can be made from a position of strength.
This article considers issues that we suspect investors will be seeking answers to, with a view to enhancing the resilience of their portfolios over the years ahead.
Performance and style bias
We have always thought it important that investors have the ‘measure’ of their manager. Understanding the style they are practising can go a long way to explaining whether you should be happy, frustrated or simply accepting of how they have performed.
When markets have been trending in one direction for some time, certain types of manager look better than others. This might well be the result of a style bias that has overshadowed everything else. If that style is baked into their DNA it will almost certainly drive similar performance in the future. When you look back at the last decade, are you pleased with the overall result? Is the shape of the performance as you expected, or have you learned things that might make you reconsider your manager?
If 70% is a relatively common strategic equity allocation within long-term, multi asset portfolios, those glass-half-full managers who held 80% or more in equities and other risk-facing assets like private equity will have fared extremely well up until February this year. At that point, they probably produced some of the worst results. While on this occasion, markets appear to have performed a rapid ‘V-shaped’ recovery, might the next bear-market be more of a ‘U’ than a ‘V’? How will your trustees feel about nursing above average losses? Perma-bulls can produce attractive results for long periods, but their clients need to ensure they can withstand above-average losses when bear markets surprise them.
Or perhaps you are invested with a glass-half-empty type, concerned that a collapse in confidence lies around every corner? Managers who held 60% or less in equities and other risk assets will have produced more pedestrian returns until the first quarter of 2020 when they will have looked heroic, rebuilding their performance to creditable levels. Were they tactically right, or is their approach a bit like a broken clock: correct once every 12 hours, or 10 years? These perma-bears need a savage bear market once every five years in order for their long-term results to match the perma-bulls. Is that regularity and magnitude of setback likely?
Lastly, your manager might be less style-biased than either of the above examples, relying heavily on constant diversification and active stock selection to see them through good and bad times. These managers need to prove their worth across the investment cycle and will hope to have the most consistent long-term records.
Each of the four styles we have outlined can be practised well or poorly and the one that suits you will depend on your own personality and perception of risk: there is no single best approach. However, it is important to have the measure of your manager and if the past few years have surprised you or suggested you don’t own what you thought you had bought, then a review is probably the route to long-term happiness.
Ethics, responsible investment, stewardship and sustainability
We are often asked whether ethical constraints and/or positive screening enhance or detract from performance. The first six months of this year have added fuel to the fire, in so much as portfolios with high ethical and ESG standards have typically outperformed their unconstrained brethren significantly. Unhelpfully, the long-term data points in both directions. The reason for such a fog of information is because the issues are complex and the truth cannot be neatly packaged up into a simple good or bad answer.
Our goal has always been to educate, debunk the myths and help investors find the approach that suits their circumstances. We typically break the answer to this question into two parts:
Negative screening: by restricting investment in the classic ‘sin’ sectors you exclude less than c.7% of a world equity index. There have certainly been and will continue to be periods when these sectors perform differently to the indices. But over the medium term, we would suggest that performance will be more influenced by who you appoint and what they own and not what you have instructed your manager to avoid. Looking back over the last 25 years, one can find excellent and dreadful funds with no exclusions and excellent and dreadful unconstrained funds. Focusing on how an ethical index has performed relative to one screening out 5-10% of the universe probably only matters if you are thinking of passive implementation. Our guidance on ethical screening (unless it results in more than 10% of indices being excluded) is simple: avoid what your organisation needs to avoid and then spend much more time focusing on finding an active and responsible manager.
Positive screening: there is increasing evidence across the investment industry that portfolios made up of stocks with strong ESG (Environmental, Social and Governance) credentials outperform those that are managed less responsibly. This has become an area of increased focus for Sarasin & Partners: whilst we have managed portfolios with ethical exclusions for over thirty years, it is only in the last decade that we have added significant resources to our positive screening activities. Firstly, to ensure that all three of E, S and G are embedded in our research function and secondly, so we can engage positively with companies when things need changing. Over the past five years, we have made waves over and above company-specific activities with our policy work, partnering with a range of organisations to push for laws and standards to be changed where we feel it will protect and add value to our clients’ assets. We can see that this has enhanced our performance and would encourage all investors to think about how strong ESG principles can enhance performance.
One final thought: the portfolios of clients who ask us to apply negative screens and those who allow us to operate in an unconstrained manner are more closely aligned than they have ever been. We will see how this develops, but for the moment, our focus on being good stewards of our clients’ assets, investing in a responsible and sustainable manner, seems to increasingly lead us to the same companies and assets.
‘UK vs Global’ and the ‘will higher yielding value stocks continue to underperform’ debates
One of the biggest differentiators over the past six months and five years between fund managers is their allocation to UK equities. Fully global managers and those who carry a small bias to their home market will have fared best, while those carrying 40-50% allocations to UK equities will be at the bottom. Despite the UK stock market’s very poor relative performance over 1, 5 and 10 years, we remain committed to a more global approach. We can see pockets of value in the UK and continue to like corporate governance standards. However, while owning some income-oriented stocks that pay dividends in sterling is a useful part of a diversified portfolio, we fear that those with high UK allocations will continue to miss out on increasingly rare, genuine growth opportunities.
In the same vein, while we would be the first to acknowledge that Sarasin & Partners places a high value on sustainable sources of income, we do not seek out income at any cost. We recognise that many higher yielding stocks are businesses in and thus value traps. It will continue to be important for investors to own enough of the newer, often lower yielding growth sectors and occasionally, assets classes like gold.
Managers who strive for higher yields with large allocations to UK equities have performed poorly in the bear market of 2020 and the bull market that preceded it. While it probably feels unpalatable to lock in underperformance, we would suggest these are not trends we will see the end of any time soon.
Service and strategy: were you well-prepared for the volatility witnessed in 2020?
Has your manager maintained or even enhanced your confidence in them during the crisis? Have they stayed calm and ensured you are kept abreast of prevailing conditions, ensuring that your strategy remains in keeping with your objectives? The lockdown will almost certainly have changed how you stay in touch with your portfolio; the best managers have stepped forward and embraced the challenge. Thanks to technology, no investor should have felt underinformed during this crisis.
The strategic investment skills and services offered by the best investment managers should also have proven their worth. These softer elements go a long way to ensuring the journey through volatile markets is as comfortable as possible. These skills are often more predictable than short-term, tactical investment performance. Ultimately, given strategic asset allocation is the key driver of returns and should ensure you are never surprised by performance or forced to sell at the bottom, 2020 is a good moment to consider whether the strategy devised by your manager has delivered.
Drawing all of this together, we would never recommend a hasty knee-jerk reaction to short-term performance or service issues. However, savage bear markets typically stress-test weaker performers beyond their clients’ limits.
In conclusion, bear markets are best prepared for well in advance. Any manager changes you make over the coming months should be viewed as the first steps in preparing for the next bear market, hopefully well in advance of it striking.