Time to Consider UK Mid-Caps?

Medium sized companies, also referred to as mid-caps have delivered cracking returns in the last five years, outperforming large companies in the UK by a wide margin. Mid-caps you are no doubt aware are typically represented by the FTSE 250 index.  In 2013 commentators suggested valuations of medium sized companies were high after the strong rally and I have avoided recommending mid-cap funds preferring smaller companies. (As an aside I remain positive on the latter with the UK economy recovering well. Smaller companies historically outperform larger companies during the recovery and growth phases but underperform during recessions. Further the lack of research and analyst coverage means good stock-picking fund managers can unearth mispriced gems). However I have recently had a rethink on medium sized companies following comments and information from fund managers, F&C and Neptune Investment Management and I can now see a place for mid-cap funds in portfolios. There are several key arguments that I find compelling:

Fundamentals Are Good

Michael Ulrich, manager of the F&C UK Mid-Cap fund argues evidence in the last 20 years shows mid-caps have grown faster than larger companies, they are more nimble and adaptable and their size does not limit growth. However they are large enough to be dominant in niche markets with a competitive edge difficult to challenge. The new thought for me was that successful companies in the FTSE 250 index eventually get promoted to the FTSE 100 in advance of them getting too big to sustain good growth rates or become too expensive. At the same time the index is refreshed by exciting smaller companies getting promoted from the small cap index.

Mid-Caps Complement Larger Stocks

Another reason to consider medium sized companies is that FTSE 250 companies tend to be more focused on the domestic or consumer economy whilst FTSE 100 companies are global companies with strong overseas earnings. This means the sector weightings in the two indices are different. For example oil majors, miners, banks, telecoms and pharmaceuticals tend to dominate the FTSE 100 index whilst house-builders, industrials and financial services companies are more likely to be found in the FTSE 250. As a result stocks in the two indices are complementary and for many investors the addition of a mid-cap fund will add diversity to a portfolio those UK equity funds are dominated by FTSE 100 companies or indeed a few mega-caps such as Royal Dutch Shell, Vodafone, GlaxoSmithKline and HSBC.

Mergers & Acquisitions

Neptune Investment Management who also run a mid-cap fund argue that mergers and acquisition activity that has been muted in recent years is set to increase and mid-caps could be attractive targets with their strong earnings growth.

Valuations Are Misunderstood

We noted returns on the FTSE 250 have far outstripped those of the FTSE 100 in the last five years, raising concerns about mid-cap valuations. However F&C argue the observation that mid-caps are expensive compared to FTSE 100 companies hides an important point. The relatively poor performance of the FTSE 100 is due to a few mega-cap stocks that dominate it.  The top 20 stocks of the FTSE 100 comprise about 60% of the benchmark by weight.  If you compare the FTSE 250 to the FTSE 100 excluding the top 20 stocks, you find that mid-caps do not look expensive. Mega-caps struggle to grow because of their sheer size – they struggle under a weight of bureaucracy and in the case of the oil majors and pharmaceuticals they are running fast just to maintain their current level of profitability.

In conclusion I see some good reasons to expect the rally in mid-caps to continue.

This blog is intended as a general market commentary and is not an invitation to invest in the areas mentioned. You should seek individual advice before making investment decisions.

Posted in UK Equities, UK Mid-Caps | Comments Off

Beta Jockeys to Fall at the First Hurdle?

Data* cited in an article by Apollo Multi Asset Management show major global stockmarkets for the five years to 31/12/13 have performed strongly with the S&P 500 index up by about 120%. Even the MSCI Emerging Markets Index was up by 95%. This five year period started after the financial crash in 2008 and barring some set-backs, notably the EuroZone crisis, the trend for equities has been up. I guess it has been a classic bull market.

Apollo argue that “Beta” has been a major driver for equities across the globe with general market exposure more important than the companies being owned. To explain Beta. Simply it is a measure of how a fund performs compared to a stockmarket index. If an index, for example the FTSE All Share index rises by 100% and a UK investment fund that is benchmarked against it rises 100% the fund’s Beta is 1.0. If the fund however rises by 120% its Beta will be 1.2% or if by 90%, Beta is 0.9%. Ideally investors would like a Beta in excess of 1.0 when markets rise and a Beta of less than 1.0 when they fall. Unfortunately most funds don’t behave this, so a fund that outperforms the index in a rally tends to underperform the index in a sell off. Peak to trough volatility is higher.

Apollo argue that some fund managers have been Beta jockeys aligning their portfolios with the index to ride the general upward movement of the market. It has been an easy ride with favourable markets generating good headline performance for the fund managers without too much skill. Another term for a Beta jockey is a closet tracker. These are ostensibly actively managed funds but are largely passively invested by hugging the index. At least an ETF or index tracking fund does what it says on the tin.

However a key observation Apollo made is that the average dispersion between stocks i.e. the disparity in returns between companies in an index has been very low. Good and bad companies have seen their share prices rise. Equities have benefitted from a wall of liquidity from quantitative easing (QE). However easy money is now coming to an end and according to Apollo investors are now more discerning in the companies they invest in – good companies will be rewarded for hitting or exceeding expectations and the opposite for bad companies. If this trend continues in 2014 it will become a stockpicker’s market and talented managers comfortable in taking different positions to that of the index should outperform.

Apollo cite research from Cremers & Petajisto 2009 at Yale University on “Active Share.” This is how a fund’s portfolio differs from the index. They concluded those funds with the highest active share outperform their benchmarks and have the highest persistency of returns. However I have not read their paper nor have information over what periods they measured performance. That said it is my observation as previously reported that index tracking funds tend to do well in steadily rising markets for example over the last five years and during the golden period for equities in the 1980s and 1990s. In periods of volatility, especially where markets move sideways active fund management outperforms. Index tracking by definition is set to fail if the index being tracked starts at a certain level and ends at the same value several years later. It is worth being reminded that the FTSE 100 ended the year in 1999 at 6,930 and more than 13 years later the index has continuously traded below this high. An unfortunate investor in a FTSE 100 tracker at the end of 1999 would of course have received dividends and it is also true other index tracking strategies have been more successful including those following the FTSE 250 and various US indices.

Apollo, a specialist multi-asset portfolio fund manager who pick funds rather than stocks for their portfolios conclude that 2014 will not only suit stockpickers but those fund managers who employ long/short equity or fixed interest investment strategies. This permits funds manager to take positions in companies they like and those they don’t and profit from both sides of the trade. With dispersion of returns set to increase it is important to identify those few fund managers with the necessary skill set to outperform the market in general.

Bull markets always come to an end. This one is difficult to call because it started from a very low base after the worst financial crisis since the 1929 Wall Street crash and subsequent depression. The global economy is still very much in the recovery phase, growth is patchy, inflation is muted and QE life support, although in a tapering phase is still supporting the patient. When the bull market ends periods of volatility and sideward movement of indices is likely to be a hurdle that will cause the Beta jockeys to fall.

*Source: Financial Express from 31/12/08 to 31/12/13 in local currency terms, S&P 500 120.85%, MSCI Emerging Markets 95.53%.

This blog is intended as a general market commentary and is not an invitation to invest in the areas mentioned. You should seek individual advice before making investment decisions.

Posted in Index Returns, Index Tracking, Stockmarkets | Comments Off

Global Market Commentary and a Question, is the US Expensive?

February has been a good month for investors. Miners and gold have rallied and the emerging markets’ crisis appears to have abated. There are signs that muted mergers and acquisitions (M&A) is picking up. That said mounting levels of Chinese debt is a systemic risk to the global financial system which is concerning many commentators.

There appears to be almost universal optimism about the UK economy and UK equities although smaller companies are generally well valued after a strong rally in 2013. That said leading fund managers are still confident of unearthing undervalued gems. They exist because this sector of the market is large, diverse and very under-researched.

Sentiment to Europe has improved significantly with some declaring the EuroZone crisis is over. I doubt it, but like many I would not have predicted a few years ago at the height of the crisis that we would reach 2014 without a calamitous break-up of the EuroZone or at least an exit by Greece.

The US had a stellar year in 2013 leading many investors to view the market as expensive and rotate to UK and European equities. This leads me to the most interesting article I read in February by Felix Wintle, manager of the Neptune US Opportunities fund. He argued the prospects for the US market is very bright. At the date of writing on 4/2/14 he noted the S&P 500 had a forward PE ratio of 16, neither cheap or expensive and around the 10 year average. To explain a PE ratio is a standard valuation measure of a stockmarket index or individual stocks. It is calculated by dividing the share price of a company, P, by the earnings per share, E. For example if a company has a share price of £30 and earnings of £2 per share then the PE is 15.

At a level of 16, you would need to buy and hold the index for 16 years before your earnings or dividends recouped your outlay. In the US the chief concern is that the PE ratio has risen without the earnings growth. In other words the price of the market has risen faster than the earnings.

Wintle counters this by stating that markets are forward looking and discount events before they happen. He argues PE expansion is exactly what one should expect before the GDP and earnings recovery happens. He concludes PE expansion is a vote of confidence that markets and companies will be doing better in a year’s time than they are today.*

Another observation Wintle makes is that although the S&P 500, an index that is more representative of the US equity market than the Dow Jones 30, is at an all-time high the previous bubbles in 2000 and 2007 were different. In 2000 the market was driven by a single sector, technology whilst in 2007 it was commodities and credit (banking). The current market rally is much broader with healthcare, consumer discretionary, financials, industrials and staples all performing well. Moreover this advance has been without debt; at the corporate and individual level gearing is at an historic low.

Wintle also notes that the global macro-economic backdrop is better than it has been for seven years and developed markets are rallying together, the first time for 30 years. He considers QE tapering is positive, the outlook for inflation is benign and M&A is beneficial. On this point he argues that US companies are so lean and efficient that acquisitions are additive to earnings immediately. Finally he observes for UK investors a strong dollar will be beneficial to returns.

Aside from the query below I find Wintle’s case pretty compelling and remain positive to the US as part of a diverse portfolio.

*Nerd moment. A forward PE ratio is based on forecast earnings over the next 12 months or the next fiscal period. It is not as reliable as a PE ratio based on the “current” earnings. Technically this means earnings in the last 12 months i.e. trailing or historic earnings.

 If earnings are expected to increase in the future a forward PE is expected to be lower than the current PE. So a forward PE ratio of 16 for the S&P 500 equates to a higher trailing PE ratio today. What puzzles me is Wintle argues earnings will increase in future, but if so a forward PE for the S&P 500 of 16 implies the higher earnings have already been priced in. If they come through then in a year’s time the trailing PE should be same as the forward PE now. I’ll talk to Neptune and hopefully report back.

Hard hat moment. This blog is intended as a general market commentary and is not an invitation to invest in the areas mentioned. You should seek individual advice before making investment decisions.

Posted in Stockmarkets, US | Comments Off

Bonds v Equities – Away Win or Score Draw?

During an unprecedented four week holiday in Lanzarote, enjoying its unique volcanic landscape, tapas bars and restaurants, I largely forgot about work. I guess the plan worked. It was somewhat surreal therefore to return to the world of stockmarkets and investing. I had to remind myself of what asset allocation and an ISA are. Did I really give advice on these in a previous life? However less than a week after my return I was back in the mood having negotiated a ton of post, e-mails, administration and a tricky FCA return. Flipping through investment articles as part of the rebooting process my little grey cells were piqued by an article from Henderson Global Investors (HGI) in one of their investor newsletters, not intended primarily for IFAs. These tend to be pretty basic – that from HGI however deserved some credit for its interesting content.

I would not have expected my first blog of 2014 to have been on bonds but with nothing better to talk about that’s all you are going to get. First some context to my comments on bonds. Whilst there are clear signs of global economic recovery, not least in the UK (no more flat-lining Mr Balls), stockmarkets in January were weighed down by the commencement of tapering of QE – money printing and bond purchases in the US. This has led to repatriation of money from emerging markets to dollar denominated investments. Briefly, a reduction in QE means less bond purchases and hence higher yields or interest rates. This makes dollar denominated US government Treasuries more attractive. The flight of capital from emerging markets triggered a sell-off in equities whilst central banks in South Africa and Turkey raised interest rates sharply to support their currencies which had been in free fall.

Despite these ructions and the potential for any number of other systemic risks to the markets to blow up I sense a generally good mood among investors with equities most definitely being the favoured asset class. Specifically the UK, Europe, smaller companies, miners, Japan have their advocates. I tend to concur despite the headwinds of QE tapering, debt in China and the US debt ceiling. However bonds cannot be discounted and this was the point being made by two leading and respected HGI fixed interest fund managers – Genna Barnard and John Pattullo. They were advocating the benefits of high yield corporate bonds and financial bonds on the basis that companies issuing them were “behaving sensibly,” with lower debt and strong balance sheets. They have not refinanced to aggressively spend on mergers and acquisitions (M&A), special share buybacks or dividends. In conclusion default rates, i.e. the failure of the issuer to make an interest payment or return the principle are likely to remain low.

The relevance of their observations for investors is that high yield and financial bonds remain attractive. Despite economic recovery and growth many commentators consider interest rates, as set by central bankers, will remain low in 2014 and if so high yield will be supported by income hungry investors. As an aside high yield debt is less sensitive to rising interest rates compared to government bonds and investment grade corporates for a number of technical reasons such as their shorter maturities.

Barnard and Pattullo then cited a number of bonds they hold in their portfolios. One from the Automobile Association 9.5% 2019, was yielding 6.2% p.a. at 8/1/14 (Source: Bloomberg). Another bond* from Nationwide Building Society launched in November 2013 with an income yield or coupon of 10.25% p.a. This has rallied and currently yields 8.6% p.a. (also at 8/1/14 from Bloomberg). The reduction in the yield is due to rising bond prices with capital gains for investors who bought at issue.

In conclusion high yield and financial bonds remain attractive for income investors. With 2013 being a good year for this sector, I expect most of the return will come from the coupon rather than capital growth, Combined with the tax free benefits within an ISA, to remind you the 10% tax deducted from dividends from equities is not reclaimable by an ISA fund manager but the 20% tax on interest payments from qualifying bonds is, this could be a good choice for your 2013/14 ISA. Less than two months to go.

*Preferred equity hybrid issue called core capital deferred shares (CCDS)!

This article is intended as general market and investment commentary only and not an invitation to buy specific investments. You should seek individual advice before making investment decisions.

 

Posted in Equities, High Yield Corporate Bonds, Interest Rates, Investing for Income, ISA | Comments Off

What Investors Should Expect in 2014

On one hand judging by what happened in 2013 we should expect the unexpected. This time last year we faced clouds on the horizon – a potential triple dip recession in the UK, a hard landing in China, further crisis in the EuroZone, the fiscal cliff in the US and an unknown outcome of Abenomics in Japan. In the end none of these issues led to financial storms and surprisingly it has turned out to be a pretty good year. Who would have thought the Japanese economy would be emerging out of a deep freeze and the UK would be recovering strongly, so much so that there are fears of a property bubble?

On the other hand there is a known looming threat. I listened to a recent webcast from Old Mutual Global Investors in which four fund managers were asked for their views on the global economy and markets for 2014. The overriding financial issue that concerned them was tapering of Quantitative Easing in the USA. QE through money printing and asset purchases has artificially depressed bond yields by pushing up prices. It is a manipulated market and the consequent rally in bonds and equities has been liquidity driven with easy money, rather than determined from fundamentals of economic growth and company earnings.

Now there are signs of economic recovery in the US and other parts of the world, QE needs to be turned off to allow bond markets to return to normal. However if QE is not gradually reduced with clear forward guidance there could be a sharp sell-off in the bond market. We had a sign of this in late May after Ben Benanke, Chairman of the US Federal Reserve stated tapering of QE could begin shortly. Bond yields shot up and capital exited emerging markets. Mortgage rates rose in the US and demand for home loans fell, threatening the consumer economy. Equities fell over the summer but in developed markets they have since rallied. In contrast bond yields remain above their pre-Benanke sell off levels.

So what could happen? If QE is tapered in a controlled and pre-determined way, for example if it is reduced from the current $85 billion per month by $5 billion p.m. for 17 months markets might react well. Bond yields would rise steadily but equities could still do well. If markets react badly to QE tapering a sharp bond sell off would drag equities down as well. As Stewart Cowley, leading bond fund manager at Old Mutual observed – bonds are the senior asset class. One reason here is the size of the global bond market is larger than the equity market. How QE tapering is handled by the Federal Reserve is the crucial issue in the first half of 2014, as is the US debt ceiling, which like the proverbial can keeps getting kicked down the road.

In Europe the French economy is a source of worry and Italy is also a concern with the third largest bond market in the world. The EuroZone was quiet in 2013, perhaps not in 2014. I don’t think the crisis is over yet.

Looking beyond these early 2014 events in the longer term asset prices should be determined by fundamentals. It is somewhat ironic that in May markets reacted badly to suggestions of tapering of QE, when clearly withdrawal of life support means the patient is making a recovery. With such a mind-set good economic data is perversely greeted by investors with fear, that QE tapering will commence sooner than expected.

So what do I conclude. If there is a sharp sell-off, bonds and equities will move down in tandem. However markets should subsequently return to fundamentals and unless the sell-off in assets leads to another serious financial crisis or global recession, equities should rally and do well in the medium term on the back of global economic recovery. Equities remain my favoured asset class for capital growth and income growth whilst bonds should be avoided except for investors needing a high income.

Due to my trip in January this will be the last investment blog until at least February.  I wish you a very happy Christmas and all the best for 2014.

This blog is intended to be a general investment commentary only. You should seek individual financial advice before making investment decisions.

Posted in Quantitative Easing, Review of the Year | Comments Off

Prospects for UK Inflation

The prospects for UK inflation has divided investors but I have held the view for several years now that inflation will surprise on the upside. Opponents point to the muted effect on inflation from QE and slow economic recovery from the worst global financial crisis and recession in living memory. Governments, companies and individuals have been paying off debt and storing cash rather than spending. So it was with interest that I read an article on UK inflation from Ben Lord, co-manager of the M&G UK Inflation Linked Corporate Bond fund. Some of my clients hold this investment and other inflation linked funds. The main points of this article can be summarised under the following headings:

Five years of sticky cost-push inflation

 Uniquely the UK inflation rate in the last five years has been “sticky” despite the very deep recession. It has been above the Bank of England’s CPI (Consumer Prices Index) inflation target of 2%, in conditions where deflation might have been expected. The cause of inflation has been household cost increases in energy and food. Moreover the National Audit Office recently predicted consumers face 17 years of above inflation price increases for gas, electricity and water to fund new infrastructure. To this we could add rising rail fares and rents.

Another contributor has been Sterling weakness, which makes imports more expensive. According to M&G Sterling has lost around 20% against the Euro and US Dollar since 2007. This effect on inflation has been exacerbated by the UK’s current account deficit. This means we import more than we export.

Time for demand-pull inflation?

M&G argue weak consumer demand, notably discretionary spending has kept inflation down in recent years. However Ben Lord believes we could face a demand shock to add to the cost pressures from essentials such as energy and food. This would come from the recent UK economic revival which has been stronger than anticipated whilst growth has been in manufacturing and construction not just services. The rally in UK house prices will further increase consumer confidence and hence encourage spending.

Central Bank Policy

The unprecedented printing of cash by central banks since 2007 is described by Ben Lord as an experiment where no-one truly understands the consequences. The expectation of higher inflation from Quantitative Easing (QE) has not materialised as banks have been hoarding the money they have received rather than lending it to businesses. An increase in bank lending could be inflationary.

Another key point is that the Bank of England is primarily concerned with securing growth in the economy rather than controlling inflation. In fact inflation might be viewed as a relatively painless way to reduce public debt and Lord thinks interest rates will stay low for some time.

Conclusion

Lord concludes the gilt market continues to underestimate future inflationary pressures by under valuing index linked bonds. The difference in yields between index linked gilts and comparable fixed interest bonds is used to determine what the market is pricing a breakeven inflation rate, as measured by RPI (Retail Prices Index) to be. This market rate is just 2.9% over the next five years whereas RPI has averaged 3.7% over the last three. Index linked bonds pay a real return in excess of RPI rather than CPI. The former includes housing costs such as mortgage interest. Normally RPI exceeds CPI and Lord thinks the gap will increase.

To finish Ben Lord reckons index linked bonds which provides a hedge against inflation provides cheap protection at this point in time. Inflationary expectations can increase rapidly and such protection could be considerably more expensive in the future if the market re-rates index linked gilts.

I conclude there is a case for investors to add inflation linked investments to portfolios especially where there is none. If inflation rises and the RPI increases at a faster rate than CPI, index linked gilts and corporate bonds should rally. Conversely inflation will be negative for fixed rate bonds and index linked holdings will provide a hedge against capital losses.

This blog is intended to be a general investment commentary only. You should seek individual financial advice before making investment decisions.

Posted in Gilts, Inflation, Quantitative Easing | Comments Off

Will Downbeat Sectors Re-Rate?

A notable feature in the investment markets in the last year or two has been the significant differential performance of various equity sectors. A recent example of this was highlighted for me in a report to clients holding specialist funds. The one year returns to 1/11/13 (Source: Morningstar) were:

Baring German Growth                             38.0%

Blackrock Gold & General                       -43.5%

JP Morgan Natural Resources                -18.8%

Jupiter International Financials              33.7%.

These returns reflect the significant improvement in financial stability of the EuroZone including the stronger banking sector and the dire performance of miners and commodities companies.

Commodities companies and miners are highly economically sensitive notably to the health of the global economy and emerging markets. For example China is a titan consumer and Brazil and Russia are key producers. Aside from slower economic growth, in risk off markets capital flows out of emerging markets into safe havens. The poor investor sentiment to commodities and emerging market is clearly linked. In contrast equity markets in developed economies of the US, UK, Europe and Japan have rallied sharply in the last year fuelled by Quantitative Easing, money printing and asset purchases in the US and Japan.

Another factor why commodity companies such as miners have done badly is poor management and allocation of capital. For example acquisitions may have been overpriced with unforeseen costs or there were over optimistic forecasts on returns. Finally there have been rising production costs in some sectors of the commodities market and a build-up of inventory.

If there is one abiding observation I have made over the years as an investment adviser it is this. Downbeat sectors invariably re-rate, especially if the underlying fundamentals are sound. For some time I have expected a re-rating of both commodities and emerging markets. For clients with funds showing losses I have advised retention, for others it has been appropriate to make additional purchases at low prices for example using monthly savings plans. So this week I received a couple of interesting communications on this subject. The first was from Neptune Fund Managers who run a Russia and Greater Russia fund. The manager Robin Geffen described Russia as an unloved misunderstood opportunity. On a valuation basis Russian equities are incredibly cheap and on a fundamental basis there is much to be optimistic about. Russia has one of the biggest current account surpluses in emerging markets. A nation’s current account principally is the difference between its export and imports; the UK’s is in deficit. Russia has a low debt to GDP ratio  of 11%, down from 60% in 2000; the UK’s was as high as 88.7% in 2012, and the government is taking steps to make Russia more competitive in starting and running a business. Finally a new law requires state owned enterprises to pay out 25% of net income to shareholders. This dividend culture has fed through to private companies and according to Neptune the MSCI Russia Index increased dividends by 76% in 2012.

Although Russia has been considered an economy built on the energy market interestingly the Neptune Russia and Greater Russia fund also has an infrastructure and domestic focus with consumer staples being a key sector. This is predicated on rising consumer spending power.

The second report was from ETF Securities a leading provider of Exchange Traded Commodities (ETCs). They expect on current trends, 2014 is shaping up to be a better year for this laggard asset class. China’s adjustment from 10%-12% GDP growth rates to more sustainable 7%-8% growth rates is now largely factored into markets and believe prices have largely adjusted to expected increases in the supply of a number of commodities. ETF Securities view is that markets are underestimating developed economy central banks’ bias towards supporting growth and believe monetary policy will remain more accommodative than markets currently expect. Healthy demand growth in the US and China, the world’s two largest commodity consumers, combined with continued ample liquidity, should support commodity prices in 2014.

In conclusion there is a case to expect re-rating of both commodities and emerging markets. That said I had been expecting a pick up earlier and tactical investments advised for some clients in 2012 and early 2013 are in the red. For contrarian investors, with sentiment being poor it may be appropriate to consider selective investment in downbeat sectors. At the very least existing funds should be held.

These blogs are intended to be general investment commentaries only. You should seek individual financial advice before making investment decisions.

 

Posted in Commodities, Emerging Markets | Comments Off

Neil Woodford to Leave Invesco Perpetual

A bolt out of the blue was announced last week that shook the investment community – after 25 years Neil Woodford is leaving Invesco Perpetual at the end of April 2014 to set up his own fund management group. As you may be aware Woodford has proved to be one of the most successful UK equity fund managers. Famously a contrarian he avoided technology stocks like the plague during the dot com bubble in the late 1980s and nearly lost his job in the process.  His flagship Income and High Income funds (both in the IMA* UK Equity Income sector) have delivered excellent returns for long term investors whilst he also managed the equity tranches of the highly successful mixed asset Distribution and Monthly Income Plus funds.

Invesco Perpetual have appointed experienced replacement fund managers to run Neil’s funds. For example Mark Barnett has been with the company for 17 years, has worked extensively with Woodford and is similarly a value** investor.  He runs the successful Strategic Income fund which incidentally has outperformed the Income and High Income funds over one, three and five years (Source: Morningstar to 4/10/13). That said the High Income fund is a monster with nearly £14 billion invested whereas the Strategic Income fund is a more much nimble and manageable creature with just £285 million. Following Woodford’s footsteps will not be easy and time will tell how the new fund managers will fare.

*Investment Management Association, which groups funds with similar mandates

 **Value investing means identifying stocks whose intrinsic value is not recognised by the market.

 

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Is Ethical Investment Worth It? – Part Deux

In my first post on ethical investment I explained the difference between light green and dark green funds and how the former developed to help obviate a problem with a highly restricted investment universe, poor performance. The latter is entirely predictable given strict ethical criteria rule out large sectors of the market. For example dark green funds avoid tobacco and pharmaceutical stocks which are defensive sectors with stable cash flows and largely recession proof businesses. In a downturn SRI or ethical funds (these terms are used interchangeably here) underperform without exposure to these sectors and with their high exposure to smaller companies. The latter are particularly vulnerable in recessions – riskier investments are sold off, markets for smaller company shares may become illiquid, credit is harder to access and smaller companies are less diverse than larger companies and conglomerates. For example during the financial crisis of 2007 and 2008 and subsequent recession many SRI funds underperformed. The environmental sector was particularly hard hit as those of you who held funds such as the Jupiter Ecology or the Impax Environmental Markets investment trust will know. One factor here was government subsidies for green industries was no longer a priority.

Over many years of advising clients wanting ethical investments I have to admit performance has typically been patchy and sometimes downright disappointing. It is fair to say that I would never recommend an ethical fund to an investor with no ethical restrictions. This is because there are simply better alternative funds outside the limited SRI universe, in terms of potential performance and investment credentials of the fund management. In other words in my opinion the choice of ethical investment necessitates accepting a compromise in terms of performance. This is to be expected SRI fund managers are invariably fighting with one hand tied behind their back compared to their unrestricted peers.

Despite this something remarkable has been happening recently; ethical investments have delivered excellent returns compared to their peers. The outstanding example is the Kames Ethical Cautious Managed fund is the IMA Mixed Investment 20-60% shares. Over the last year to 4/10/13 it was the 5th best fund out of 145 funds whilst over three years it was the best fund out of 127 funds (Source: Morningstar, and for all subsequent performance data). The Jupiter Ecology was 26th best IMA Global fund out of 240 peers over the last year and Standard Life UK Ethical an IMA All Companies fund was 59th out of 267 over the same period. So what has been happening? In the same way that avoidance of certain sectors can harm performance as noted above, the reverse can be true as well. Ethical and SRI funds have avoided miners and commodity companies which have been hammered in recent years. In addition since the Mario Draghi* speech in July 2012 that the ECB* would do whatever it takes to protect the Euro, “risk on” sentiment has generally prevailed leading to a rally in equities, notably smaller companies. Finally the environmental sector has come back into favour and stocks have risen sharply.

In summary the same factors that led to ethical funds crashing as explained in the first paragraph are the very same that have led to the rally. In short SRI funds are volatile doing well during rallies and less so during recession compared to their unrestricted peers. To use a bit of investment jargon they are expected to have a high Beta. If a fund rises or falls by the same amount as the index or market it is said to have a Beta of 1. If a fund rises by 10% more or less than the index or market it has a Beta of 1.1.

To conclude on the question I raised “Is ethical investment worth it?” I would say yes if you wish to make money with a clear conscience and are happy to accept higher volatility but no if potential performance is your highest objective.

*President of the European Central Bank (ECB)

 

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Is Ethical Investment Worth It?

This long overdue blog post really should be broken down into two questions. Is it worth it from an ethical perspective and is it worth it from an investment perspective? I’ll comment on these points in two separate articles; this one is on the ethical considerations.

Many of my clients opt to include ethical funds or socially responsible investments (SRI) in their portfolios either partially or exclusively. They want to make money with a clear conscience by avoiding business sectors or activities they disapprove of such as tobacco producers, arms manufacturers, trade with oppressive regime or animal testing. However ethical funds also select companies that make a positive contribution to society including the environment or third world working practices, which is attractive to some investors. The environmental sector includes waste management and alternative energy companies.

From an ethical perspective it important to note that traditionally SRI funds are “dark green” with a strong emphasis on the negatives, the sectors and activities they avoid. This mean key sections of the economy are excluded from their investment universe. Aside from the obvious “sin” stocks, oil majors may be excluded due to their environmental impact as well as pharmaceuticals if they engage in animal testing. From an investment perspective SRI funds are competing with unrestricted investments with one hand tied behind their backs. They typically underperform when markets are turbulent and defensive stocks such as tobacco companies and pharmaceuticals are favoured. In addition many ethical funds are weighted towards small and medium sized companies because larger companies including global mega caps and conglomerates have diverse business activities some of which do not meet the SRI criteria. This adds risk.

In recent years the investment issues highlighted above have been a key factor in the trend towards “light green” funds which have less emphasis on the exclusions and more on the positives, the environmental sector and shareholder engagement. The latter is where the manager of the SRI fund as a shareholder seeks to engage with the management of the companies he or she holds to influence their ethical practices. This suggests the shift is marketing driven to attract more investors. Clearly light green funds are much more inclusive which means a wider investment universe. It goes some way to dealing with the restrictions and drag on investment performance of dark green funds but it does lead to odd outcomes. A light green fund may include a pharmaceutical company if it tests human medicines on animals but not cosmetics whereas a dark green fund will avoid the stock completely. Other stocks excluded by dark green funds are included in light green funds by being the best in class, (cynically the least worst of a dodgy sector) or where the ethical good of a company outweighs its more dubious activities.

In summary, reading the ethical criteria of a dark green fund sounds a bit like the 10 commandments; “Thou shall not invest in…” whereas that for a light green fund is full of modern crafted corporate newspeak with lots of use of the word sustainable and responsible thrown in. Sustainable incidentally is one of my most disliked words – chuck in the word sustainable and the policy becomes instantly justified. Setting aside the cynic in me the key point for investors with an interest in ethical investment is to ask yourself what concerns you most and whether a light green or dark green fund is likely to suit best. Interestingly virtually all my clients with SRI requirements do not have special or single interests; it is more about a general avoidance of unethical investments or environmental concerns. One of my clients however has a specific requirement to avoid companies that engage in animal testing, meaning many ethical funds do not qualify. In conclusion you should be clear on what you are looking for if ethical investment interests you.

Next time the focus will be on investment and performance issues.

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