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Our views 28 June 2021

JP’s Journal: The influence of benchmarks

5 min read

I was intrigued by a comment made by James Anderson, the manager of Scottish Mortgage Investment Trust – where he referred to the FTSE100 index being representative of a nineteenth century economy rather than a twenty-first century one.

Credit indices are different – they reflect the currency of issuance not the physical location of an exchange. But it does appear that the UK has not developed the ‘world leaders’ to match the US and increasingly Asia, despite our world class universities and entrepreneurial streak. I wonder what role the asset management industry played in this.

Whilst the comments were aimed at equity investments, I think some of the issues are relevant for fixed income. From my perspective I have always pushed back against the malign influence of benchmarks. I have never really understood the mentality that says you can only buy what index creators deem to be part of their (restricted) universe. In credit markets, a small issue size does not imply poor quality. Similarly, a lack of credit rating encourages a lazy response of ‘too risky’ when analysis may confirm the exact opposite. Complexity is frowned upon, even if that complexity works to the advantage of investors. A great example here is Finance For Residential Social Housing: a fixed rate, amortising bond with prepayment potential. The bond is not easily modelled on Bloomberg and is relatively illiquid, with few banks trading. These ‘negatives’ are in fact great positives from my viewpoint: without them our clients would not be able to benefit from robust long-term cashflows, underpinned by over-collateralisation – achievable at a yield above that of many unsecured BBB bonds.

My second observation is that the assessment of performance is too short term. I know that RLAM sterling credit strategies, for example, will underperform at times. However, investment horizons need to be long term. In this I don’t mean three years – but a lot longer. As an example, my performance 2006-2008 was not great, with the financial crisis hitting hard; judged over that period I failed. However, clients remained loyal and we kept to our investment philosophy and judged over a 15-year period our clients have seen the benefits. A question I am rarely asked is: how have your strategies worked over 10 or 20 years? Allied to this is remuneration – I think a City bonus culture focused solely on annual performance is perverse. What I am keen on is that my team benefit from longer term performance of our clients’ portfolios and success in growing our business. This means rewarding teams not individuals and focusing on long-term achievements. 

Liquidity is another scourge of the fixed income asset management world. We are told we need liquidity and that portfolios should be liquid as that is what is expected of fixed income strategies. I think this is rubbish – or at least rubbish as it relates to a lot of our clients. Many of our pension clients are investing for the long term, looking for robust cashflows – they do not need sizeable immediate liquidity. What they want to know is that the cashflows will arrive on time and continue for the lifetime of the bond. It sometimes appears that the fixed income asset management industry has been captured by the banks (whose model is based around trading) and have fallen in line, but I see RLAM as lenders, not traders. If investors want to invest just in liquid assets – buy a liquidity or government bond fund. But remember liquidity is not costless – it represents foregone opportunities.

Cash, government bonds and currencies

As expected, the Bank of England kept the monetary policy stance unchanged last week. The vote wasn’t quite unanimous with Andy Haldane favouring a reduction in the asset purchase target for gilts to £825bn (down from £875bn); that would have had QE ending in August. Overall, the messaging around economic developments was more upbeat: inflation is transitory but will exceed 3% “for a temporary period”.

As recent global growth data has surprised on the upside, the BoE revised up estimates for UK GDP but guidance remained that the MPC did not “intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably”.

10-year US treasury yields moved higher on the week – moving above 1.5%; this was mirrored in most major markets with German yields settling at -0.16% and Italy at 0.85%. In the UK gilt yields moved a bit higher but remained below 0.8%. Real yields also rose with implied inflation generally unmoved.

Generally, strategies are tacking to be short duration, but the magnitude of positions is not great.

Credit

It has been the same theme for several weeks in credit markets: investment grade spreads little change and further compression in high yield markets.

It can be frustrating at times in these markets. As an example, we did a lot of research on Leeward Renewable Energy, a name that we liked following a review of its financials and business position. However, due to strong demand it was priced above what we thought was fair value and we passed on the opportunity. I think it is important to keep to disciplines in these markets.

The coming summer lull will probably mean fewer new issues to look at – and given the market feel it is difficult to see catalysts for widening in spreads. But that is the beauty of markets – you can never take anything for granted.

 

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.