The level of noise within markets has increased sharply in recent months and that trend is only going to continue in 2015 as central bank policy begins to diverge and, in the UK, an uncertain election looms.
But, while market chatter heads toward cacophony, the amplitude of the bets Caspar Rock and his team at Architas are willing to take has diminished significantly. “A year ago, we had some quite substantial active positions in the portfolios relative to the strategic model, but over the past year to 18 months, those have been reduced,” the chief investment officer says.
A choice of three
The portfolios in question are the firm’s range of risk-profiled funds. Each rating on the firm’s one through seven risk scale, which is based on long-term volatility, offers the choice of three fund types: completely passive, completely active or a balanced option, which Rock describes as a halfway house between the two.
Rock, along with Sheldon MacDonald and Stephanie Carbonnei aided by a team of researchers, runs the six active and five blended funds-offunds. Allocations into the funds are made relative to a long-term, strategic asset allocation model that is bought in from third-party provider EValue FE every quarter. Currently the funds are slightly overweight equities, and slightly underweight bonds.
“The way we work is that, if we like something, then all the funds willbe overweight. There will, of course, be differences within that in termsof the size or the expression of that view, but what you won’t find is a fund that is underweight that asset class,” Rock explains.
Peer pressure
But, while the group is underweight bonds relative to its model, Rock says, compared to its peer group, it is decidedly less underweight. And it is to this, and two other factors, that Rock believes the firm can attribute its outperformance in the past few months relative to the peer group.“We know we have more duration than our peers so, although we didn’t have as much as a gilt tracker, we had a reasonable amount more than our competitors. The reason for this, Rock says, is that the group was more sanguine
about the prospects for inflation.
“If you wind yourself back a year, everyone was talking about rates going up and inflation going up. We weren’t that concerned about interest rates going up, because if they did so it would only have been by a tiny little bit. So, that led us naturally to have some duration; we couldn’t bring ourselves to be overweight, but we are definitely less underweight than our peers.”
This remains the position because, as Rock explains, even if rates do rise in the UK they are unlikely to be above 1% by the beginning of 2016, which means gilts are unlikely to “massively underperform”.
“Long bonds have a purpose in a portfolio; I can’t bring myself to have none. The question one needs to ask is, are they there because of one’s view on duration or are they there because they are a diversifier?
If equity markets were down 20% next week, I don’t think long bonds would be down, they would be a store of value and provide some diversification.” The second reason for the outperformance last year was the firm’s view on emerging markets. While slightly underweight its model, Rock said, Architas’s risk-rated portfolios were more exposed to emerging markets than their peers.
Architas does not make a call on single countries within the sector, however, preferring to let its chosen managers make such decisions, but the funds in which it has invested tended to be underweight Russia and overweight China, India or both.
Uncertain times
The third differentiating factor was an explicit decision ahead of the Scottish independence referendum
to be underweight sterling assets. “The decision was predicated on geopolitics around the referendum.
We felt it was right as a hedge against a ‘yes’ vote in the referendum, because had that happened all chaos would have ensued. After we got a ‘no’ vote, looking ahead to the UK General Election we saw no reason to change the allocation back to neutral.
“The market will not take kindly to a Labour administration, sterling will be weak, gilts will go up and equities will go down.” That said, portfolios still retain some exposure to the UK market, although
it has shifted the focus somewhat in recent months, taking part of its allocation out of the JO Hambro
UK Equity Income Fund, which has more of a mid-cap bias, and rotated that into more defensively positioned funds like the Woodford Equity Income Fund.
“Those funds are held alongside the Standard Life UK Unconstrained Fund,” Rock adds, “which we have held for the past six years, and has been a phenomenal performer.” As for the rest of its equity exposure, Architas remains overweight US assets and moderately overweight on Europe. But, Rock says, a number of the team, himself included are on the neutral side of overweight. Indeed, having run European equity funds between 1990 and 2001, Rock describes himself as a “battle-hardened,
battle-weary cynic” when it comes to the region.
“Theoretically they are cheap,” he says, acknowledging they are well priced when compared to bonds, but, as he points out, bonds are expensive. From an earnings perspective, Rock acknowledges the view that many companies in Europe are currently producing cyclically low earnings. “But,” he says, “I worry that those sectors will not mean revert to the levels of profitability they had four or five years ago. Are financial companies really going to be allowed to make as much money as they did
four or five years ago? Nope. Are energy companies really going to have a cyclical recovery of the order of magnitude that people are talking about? I am not convinced.”
Healthy scepticism
However, while he is not expecting mean reversion, he does admit there is a mechanical issue that should provide a lift to the region – a weak euro means overseas earnings are better.
As for the ECB’s recently announced quantitative easing programme, Rock remains somewhat sceptical. “Putting it into context, there is already €1.2trn euros of debt that has a negative yield. It is already in selfhelp territory. Will it drive up equity markets? It seems like there is already a lot in the price.”
On Japan, the group is neutral; like Europe, it is theoretically cheap, but there remain concerns. In the US, Architas has kept an overweight position, but Rock says it is significantly smaller than it was at
the beginning of 2014. The decision to taper the US exposure was primarily taken on valuation
grounds. As Rock says, the market is clearly expensive, especially as the strong dollar does feed into lower overseas earnings, which could slow earnings momentum.
That said, he does expect the dollar is likely to remain strong, but acknowledges the long-dollar trade is starting to look decidedly crowded.
Currency focus
However, Rock does believe currencies are going to play a much larger role in portfolios going forward. “Last year I described currencies as ‘the new equity’, the swings in the currency market have been very substantial,” he said “Two or three years ago when we had asset allocation decisions
we would allocate to the market. Now we may decide to take a different decision on the currency.”
Currently, thinking with a sterlingbased hat, the firm’s biggest currency positions are: long dollar and dollar-related assets. It does have some euro and some yen exposure, but quite a lot of the Japanese exposure is still hedged, Rock says, adding it has been tough to find decent eurohedged
funds.
While he does not like commodities much at the moment, describing them as “the ultimate duration asset” because they don’t yield anything, he says the funds have always had exposure to alternatives.
In this space, two things are important. Understanding the underlying driver of return is crucial to knowing whether or not the returns really are going to be uncorrelated and, secondly the yield provided; because then you are being paid to be patient, which provides some succour along
the way.
Managing expectations
Rock believes, now more than ever, it is important to be diversified and to have some duration as a genuine hedge against equities selling off. “You can argue that Europe and Japan are cheap, you can’t argue that the US is so or, if you do, you are making a much more courageous call than you were. Valuations at the moment are just not as obvious as they were. I don’t think returns are going
to be too exciting this year,” he adds.
“Investors should adjust their return expectations and they will struggle to do so. Interest rates are
not going to go back to 4% or 5% any time soon. The level of debt, and the level of economic growth we currently have could not sustain it. Do they get to 1% by year-end? Maybe but it is looking less and less likely.”