“We had been conservative, I think, for all of 2018 when it came to equity markets. We thought they were relatively expensive. There were only a few markets that we deemed still offered an attractive return on a valuation’s basis. As of this year, that’s changed a little bit.”
Originally based with the First State Investments team in Australia, Harman moved to London to launch the Diversified Growth Fund for the UK market in 2015. Most of the firm’s assets have traditionally been based in Asia Pacific.
“We have similar products in different regions. We have a similar product in Australia, for example, with a longer track record.”
He adds: “The idea is that every time we are considering launching a product somewhere, we consider who the appropriate investors are for it, what the total return is and what constraints we have within that product. A lot of time and effort went into launching this fund, but we’ve come up with a target we think is appropriate for this market.”
The £27m fund takes a top-down approach, generally implemented via headline indices. The fund has a return target of RPI plus 4% over a five-year time horizon and the team distinguishes itself from competitors with a “blank sheet of paper” approach to asset allocation, Harman says.
“It’s about finding the best investments that we can have within the fund at any one point in time to create the portfolio.”
This “neutral asset allocation” aims to capture the beta of the market every six months while dynamic asset allocation extracts alpha, explains investment director Amalia Nuñez (pictured below).
“We believe markets are not completely efficient all the time and opportunities arise in the short term . By short term, we mean 12 months or less,” she says. A quarterly update details changes to the dynamic allocation and, where relevant, the neutral allocation.
‘Anyone that holds global equities inherits some sort of FX exposure’
The latest neutral asset allocation review took place in May with the team exiting the 8% emerging markets local currency bonds position in favour of short-dated gilts, which now account for 35% of the strategic asset allocation. Brexit uncertainty and downward pressure on inflation means the team expects yields could go lower still in the UK.
The previous neutral allocation took place in November 2018, when allocations to UK and global (ex-UK) equities increased from 35% to 50%. US and Australian inflation-linked bond positions were dropped while an allocation to corporate credit was re-introduced via US high yield.
The fund goes long or short in equities, bonds, currency and commodities, although it currently has no exposure to the “particular volatility” in oil, and makes only dynamic allocations to gold as a hedge against volatility.
“It’s interesting with FX because we find some competitors will not talk about it as a return driver, and the reality is that anyone that holds global equities inherits some sort of FX exposure,” states Nuñez.
In the lead up to Brexit, around half of the fund was in foreign currency, but during the run up to the 2017 general election, exposure was very low. Today, all US and European equity exposure is hedged. Around a quarter of the fund is in foreign currency with emerging markets making up the bulk.
“We actually believe the risks are relatively balanced and potentially the benefits of a falling sterling have been captured by currency markets.”
Dialling down duration
One of the biggest shifts in the fund between 2018 and 2019 has been duration, which now sits at 3.2 years compared to around five years at the start of last year, says Harman.
“It’s almost entirely made up of emerging markets duration and a little bit of high yield. At the end of last year, we made the choice to exit all of our long-dated government bond exposure in preference for cash,” he says.
The cash allocation at that point was 7.1% but was reduced during Q1 to 5.5%. Government bonds still account for a large part of the portfolio, representing 44.3% at the end of Q1 2019, albeit reduced from 51.6% at the start of the period.
The dialling down of interest rate sensitivity comes as central banks become more cautious. In January, US Federal Reserve chairman Jerome Powell said the case for hiking rates had weakened as the federal open markets committee held rates at 2.25-2.5%.
“Central banks have been quite dovish, but interest rates have already really reflected that,” Harman says. “Since the beginning of the year, bond yields have risen. US yields are up almost 5bps, so even in a dovish environment you can have bond yields rise. It’s really about how much is already priced into those longer-term government bonds.”
The team’s top-down approach begins with regional economics in the big blocs. Harman says: “Then we dribble down into the larger markets. We stop either at a country or a sector level.”
While the team may not like longer-term interest rates as a whole, it still takes country views. Harman explains further: “For example, we had duration within Europe, Germany and France, and we have the equivalent position on the short side for the US. We’re effectively taking the spread risk between Europe and the US at the moment.”
Direct index exposure over funds
As a rule, the team tends to use headline indices to implement views. “In the UK it would be the FTSE 100 and in the US it would be the S&P 500. Generally large-cap equity markets,” he says.
However, the team prefers to gain long-term index exposure via the underlying securities. “We want the risk/return characteristics of the underlying investments in the most efficient way possible, and that’s going direct.”
There are other advantages too, Harman points out. “Holding a direct asset allows us to have much better stewardship capabilities,” he adds. “It allows us to vote. We disclose all of our voting in real time to the rest of the firm online. It also allows us to effectively do things like carbon foot-printing, and monitor ESG characteristics of the underlying holdings with the fund.”
ETFs have been used in the past to get quick access to a broad range of securities. Harman points to high yield as an example. “There’s over 1,500 names in corporate credit. For us to go out and source those names would take a lot of time.”
Interactive investor communications
In order to keep investors updated about the fund, First State has launched a website called DGF Navigator, which breaks down asset allocation quarter by quarter with forward- looking commentary about why decisions were made.
“It gives you a high-level summary of equities, bonds, currencies and commodities, and then you can also drill down into the country allocations at any point in time and see how that changes,” says Harman.
Brexit would be a good example whereby investors could go back and check the managers’ thinking in the lead up to the event.
“It’s very easy now that you know the outcome to think about what you should have been doing, but at the time there’s a number of considerations there that you needed to step through.”