Equity markets continue their upward march, giving investors good reason to allocate more to stocks. The fact that Donald Trump’s trade tariffs are likely to create a bumpy ride along the way, is prompting the team at Cornelian Asset Managers to take some risk off the table.
When Trump’s rhetoric around tariffs began back in February, Cornelian chief investment officer Hector Kilpatrick and his team thought the ensuing market sell-off was too hasty a reaction because the subsequent risk was not yet at a level that threatened global growth. This view was vindicated when markets bounced back during April and May.
Trump tiff with Trudeau unsettles confidence
That confidence has since taken a hit, with the turning point for Kilpatrick coming in June following the G7 meeting and Trump’s subsequent character assassination of Canadian prime minister Justin Trudeau. After two of the president’s advisers came out in public support of him, Kilpatrick started to think Trump was no longer being advised as he had before.
“Confidence in our previous stance has been shaken by some of the people surrounding Trump,” he says. “I was not anticipating how sycophantic they would be.”
With Trump upping the ante on a trade war, the Cornelian team decided to reduce equities in the portfolio, albeit marginally. The firm’s Progressive Fund, the most aggressive in its risk-managed range, has had a reduction in equities from 92% to 88%, which Kilpatrick says shows the firm is still happy to take risk.
What concerns Kilpatrick most about the trade spat is not the impact of tariffs on the economy, as any effect will likely be localised to certain sectors, but the effect on confidence and investor psychology.
“That could be greater than the actual impact of trade tensions, which is why we have taken risk off the table at the margin.”
According to Kilpatrick, there are still plenty of reasons to be optimistic about equity markets on the belief that the earnings upgrade cycle is going to be better and last longer than most people expect. The rally will be primarily in the US where, buoyed by Trump’s tax cuts, Kilpatrick believes companies will grow investment in capital expenditure and improve productivity in the services and manufacturing sectors.
“We are hearing from companies we meet that the next wave of productivity gains is coming through, helped by the automation of services and industrial processes, artificial intelligence and the internet of things,” he says.
Kilpatrick believes outperforming the US index is difficult and so the team relies on passive strategies and ETFs for exposure to the US, even in its active fund range. The range used to have about two-thirds exposure to ETFs and a third to active managers, but that has been tweaked to around 50/50.
Cornelian’s generalist investment team
Cornelian opts for managers that it believes are good at inflection points and can outperform in both up and down markets. Kilpatrick says both its US managers, Findlay Park and Polar Capital, have “demonstrated excellent performance in all environments”.
“We acknowledge we are in the last third of the bull market and more exposure to active managers is sensible.”
Kilpatrick describes the Cornelian investment team as “generalists”. As CIO, Kilpatrick leads on asset allocation and supports investment director David Appleton on the direct UK equities operation. Senior investment manager Richard Stark leads on fund selection, backed up by Appleton, while Ewan Miller, also a senior investment manager with experience in European small caps, helps across the board, as does investment analyst David Whytock.
“We are a tight team and everyone is involved in discussions and investments across all asset classes,” Kilpatrick says.
The firm’s risk-managed funds have RPI plus targets net of fees over an investment cycle (five to seven years) with the defensive fund targeting RPI plus 1% and the progressive fund, RPI plus 3%.
Passive risk-managed funds
Last year, the firm launched a passive version of its risk-managed funds using passive vehicles to achieve the same asset allocation exposures as its actively managed portfolios.
When it comes to risk management, the team does adhere to an upper volatility limit for all its funds, which it is strict on not breaching, but there is no lower limit.
“If we don’t like the outlook for the market, we can de-risk materially across the board, only stepping back up the risk curve when we are comfortable,” Kilpatrick notes.
An example of this came in Q1 2015, when the team reduced the equity allocation in the Progressive Fund to 66% from lofty highs of around 98%. Kilpatrick says this successfully protected clients’ capital in 2016, when markets were off before the team deemed it appropriate to ramp up exposure.
As a house, Cornelian invests directly in UK equities, treasuries and gilts, and for other asset classes uses third-party expertise.
Kilpatrick believes the firm gets an information advantage by investing directly in UK equities. Having to consider factors such as fear, greed and the profits outlook for companies provides a clearer picture of the risk the team wants to take across all assets.
At the moment, the team does not view the UK as expensive but has avoided the temptation to rotate into domestic cyclicals exposed to the domestic economy. “A lot of these have been challenged by disruption, so we have not felt the need to bottom fish,” says Kilpatrick.
Instead, he favours UK-listed companies with international earnings exposed to the economic upswing, particularly in the US.
European equities shake-up
The team recently reshuffled its European equity exposure after selling out of Alex Darwall’s Jupiter European and John Bennett’s Janus Henderson European Selected Opportunities funds.
Kilpatrick says while Darwall has an excellent track record, the team felt they could not add to the fund because of its concentration risk. The top 10 holdings account for more than 60% of the fund, which leaves it open to liquidity risk.
“We do like him as a manager and respect him highly but felt that the concentration risk was too much.”
In the case of the Janus Henderson fund, Kilpatrick says it has struggled in recent times and had some staff turnover.
European exposure is through the Blackrock European Dynamic Fund, managed by Alister Hibbert, and the Waverton European Capital Growth Fund, managed by Chris Garsten and Charles Glasse, which Cornelian bought recently based on the duo’s track record through inflection points.
Fixed-income exposure has a bias towards short-dated paper because of the popular duration call prevalent in markets and while the portfolios have some exposure to index-linked gilts, the team prefers treasury inflation-protected securities, albeit with a wary eye on currency risk.
Elsewhere, strategic bonds are accessed through the Twentyfour Dynamic Fund and Kilpatrick likes Eric Holt’s Royal London Sterling Extra Yield Bond Fund and the Pimco Global Investment Grade Credit Fund.
Dollar doldrums
The portfolios have been underweight emerging markets for a while on the belief that the region will come under pressure from the likely strengthening of the dollar as the US economy pushes higher.
“If you see China respond to US threats on trade you are likely to see the Chinese currency weaken, which will weaken competitiveness of other emerging market economies and companies trading there. As a result, we have a limited exposure to EM equities and no exposure to EM debt.”
Absolute return is accessed through five funds: BH Global, Highbridge Multi- Strategy, Jupiter Absolute Return, Natixis H2O Multi-Returns and the Invesco Global Targeted Returns Fund.
“Some have performed better than others,” says Kilpatrick. “BH Global is starting to put in some numbers and Highbridge has been tremendous. Jupiter has struggled recently but its value as a diversifying asset in 2015/16 was amply demonstrated, so we are fans of James Clunie.
“The H2O guys take on more risk; it is more like equity market returns but does not correlate to equity markets, so we slice that accordingly across the range. Invesco has struggled recently but we continue to back that management team.”
For Kilpatrick, absolute return is “a critical part of managing downside risk” and he is optimistic the struggling sector will turn things around as central banks reduce their quantitative easing programmes.
“If you can get those calls right then the rest falls into place,” he says. “The real test has been this period of QE where it has been difficult to differentiate and add real value at times. With the US seeking to normalise monetary policy, opportunities will improve to generate alpha in the space and we would expect returns to be better than in the past.”
The allocation to infrastructure, via the International Public Partnerships (IPP) investment trust, was halved in the defensive fund in October last year on the back of the risk of a Corbyn-led government and news on Carillion. However, Kilpatrick says the track record of the asset class in terms of the share price return has been excellent.
The portfolio still holds IPP and used to hold HICL Infrastructure in the Managed Income Fund but it sold out of that completely last October.
