This week’s Investment Soundbite Q&A from FundCalibre is with James Mee, Elite Rated manager of the Waverton Multi-Asset Income fund, talking multi-asset investing as well as risk management and the critical topic of inflation.
(Recorded 30 May 2023)
As the core purpose of this fund is all about managing risk, how do you define risk and how do you go about managing it?
We think about risk in two ways. First is underperforming inflation over the time horizon of the fund, or over the time horizon of the ultimate investor, ensuring that a hundred or a thousand pounds invested today, or at our inception nine years ago, is worth at least as much in 10, 20, 30 years’ time, or could buy you as much as it did when it was originally invested.
And then the second way we think about risk is permanent capital loss. So, crystallising a loss or investing in something that perhaps might go to zero. They’re the two key risks as we see them.
In terms of how we manage risk number one – underperforming inflation over the time horizon – we’re invested in equities, we’re invested in real assets – that means property, infrastructure, commodities, specialist lending and finance. And these have an implicit or an explicit inflation linkage. We think that over time we can compound your capital at least in line with, if not ahead of, inflation. And we have a track record of doing that.
And in terms of permanent capital loss, how do we manage this risk? Clearly, we’re a multi-asset fund, so we start with diversification across asset classes, sub-asset classes, currency, sector, style, et cetera. But we also employ hedging strategies that are designed to generate a positive return in negative markets and limit left tail risk.
Could you explain how you use hedging strategies and give an example of an opportunity where you used a strategy that’s paid off?
When it comes to hedging, rather than have a one-to-one relationship with equity markets, for example (so the equity market’s down 10, and hedging is up 10,) what we are looking for is for these positions to be up more like 150.
TO give you a real example of that, we have a proprietary, internally-managed, protection strategy at Waverton: in the worst 14 trading days of Q1 2020, the equity market in sterling terms was down 35% peak to trough – and the protection strategy was up 150%.
We held a credit hedge in the multi-asset income fund, more specifically, a put option on credit risk in Europe. Again, the equity market was down, systemic risk was certainly prevalent and that position was up three and a half thousand percent.
Now we own these positions at the margin in a very small weight. It was a put option on the iTraxx Crossover credit position, it went in in January at a 0.1% position. Over the course of those 14 days, it went up three and a half thousand percent and we were taking profits as it was happening.
So we could go to a market desperately seeking liquidity, and provide liquidity into a market. We can pick up some high quality businesses at a much more attractive valuation given our long-term time horizon.
The fund has an inflation target. Give us your outlook on inflation – how do you go about targeting it?
Given how we think about risk and risk number one being underperforming inflation over the investment time horizon over the medium to long-term, it’s probably unsurprising that we have a CPI + X target for the fund. What we’re trying to achieve through the cycle is CPI +2.5% on the multi-asset income fund which we do by investing across a number of different asset classes
It’s incredibly difficult to predict any individual economic variable over any kind of time horizon. That said, many of the drivers of long-term disinflation, which we’ve seen over the last 30-40 years, we believe may well be shifting. There was a huge introduction of labour or the labour supply increased materially, particularly from China, and particularly after China joined the WTO in the early 2000s. That increase in supply of labour means that there is a depressive effect on the price of labour in developed markets. Essentially wage inflation is flat to zero, certainly in real terms, if not negative in real terms. And that may well be changing.
We talk about globalisation, about the globalisation of supply chains, and we got to a point of just-in-time inventory systems; all of that meant that the cost of goods to the consumer ultimately declined over time. It had a disinflationary impact at the aggregate level. And digitalisation itself had a very similar impact. Today we’re in an environment where possibly we’re going into de-globalisation, with reshoring / nearshoring / friend-shoring which should in and of itself raise the cost of goods sold to businesses, and usually those businesses try to pass those on to the consumer. So, that has an inflationary impact. There is a disaggregation of the inventory systems, as we know.
Geopolitical tensions means that there’s more investment in defence and in energy security, that in and of itself should have an inflationary impact at the national level.
And now we have a demographic headwind, with the working age population actually now in decline. So labour supply is down, lower supply generally means higher prices, and that would include in China, all of which speaks to the inflationary dynamics.
There are two things really that we think will continue to be disinflationary. One is debt. Normally, when you go from a low level of debt to a high level of debt, using debt can have an inflationary impulse. But when you get to a high level of debt, it can be disinflationary in and of itself. For example, if you borrow a hundred pounds today, in round numbers you now have to use four pounds of your income just to service the debt, not even to pay it off and to pay it back. Whereas three years ago, you could have used three of those four pounds to invest in the economy, to spend in the economy which would generate growth.
The second reason is digitalisation. Digitalisation has been a disinflationary force over the last 40 years. We believe that the impact of artificial intelligence, of digitalisation, will, over the long term, have a disinflationary impact as well.
But the best way to respond to those questions is to look at what we’re doing and what we’re invested in. So, in the portfolio, we’ve added to fixed income and we’re adding to duration at 4% yield. So, that should be telling you really that in the medium-term time horizon, we think inflation is going to fall, although it’s not as transitory as we thought it might be. But certainly, we think that that it’s going to fall from the levels that we’re at today, possibly to 2%, possibly below 2% at the headline inflation level. But I would argue that it’s unlikely to stay there in the medium term. I think AI is a structural force. I think digitalisation in general is a structural force, and that will put downward pressure. But certainly, there are some cyclical pressures, labour, supply of labour – particularly in the US – being a very obvious one, that ought to keep that elevated.
Can you give us an example of some of the companies and underlying holdings you have in the portfolio.
We’re currently running 46 – 47% in equities. And one of our largest allocations within equities is in the US. We don’t do that from a benchmark perspective as all of our ideas come from the bottom up. Nonetheless, we find a lot of great ideas. And, CME, the Chicago Mercantile Exchange, is a very good example. So, CME is the largest derivatives exchange in North America. Its products are essentially interest rate swaps, equity futures, options et cetera. And it actually has a pseudo-monopoly on certain contracts which gives it tremendous pricing power over the long-term. It hasn’t used that significantly in its history, but it continues to build pricing power, and we think it certainly has the option of doing so.
Its competitive advantage comes from its scale, and from an inherent network effect, which pulls buyers and sellers into its ecosystem. So, more buyers increases liquidity; increased liquidity attracts more sellers; more sellers attracts increases liquidity and attracts more buyers and so on. It has a sort of virtuous cycle to it, and it’s a very asset light business model. That means that really the focus should be on revenue growth. Revenue growth is key to the growth in free cash flow and is driven essentially by average daily volume growth – and to some extent pricing. The company is investing in its sales to maintain scale advantage and in so doing, it furthers the economics of the network effect. And it’s investing in innovation, so it’s bringing out new products which, in turn, tend to attract more volume.
It’s also reducing the amount of money one would need to invest in each individual contract so, from a hundred thousand dollars, which means you and I probably can’t trade that individually, to a thousand dollars, [which] means we might well be able to if we wanted to.
And we think the business is relatively cheap, certainly versus its own history. We think that it’s got meaningful upside over any reasonable time horizon, which for equities, for us, is five years plus.
Are there any areas in alternatives that you are particularly favouring at the moment?
The majority of our 19 – 20% allocation to alternatives is in real assets. A lot of these are in investment trusts, UK listed investment trusts, many of which have had a really tough time of it, of late. And we think that there’s been some indiscriminate selling. So, one name in particular that we like that we own and that we’ve been adding to is PRS REIT. So PRS REIT builds and rents family homes for the private rental market. Their passing rents are how much they charge the tenant, which is 25% of the tenant’s disposable income, and well below the 35% government target. So, we think that provides some upside to pricing and therefore to revenue growth. And the leases are generally on a one-to-two-year time horizon. Each of those leases comes up every 12 or 24 months. It provides the company an opportunity to raise rents, to raise the cost or to raise the revenue in the face of inflation. There is an implicit link to inflation over time and the weakness in the share price, we think is really inconsistent with the economic backdrop. If you think about it, in a cost-of-living crisis, this is exactly the environment where demand for these sorts of properties really should rise.
Where are you looking for opportunities in fixed income?
I’d say the investment grade area. We currently have 25% allocated to fixed income and we have been de-risking over the last 12-24 months. As we’ve increased our allocation to fixed income, we’ve increased the level of duration that we are carrying, ie. the level of protection, if you like. So, we’ve increased the weight of extended duration, a fair bit in US treasuries, and to some extent in UK gilts. And the way we actually do that in US treasuries, we can either buy the bonds themselves to cash bonds, or we can buy options on the bonds. And we’ve done both; we’ve increased our allocation to the cash bonds, and we’ve bought options on the bonds which provide, again, some convexity in the event that we do see recession, for example, and bond yields come down and bond prices rise.
Listen to the full interview here:
