Whilst the headline indices held up in 2015, the drivers behind the US equity market have been weakening for sometime. (more…)

Value Ranking for Government Bonds

The above chart, which is sourced from the Bank Credit Analyst, depicts the deviation from mean real yields since 1980 for the world’s major government bond markets.

The picture it paints is stark: with a very few exceptions, the valuation of most bond markets stand at more than one standard deviation from long term norms. Some bond markets are approaching or have exceeded two times normal levels.

For the kind of new normal described by these valuations to prevail, something definitive and long lasting has to have taken place with regards to inflation.

We continue to be of the view that greatest risk facing markets is that either growth or inflation surprises to the upside. Bond markets, inflated by non-price sentive buyers, are now priced for only one environment: pervading disinflation.

Within global equity markets, April saw value style indices outperform growth style indices. The relative return of one style versus the other would not typically be a significant event and the relative outperformance was just 1% according to the Russell Global Style Indices. However, the prolonged period of underperformance of the value style versus growth (a 5% difference over the last year and a 37% difference since 2005) and the associated headwind for equity investors with pronounced value style bias means that observers are in a mood to call for a change in trend.

Can we observe a similar pattern in active manager universe data? For reliable style universe data we look to the Morningstar US large cap value and growth peer groups. The median value manager has underperformed the value and broad market indices over the last five years while outperforming over one and three months. Meanwhile the median growth manager has lagged the growth and broad market indices over the last month after a prolonged period of outperformance over the broad index (the median growth manager rarely outpaces the growth index).

So perhaps we are onto something? It is important to remember that a value style index is a naively implemented strategy which will typically have high allocations to companies which are optically cheap on asset and earnings multiples. There is also a tendency for value style indices to hold high weights in cyclical industries when trailing multiples suggest value, because the equity market discounts a cyclical decline in earnings. We must therefore look to the underlying composition of the style indices.

When we do this, the picture becomes clearer. The largest sectors in the Russell Global Value Index are Financial Services and Energy – two beleaguered sectors which performed strongly in April.

So it appears that we are really looking at a sector effect. Peering further into the data can provide some support for this stance. The outperformance of value over growth in Latin America, again according to the Russell Indices was 9%, a much greater differential driven by the significant weighting in extractive industries within the Latam area. The picture is murkier in Asia ex Japan, a region with a much lower weight to Energy, but a high weight in Financials, particularly in China which rallied hard in April. The headline style indices suggest value also outperformed in April. However, the style team at UBS performs a much more granular assessment of style returns than the major index providers and they found that value styles continued to fare poorly across Asia.

Does any of this help us in managing our equity allocation? Emphasising value over growth is very different to implementing a valuation discipline – we would always argue in favour of the latter. Given the driver of style returns appears to continue to be sector, it makes more sense to spend time making sure stock and sector exposures are supported by a sound investment thesis. cheap hotels . With regards to manager selection, deep value managers with an unconstrained approach to sectors are the group with the most to gain from sector reversals – just be certain they are not holding value-traps enjoying a dead cat bounce.

This article first appeared in Wealth Manager magazine.

I recently met Colin. He has the longest unbroken track record in the UK Equity Income sector.

We did not talk about his Income fund; instead, we talked about his Blue Chip Equity Fund, which, notwithstanding a long track record has seen assets dwindle as investors joined the passive bandwagon – predominantly through Exchange Traded Funds (ETFs). Colin’s fund will be converted into a UK Rising Dividends Fund. The strategy makes a great deal of sense – focus on businesses with a track record of dividend growth and with the potential to maintain that growth. A set of rules whittle his universe down to a manageable list, then his experience and brain take over.

The challenge for Colin is that the passive ferry may have already picked up his potential passengers. The growth in ETF-land is now focused on “Smart Beta”, “Factors” or “Advanced Beta”. The terminology proliferates as quickly as the number of ETFs. domain name search Total assets under management (AUM) in these products exceeds half a trillion dollars.

If an active strategy can be defined by a set of rules using publicly available data, an index can be calculated and an ETF can be created to passively track that active strategy. We have recently witnessed a slew of ETFs offering exposure to “Value”, “Momentum”, “Quality”, “Size” and “Minimum Volatility”.

So, the world of passive is increasingly active, aggressively so, but is the man at the tiller awake? We know that the weight of AUM following any given strategy has an impact on potential returns. Even P&O’s finest ships have a finite capacity for passengers, cross that limit and the ferry begins to sink.

And what of Colin? Naïve dividend ETFs have been with us for some time – they were loaded up with high yielders prior to the Financial Crisis and holders quickly experienced the pain of dividend cuts – the pay-out on the iShares UK Dividend ETF is still 29% below the peak in 2008; its current largest holding is a supermarket. Colin understands that investment management is a blend of art and science and is very much alert and in control of his tiller.



Friday, September 26th 2014 will be etched into the memory of followers of investment management companies and fixed income investors alike. Shortly after lunchtime, when London based manager researchers and consultants were probably settling down to an afternoon of email inbox and desk tidying, Janus Capital announced the recruitment of William “Bill” H Gross. Indeed, many will have missed this given the high likelihood of an email from Janus being ignored or deleted (Janus has struggled to reinvent itself after riding the tech bubble up and down and then becoming embroiled in the 2003 market timing scandal).

Within minutes the newswires were alive with the news that PIMCO – Bill Gross’ home for the last 43 years – eventually confirmed in a statement which confirmed the general observation that relationships within PIMCOs Investment Committee and with the business heads had become increasingly challenging.

This is the “big one” which will have transition managers salivating. Investment manager moves are not uncommon; sometimes they run a few hundred million dollars, maybe a few billion. Occasionally, a manager is responsible for a few tens of billions of dollars. The size of the AUM under a managers’ control will typically determine the workload for the manager research and investment consulting community along with the number of words written by journalists. Bill Gross is best known as the manager of the US$220bn Total Return Bond Fund and was the named portfolio manager on 27 PIMCO Funds and ETFs according to their own press release. It is probable he was named manager on many more segregated accounts run for pension funds and other institutions. As CIO of PIMCO, and given Gross’ temperament, he will have had some level of influence on every one of the US$2 trillion dollars managed by PIMCO.

The very scale of these figures is overwhelming and they are all well reported in the press which means the ‘phone of every manager researcher or investment consultant with exposure to PIMCO will be ringing and the inbox will fill up faster than he or she can press delete. Anyone tasked with coming to a reasoned opinion on the strategies that were run by Bill Gross, other PIMCO strategies and indeed PIMCO as an investment house should turn the newswires off and the Do Not Disturb button on. It behoves these consultants to now think clearly and advise their clients about PIMCO ex Gross.

Bill Gross led the investment team of PIMCO.

There was a clearly articulated investment process built around regular meetings of the upper echelons of the investment team, a team which has been expanded significantly over recent years. Depending on which of the new CIOs you speak to, PIMCO has between 240 and 400 portfolio managers.

In their communications so far, PIMCO have noted that until Friday 26th September, the investment competency operated on a founder-led model.

In plain English, this means that Bill Gross determined investment policy and strategy.

This agrees with our understanding of Bill Gross’ level of influence across the firm, built from conversations with employees past and present. The highly structured investment process allowed the firm to run a huge book of business efficiently (PIMCOs operational protocols are top-notch). Going forward, PIMCO will operate a team based model. To this end, PIMCO now has a Group CIO; Dan Ivascyn and five additional CIOs; Andrew Balls, CIO Global; Mark Kiesel, CIO Global Credit; Virginie Maisonneuve, CIO Equities; Scott Mather, CIO US Core Strategies; and Mihir Worah, CIO Real Return and Asset Allocation.

What is the collective term for a group of Chief Investment Officers? A clutch? A huddle? For evidence of this move to a team approach, we can see that on all the high profile fund strategies, a single named portfolio manager (Gross or Scott Mather) has been replaced with a team of two or three portfolio managers. These managers are going to have to spend time with manager researchers to demonstrate clear lines of accountability within this approach. They must convince investors of their ability to adapt to a new operating model – notwithstanding any protestations that they are just “doing what they have always done”.

We were told on a conference call by PIMCO’s President that Bill Gross’ departure marked the “conclusion of a prolonged period of succession planning”. This indicates that the aforementioned CIOs and others have been positioning themselves over the last year to achieve their own personal ambitions. Hence, the new structure may well be the result of a series of horse trades. There will undoubtedly be disappointments which can lead to resentment, dysfunction and, ultimately, departures. A high level of organisational instability is a clear and present danger. Of course, the fact that Gross has turned his back on the team could unite the wider group in the same way as the presence of a management consultant can act as the focus of hostility in a dysfunctional organisation causing team members to put differences aside and work together towards a shared goal. Only time will tell and for now we have a high level of uncertainty around the organisational environment in which PIMCO’s investment team members operate.

At Cerno Capital, our preference is to be confident that the investment managers we entrust with capital are sitting in a stable environment which allows them to give their full attention to investment issues when they choose to do so.

Clients of PIMCO will look to the underlying exposure of their accounts as part of their analysis of the situation. A portfolio of US Treasuries has a very different complexion in comparison with an unconstrained bond fund or a total return bond fund – the favoured strategies of Bill Gross who has historically made significant use of credit, derivative overlays and securities, a concoction which is plainly not vanilla.

It is reasonable to expect some of the assets previously managed by Bill Gross to follow him to Janus; likewise it is reasonable to expect some clients to look for a manager with less organisational risk.

This inevitably leads to a consideration of liquidity as concern grows over a destabilising event in the markets. PIMCO have so far told us that “the bond market is big”, “people forget how liquid the bond markets are” and “cash and treasury holdings are high as a result of our new neutral hypothesis”.

It is true that bond markets are big; it is also true that PIMCO is big and it is true that size does not in itself infer liquidity. Some people may have forgotten what the over-riding level of liquidity is in bond markets, but most investment managers we talk to remind us regularly that liquidity in credit markets is exceptionally poor given changes in market structure since the financial crisis. Cash and treasury holdings may be high relative to PIMCO’s recent history, but the Total Return Bond Fund exposures to MBS, credit and emerging market debt remain significant at 41 percent of total market value according to PIMCOs last summary. In specie transfers, particularly in PIMCO’s book of segregated accounts would reduce any short term market impact, however, it is reasonable to expect some turnover and leveraged investors are likely to try to get ahead of any PIMCO position unwind.

Some might view it as fitting if events resulting from Bill Gross’ departure mark a significant juncture in the history of fixed income markets.

At the risk of sounding like a broken record, the organisational risk presented by significant outflow surely outweighs any short term market impact for an existing or potential client of Gross’ former shop. PIMCO have told us that they have hired significant numbers of people in recent years. PIMCOs revenues are tied to their asset base. If assets shrink, revenues shrink and the cost base (staff numbers) may have to shrink to retain profitability. A shrinking firm is rarely a happy firm.

Then, there is a potential impact on investment performance if outflows are sizeable and prolonged. Redemptions are funded by cash and payments will therefore lift the percentage of a fund exposed to less liquid assets. If selling pressure is maintained in the less liquid parts of the portfolio, the performance impact is magnified as the portfolio moves further away from the portfolio manager’s targeted allocations. Furthermore, there is the danger of a negative psychological impact from a continual stream of redemptions that can result in portfolio managers simply throwing in the towel – typically at the point of maximum pain.

The allocator or manager researcher tasked with delivering an opinion on a PIMCO strategy or on the firm must assess the above risks and place probabilities on the outcomes. To do so will require an intimate knowledge of the processes in place at PIMCO and of the relevant individuals and their relationships within the broader firm. With a firm the size of PIMCO, this knowledge can only be accumulated over many years of working with PIMCO.

PIMCO’s clearly presented investment approach, its well-resourced investment team and highly efficient operational structure has enabled it to run large blocks of capital in both tightly defined and more unconstrained investment mandates. The efficiencies of scale result in an ability to offer active portfolio management at relatively low cost. This has allowed PIMCO to become the fixed income manager of choice on many consultant buy-lists and gather large numbers of segregated accounts from institutions and addition to institutional subscriptions to its pooled vehicles.

The investment team at Cerno maintains an approved list of manager strategies from which we construct portfolios, a key difference when compared to a consultant buy list is that we do not require multiple options in each asset sub-class, in order to cope with the multi-billion dollar accounts which follow consultant recommendations. This naturally steers us away from asset gatherers and towards firms where investment performance is the number one priority. Furthermore, access to key decision makers is a core tenet of our approach and while this is easily obtainable by look to investment boutiques, we are also able to navigate the corridors of some larger operations where we can locate like-minded investment professionals who can clearly articulate an approach which we believe will make money and crucially, who have a clear thought process around the capacity of their strategy.

Cerno Capital client portfolios have no exposure to any PIMCO funds.

Infrastructure can be defined as the essential services, facilities and structures which societies and economies depend upon. A rising middle class throughout the world and the shift towards urban living has made infrastructure spending a priority for many emerging and developed market economies. For investors it offers the opportunity for long term, inflation protected cash flows and attractive yields.

Infrastructure assets are typically characterised by a number of features –  their long asset life, the ability to protect against inflation through concession agreements or other long term contractual arrangements, low correlation to other asset classes, their monopolistic nature, stable cash flows and inelasticity of demand and therefore resistance to economic cycles.

The two broad categories of infrastructure investment are distinguished by the stage at which market participants enter the space; greenfield investments are made in the riskier, early stages of development and brownfield refers to investments made in already operational facilities. Within these categories, there are different ways to gain exposure; either through direct investment, pooled funds (listed and unlisted), listed equity or debt instruments, each providing differing levels of control and liquidity, resources required for achieving diversification and correlation to the general stock market.

Direct investments typically offer the highest level of control and the lowest correlation, however substantial resources are required to avoid concentration risk. At the other end of the spectrum are direct investments in the equity of listed companies which are highly liquid, but more influenced by general stock market activity. Listed and unlisted funds lie somewhere in-between. Infrastructure debt is rising in prominence due to low observed default rates and high default recovery, low-risk, steady income streams and a long dated liability profile.  To mitigate potential political, regulatory, legal and construction risk a balance between regulated and non-regulated assets should be sought.

The UK government is to sell the 500-year-old Royal Mail. Veteran dealmaker James Leigh-Pemberton is to take on the helm of UK Financial Investments with its holding in Lloyds in his sights.

Will the sale of Royal Mail come with a “Busby” or “Tell Sid” campaign familiar to those who lived through the BT and British Gas privatisations of 1984 and 1986 respectively? Both events took place during a well-entrenched equity bull market.

The Royal Mail sale comes four years into a bull market which began in early 2009 and has made progress ever since, notwithstanding repetitive summer-time blues. The MSCI World Index has delivered a total return of +16% per annum in sterling terms in the period from March 2009 to August 2013.

We have postulated that the stop-start nature of recovery since 2008 has held animal spirits in the corporate world at bay. Certainly, data from Mergermarket shows that while the equity markets have regained their highs, the value of M&A remains depressed in comparison.

This summer has been marked by an absence of crisis news-flow and a continuation of a strong bull-market in equities. We have also witnessed the announcement of the sale of Vodafone’s stake in Verizon Wireless to Verizon Communications for US$130bn. This is a deal that for a long time has been placed in the “too difficult” box. It is also a deal which results in Verizon making a record-setting US$49bn bond issue to fund the purchase. While Vodafone will return cash to shareholders, it also intends to go on an acquisition spree in Europe in addition to the current purchase of Kabel Deutschland.

Closer to home, construction firm Kier Group has bought May Gurney – the guardian of much of our motorway network. Meanwhile a small Midlands industrial property investor with a 23 year record of dividend increases has made a couple of purchases after 4 years of inactivity.

The first signs of mega-deals and anecdotal activity of rising corporate activity suggests that multi-strategy managers should be revising prospects for Event Driven managers.




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