My note: this piece was written by Julian Marr and captures nicely many of my beliefs about multi-asset investing and investing more broadly.
by Julian Marr
A truly active fund should be designed with the potential to outperform and the process to help it realise that potential Seneca Investment Managers chief investment officer Peter Elston tells Julian Marr
Peter Elston knows he is being a little unfair when he describes active, passive and benchmark-hugging funds as, respectively "the good, the bad and the ugly". "Of course passive funds are not actually bad," Seneca Investment Managers' chief investment officer quickly clarifies. "They are great for people who do not have the tools, time or inclination to look for good active managers. Unfortunately, Sergio Leone did not call his movie ‘The good, the OK for some, and the ugly'.
"This is about applying the principles of traditional equity value investing – namely, buying things cheaply – to the whole spectrum of multi-asset"
"But as for those heinous closet index-trackers - in my book, to hug the benchmark and charge active fees for doing so is absolutely the worst crime any fund manager could commit because they are going to underperform once fees have been taken into account."
Informed by one delegate on the Harrogate leg of Professional Adviser's Autumn Multi-Asset Roadshow he was "too much of a straight talker", Elston chose to take this as "the greatest praise one can receive in Yorkshire". "And, at Seneca, we do need to be straight talkers," he adds. "We are a small company so we need to tell people loudly and clearly who we are - not least because a lot of our competitors are pushing the idea bigger is better.
"Yet, if anything, the opposite is the case. We are not small in the sense our funds are not viable from a cost perspective but we are certainly small enough to take advantage of interesting investment opportunities – for example, UK midcaps, which have outperformed large caps by 4% a year over the last 20 years, or specialist investment trusts such as the smaller REITs, environmental infrastructure trusts, asset-leasing and so on."
Elston is also keen to convey the message that when advisers pick an actively managed fund, it really should be actively managed. "There are two very different stages here," he continues. "The first is to design a fund that has the potential to outperform, which is about structure - having high conviction and being very different to the benchmark. The second is to have an investment process that allows you to realise that potential."
To gauge that first stage, Elston suggests advisers first look at funds' tracking error. "For a passive fund, you have very low tracking error - in other words, your distribution of returns is very narrow," he explains. "For a benchmark- hugger, the tracking error is a bit higher - though still pretty low - but a good active fund is where you see very high tracking error. "You can then link this with the fees being charged and the combination will give you a sense, quantitatively, of the chance each fund has of producing decent alpha net of fees or, in the case of passive funds, of achieving their objective.
"Passive funds and good active funds give themselves the chance to produce good performance but the benchmark-huggers have a very low chance of producing good performance net of fees."
Moving on to process, Seneca has come up with an approach it calls ‘multi-asset value investing'. "This is about applying the principles of traditional equity value investing - namely, buying things cheaply - to the whole spectrum of multi-asset," Elston explains. "It is essentially a value-oriented approach - but what we are trying to do is to create a coherent, integrated investment style that produces good results and people can understand."
To advisers seeking a sense of whether or not something is good value, Elston recommends yield as a metric. "Obviously, that is a little simplistic but yield is absolutely at the centre of measuring value - whether it is the value of a stock, an equity or a bond market or a specialist investment trust," he says.
"The simplest example would be the bond market - when real yields are negative, returns are negative; when real yields are high, returns are high." Other principles underpinning the Seneca process include consistency, simplicity and teamwork. "Teamwork is critical in investment but particularly so in multi-asset, where you are covering all the asset classes and, by extension, the entire world," says Elston. "Each of the Seneca team has a responsibility for a particular asset class or area where we are making active investment decisions."
As for consistency and simplicity, Elston points first to the company's compact stable of three funds and their aim of beating the consumer Prices Index on an annual basis, net of costs - in two cases by 6% and the other by 5%.
"We do not do anything complicated so we have easy-to-understand investments," he continues. "We are more than a boring old balanced fund because we own a number of specialist investment trusts but we are not investing in derivatives, structured products and so forth. We also have consistency at a holding level - you will see the same holdings across all our funds, albeit in different proportions.
"With fewer investments, you can more clearly see what you are doing and, with our lower turnover, we are aligning our long-term time horizon with the companies in which we are investing. We have a simple investing style - buying things cheaply - and, while obviously you do not want to have too much tracking error, it is just as important not to have too little. Otherwise you are simply not giving yourself the chance to outperform."
There are three principal reasons why, to Peter Elston, inflation is "without doubt" the biggest challenge for investors - the first being that high inflation hurts growth. "Inflation of, say, 5% might mean prices are rising at 5% but it also might mean interest rates have to rise from, say, 1% to 5%," he says.
"That is a 400% increase in interest costs so you can see how a large swathe of the population who are very indebted would be affected." Inflation is also well-known as an enemy of bonds - not just because, when inflation goes up so do yields, meaning prices go down, but real interest rates also rise. "So there is a double whammy there," Elston continues. "And then inflation is bad for equities too - though, interestingly, not nearly as bad as you might think because equities have a way of dealing with inflation. They can raise prices, cut capital expenditure, cut workforces and so on.
"So while bonds are traditionally seen as the bedrock of a balanced fund – the provider of safety and nice stable returns - history shows there can be extremely long periods where bonds will not give you that and indeed give you negative returns. So you have to ask yourself - which timeframe is more important?
"We all think equities are riskier than bonds - and that is true, if you look at things on a short-term basis. But if you look at volatility longer-term, it is the opposite. Now, I cannot say when this long bull market in bonds will end - there is an argument it already has but maybe it has another two or three years to go.
"What matters to me, however - and what I suggest matters for clients - is not the next two or three years but the next 20 or 30. Within that timeframe, you can be almost guaranteed we are going to see a bear market in bonds and investors need to be ready for that."
When judging asset allocation, Peter Elston uses business cycle analysis, arguing there is "very strong empirical evidence" linking each of the four phases - expansion, peak, recession and recovery - with the performance of different asset classes.
"Each of these phases is defined by certain things happening in the economy - whether it is growing or shrinking, say, or whether monetary policy is being tightened or loosened," he says. "Equities, for example, do well in recessions, which is perhaps counterintuitive but equities will anticipate economies coming out of recession.
"The poor performance for equities is when you have a peak phase and, arguably, in the US we are now there, with inflation rising and monetary policy being tightened. If you can discern this distinct performance in each of the four phases, you can add a huge amount of value through tactical asset allocation."
So where would Elston say we are at present? "My view is we are looking at a global downturn in 2020," he replies with a surprising degree of precision. "There is nothing scientific about this - it is the ‘art' part of my process - but I assess the business cycle by looking at unemployment rates, where you tend to see very gentle, distinctive cycles.
"And a continuation of current unemployment rate trends suggests that by 2020 - or 2019 - we will reach the point where, historically, monetary policy has been tight and economies have started to shrink and then equities have gone into a bear market. So I have been reducing our equity weight for the last year and will continue to do so for the next two years. It is like driving a car - you do not brake at a bend, you slow down gradually as you approach it."
Published in Professional Adviser