Everyone has a view on cryptocurrency, and in most cases it’s a tale of extremes. On one side sit the sceptics, who believe that cryptocurrencies are one big Ponzi scheme that will self-implode like the ‘tulip mania’ of the 17th century Dutch Golden Age, which saw the price of tulip bulbs reach incredible highs and then dramatically collapse. On the other side are the ‘true believers’, who believe cryptocurrencies such as Bitcoin are not just a new form of currency but a symbol of decentralisation and freedom from central banks and governments.

I am by no means an expert on cryptocurrency and blockchain technology, however it is worth noting the growing interest by various institutions in cryptocurrency. Probably the highest profile announcement was Tesla’s decision to buy US $1.5 billion in bitcoin and its announcement that it would start accepting bitcoin as a payment method for its products.

The sceptics would say, yeah but it’s Elon Musk, the guy who sends rockets into Mars and wants to insert computer chips into people’s brains. However, we have seen institutions such as Mastercard indicate that it would bring cryptocurrencies onto their network, and recently JPMorgan Chase & Co strategists have been floating the idea of investors using cryptocurrencies such as bitcoin as a way of diversifying portfolios. According to a survey released by specialty insurer Hartford Steam Boiler Inspection and Insurance Company, 36% of small- to mid-sized businesses in the US accept digital currency for payments for goods and services.

From an investment perspective, proponents of cryptocurrencies such as bitcoin have considered the digital currency from two main perspectives. Firstly, bitcoin can be viewed as a store of value akin to gold. This view has been amplified in a world where central banks have been flooding economies with money via their quantitative easing programs since the time of the global financial crisis. The decentralised nature of bitcoin means that the price is not influenced by central banks, which is the case with traditional fiat currencies. Interestingly the uptake of cryptocurrencies has been strongest in some emerging economies where arguably they are more prone to government instability, and in some instances they have experienced the effects of hyperinflation, which has rendered traditional currency worthless.

Secondly, bitcoin offers ‘frictionless’ transacting, whereby the blockchain technology underpinning the digital currency uses a public ledger system to validate transactions, effectively cutting out the ‘middleman’, hence increasing the speed of transactions and reducing costs. The potential applications of blockchain technology beyond cryptocurrencies are far reaching and many institutions are actively exploring its application in areas such as property transfer, execution of contracts and identity management.

However, there are fundamental questions that need to be addressed before cryptocurrencies can become mainstream. From an investment perspective, how do you value crypto assets? What are you valuing and what metrics do you use to value it? These are valid questions and, in my view, we are yet to address them adequately as an industry. Questions around the secure storing of cryptocurrencies and the associated risks with the different methods, ranging from holding assets on an exchange through to storing assets via a digital wallet using web-based or hardware solutions, all have their pros and cons in terms of security, and need to be considered when allocating assets to crypto. For large institutional investors such as super funds, how they hold investments is very important, and having a custodial structure supporting crypto assets will be imperative for the asset class to gain traction in that market.

We have seen BNY Mellon, the world’s largest custodian bank, announce that it will roll out a new digital custody unit later this year to assist clients in dealing with digital assets. Furthermore, we have already seen crypto ETFs launched in Canada and we will no doubt see managed fund and ETF structures reach our shores at some stage, which will alleviate some of the issues associated with storing crypto.

Another area which has come under the spotlight regarding crypto currencies is ESG (environmental, social, and governance) concerns over the energy required to mine cryptocurrencies. According to the Cambridge Center for Alternative Finance, coal accounts for over 38% of energy consumption by miners. Given ESG is a growing part of people’s investment considerations and processes, this will be a relevant aspect of crypto which will need to be explored further.

Finally, we expect the sector to become more regulated as cryptocurrencies gain greater acceptance. While this does create uncertainty, it is also an important step for digital currencies to become accepted more broadly.

Cryptocurrencies and the associated implications of blockchain protocols and their applications are arguably still in their infancy and will dramatically evolve over time. While we don’t expect cryptocurrencies to suddenly appear within your standard diversified portfolio in the near future, to simply dismiss the sector without trying to understand it would be a mistake. At a minimum, clients are increasingly likely to ask questions about cryptocurrencies, particularly as we see product structures such as ETFs and managed funds make the sector more accessible for investors. The more we learn, the more we will be able to provide an informed response to our clients.

 

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

Traditionally value managers used the book-to-price ratio (B/P) as their standard value metric. The B/P ratio served value managers well back when economies were largely industrial. However, as the developed world shifts to a service- and knowledge-based economy—thanks in part to the catalysing effect of COVID-19—the B/P ratio has become a less meaningful metric and used on its own fails to capture some important information.

As more and more companies invest in the creation of intangibles such as R&D, patents, and other intellectual property, the book value of these companies can be greatly understated by an investor relying solely on the B/P ratio. Because the book value of a company does not reflect the value of intangible assets, managers tend to use price/earnings (P/E) and similar ratios in conjunction with traditional value metrics like the B/P ratio in order to get a better understanding of a company’s fundamentals and prospects.

A recent study in the Financial Analysts Journal showed that, due to this trend of using a broader set of metrics, many value managers now have portfolios filled with stocks that would previously have been categorised as growth stocks. This raises interesting questions about how we define value and growth, and the extent to which the lines can become blurred.

There was a sigh of relief for many investors incorporating value strategies in their portfolios when in Q4 2020 we saw a long-awaited rally in value stocks. Unfortunately, for many ‘value’ managers, the rally did not seem to extend to their own portfolios. On closer inspection, it appears that value with a quality bias generally did not join in the rally, but that it was predominately cyclicals that performed strongly as the market gained more confidence in the COVID-19 vaccine rollout.

What does this mean for value managers?

Firstly, it means that those traditional value strategies that stuck to their knitting (or as some may now argue, stuck to a very narrow definition of value) and built portfolios comprised of quality companies trading at a discount to their perceived value underperformed the market. Secondly, it means that managers who were less focused on quality—or were less narrow in their definition of value—may have been rewarded.

So why would quality value not rally with the rest of value? Quality is typically referred to as a factor using a collection of metrics indicating robust financial health within a company. While there is no standard definition of quality, according to a recent article, it is typically a combination of broad categories including profitability, earnings stability, capital structure, growth, and other such metrics.

Why did these types of quality companies not participate in the rally? When will the market finally recognise their value? These are questions baffling today’s investors, and it may be some time before we ever find satisfactory answers. For now, we can only be aware of the challenge and respond to it by maintaining exposure across a broad selection of styles and strategies, and by understanding the nuances of each investment and how it may or may not react in certain market conditions.

Ultimately what matters to investors is not the relative returns over the past decade or century, but the relative returns over an investor’s time horizon. On that basis, predicting the winning style is impossible. But making sure we are diversified across a range of styles is not only possible but prudent.

 

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

As always there will be many different opinions on what might happen to markets in the coming year, but by and large most will agree it is unlikely to top the volatility and uncertainty of 2020. Amid the stimulus packages, lockdowns, PPE and politics, COVID-19 also brought to an end one long running market cycle and ushered in a new one, offering investors new opportunities with the potential for new risks and returns.

We believe understanding and navigating both will be more important than ever.

One of the main risks that still carries over from the last few years is the concentration of the index in just a few mega-capitalization companies. In fact, when considering the S&P 500, the top 10 companies still account for around 28% of the index, and as of late December 2020 the top 6 were worth more than the bottom 372 companies.

 

 

Why is this a problem?

Well if you’re buying the index you’re buying very expensive companies that have already grown substantially during 2020 such as Apple 86% and Amazon 76%. What’s riskier is Tesla (TLA) is nearly 2% of the index but only joined in late 2020, so index investors didn’t receive most of the benefit of its 700%+ growth, but bear all the downside if the stock were to fall.

Investors usually choose indices for their diversity – perhaps now they need to look again.

In addition, while global stimulus and support packages have helped economies from falling off a cliff, they have also pumped a lot more liquidity (cash) into the system. This, along with low interest rates may well support inflation for the first time in decades which even in small amounts can have a profound effect on stocks. Stocks with high valuations that are dominating the index (technology) are more susceptible to the increase in interest rates that usually accompanies inflation, meaning to get your money back you need to wait years if not decades. This is less the case with other sectors.

Is this likely?

While the potential for inflation is there, so too are signs of a rotation away from the tech stocks to those less highly valued sectors of the economy. From September to mid-December 2020, the S&P500 Value index outperformed Growth by around 8%, driven by more certainty about the real economy restarting on the back of a COVID-19 vaccine. While we can’t predict the future there is precedent here going back to the dotcom bust of 2000, where in the following 5 years Value had a resurgence to the point where it outperformed over the 10 years pre and post the bust.

 

To add to this are current data showing a significant increase in activity in the bellwether ISM New Orders Index which measures manufacturing activity, up 40% since the lows of 2020 and its highest level in over 3 years. The opportunity here lies in those sectors and regions that benefit from this new cycle economy, sectors that have been neglected, and so are cheap, but stand to benefit from the surge of global economic activity as populations slowly become vaccinated. The rewards here could be substantial.

Added benefit of options

Finally, the market is currently experiencing an unusual set of dynamics. Volatility (uncertainty) is higher than the long-term average, but so is the market. Usually the market is lower when volatility is higher.

This represents both heightened uncertainty alongside optimism, which has been fueled by some arguably unsophisticated market participants.

This creates unprecedented opportunity for professional investors, and especially for Talaria’s process of using put options to enter stock positions because:

  • There is a greater contracted rate of return on the put options we sell, which can generate 3-4% p.a. more option premium into the portfolio p.a. all else being equal.
  • The opportunity cost of not being fully invested is materially reduced given low expectations for equity market returns.
  • Heightened volatility allows us to widen our buffers against loss and maintain our risk credentials.

As we like to say, certainty empowers you.

The performance of the Lonsec Alternatives universe generally performed well in the December 2020 quarter and into January 2021. The vaccine breakthroughs played a significant role in buoying investor sentiment, and while there have been logistical hiccups in some countries that have delayed the rollout, overall developments are positive for markets.

A key catalyst for stronger performance outcomes has been the return of the value risk premia after a long period of headwinds. Value has benefited from the vaccine narrative and the return to more normal operating conditions, while fiscal and monetary measures helped to plug the liquidity gap, patch up balance sheets, and prevent a complete collapse in confidence.

Risk premia strategies have benefitted from the factor rotation in the market, with risk premia such as value, carry, trend and volatility becoming more favourable, and to a lesser extent equity long/short.

Private equity and debt markets were up in the December quarter, underpinned by the risk-on mood, strong returns, excess liquidity and the chase for yield. However, given the strong rally and sentiment in public markets, stress and forced selling hasn’t yet materialised across the sectors, with the exception being real estate. Managers with excess capital are well placed to buy attractively priced businesses if forced selling becomes more widespread.

Managed Futures strategies performed relatively well over the December quarter as buoyant market conditions and improving market sentiment reversed trends seen in the previous quarter. US dollar weakness trends underpinned the advance, with continued strength in all major currencies against the US dollar, and a continuation of the upwards momentum in stock markets. Additionally, strong trends across agricultural and energy markets aided commodities indices.

Equity market neutral strategies have been mixed. Factor rotation leadership and the buoyant sentiment driven by vaccine developments, political changes, and fiscal stimulus led to a decrease in stock dispersion, which tends to be unfavourable for these strategies. Notably, factor correlations have risen to the highest level in two decades, and equity issuance slowed further within the Australian market over the quarter. Equity issuance had allowed for strong alpha capture in previous quarters as many offers were priced at attractive discounts to market prices.

Global macro strategies performed well through the quarter, buoyed by the positive market sentiment, with discretionary managers finding attractive trading opportunities around political events, as well as significant policy changes being made by monetary and fiscal authorities. Lonsec continues to believe the qualitatively driven strategies appear better placed to adapt and react to changing market conditions and significant central bank intervention compared to their systematic global macro peers.

These strategies tend to be better placed to balance the portfolio across asset classes using a combination of directional and spread trades in addition to dedicated hedges. Nonetheless, quantitative macro strategies were favourably positioned for the December quarter, most notably benefiting from a return to fundamentals and the value risk premia.

Within private debt, despite risk appetite continuing to return, the market is still less favourable for debt exposed to leisure, retail and energy sectors. Nonetheless, newly priced issues tend to require a greater level of asset security and financial covenants, which are favourable for the lender.

Markets finished up January relatively flat on a global and domestic level as markets were spooked following the targeted trading by a cohort of retail traders of stocks that were heavily shorted by hedge funds such as GameStop which reached record highs. This created a so called ‘short squeeze’ which resulted in hedge funds holding the targeted stocks to cover their short positions by selling other investments, which contributed to volatility in markets.

On the policy front rates remain at low levels and the most recent decision by the RBA to keep rates at historical low levels remains positive for risk assets as investors have no other option but to take on risk to have any chance of generating a positive real return. Fiscal policy also remains supportive with the key focal point being the US where markets are closely watching to see if the Biden government will be able to push through their $US 1.9 trillion (almost 10% of GDP) stimulus package.

Our overall asset allocation positioning remains positive on risk assets including Emerging Markets which are leveraged to an economic recovery. However, we believe that from an investment selection perspective diversification remain important and we continue to retain our exposure to some defensive sectors within our Equities exposure. I wish everyone a healthy and prosperous 2021.

The yield curve is one of the most watched barometers of perceived economic health in financial markets. Investors turn to it for a gauge of central bank policy changes, inflation expectations and, more importantly, recessions. Given the yield curve’s undefeated record of recession prediction, ignoring it is to any investor’s detriment.

News headlines in 2019 flashed their warning bells when the yield curve inverted (which happens when short term rates are higher than long term rates). Today the signal is much more positive, with the Australian yield curve at its steepest level (as measured by the spread between the 10-year rate and 2-year rate) since May 2014. Headlines have been quite lazy in picking up on the curve’s resurgence given it is the ‘norm’ for it to be upwardly sloping. But why is the Reserve Bank of Australia (RBA), and its chair Philip Lowe, vehemently against its rise?

Firstly, a steepening yield curve can be driven by multiple factors with varying interpretations. Typically, the basic premise of steepening is that long-term rates rise faster than short-term rates, or short-term rates fall faster than long-term rates. At a more rudimentary level, the ‘short end’ of the curve reflects current and perceived central bank policy, while the ‘long end’ reflects expectations relating to inflation and the state of the future economy.

Australian government bond spread continues to widen

For context, the spread between the Australian 10-year yield and the 2-year yield is currently 116bps versus 29bps this time last year. The RBA, with its sizable quantitative easing (QE) programs and revisions to the overnight cash rate, has done the job of running a steam roller over the short end. But the long end has potentially gotten away from them.

When we think about buying a property, there is one word we think about, and that is location, location, location. With a government bond, that word is inflation, inflation, inflation. Which is what the RBA wants, right? Well, yes and no. The RBA does want inflation, but unfortunately for them inflation expectations are reflected in nominal yields, generally at the long-end of the curve (10-years and longer), and eventually across the whole curve when the market anticipates a rate hike. However, we can dig into this a little further.

Many chalk up the rise in long-dated yields to a rise in inflation expectations, but it is also important to note that there has been around $186 billion of government bond issuance since January 2020, with around $34 billion of that issuance around the 10-year tenor. This has had the knock-on effect of repricing other yields around that maturity, from both a liquidity and supply standpoint. So, inflation ‘expectations’ may be driven more by liquidity than a standard interpretation of the curve tells us. However, the raft of fiscal and monetary measures taken has indeed stoked the fire—so why is this a potential issue?

The RBA is dealing with the problem of high domestic and attractive AAA-rated Australian government bonds (AGBs) when compared to other sovereign issuers, many of which are lower quality relative to AAA-rated AGBs. When considering global rates, Australian yields continue to be some of the highest and safest in the world, hence a strengthening Australian dollar. While the rise in the dollar is not entirely attributable to capital flows and is in part due to the rise in commodity exports, this is still bad news from an economic growth perspective.

Australian government bond issuance over the past 12 months

In Australia, there is a reliance on resource exports as an important source of income. A higher dollar weakens our export trade to some extent, and the RBA knows this. It is therefore reasonable to believe that the RBA is fighting a battle with a stubbornly high Australian dollar, partially stoked by ‘high’ relative rates and, thus, inflation may be the only road out.

Thankfully, imported inflation from a weak dollar is one avenue by which the RBA could boost CPI prints in the future, ultimately pushing them closer toward their target 2–3% inflation band. But then again, they have not hit their target in nearly five years. Furthermore, other major central banks have extended their own QE programs alongside additional government fiscal stimulus in response to the global economic fallout from the pandemic. This has provided further downward pressure on their own respective currencies compared to the Australian dollar.

Ultimately, a competitive currency devaluation exercise is taking place in order to stoke imported inflation. One could question whether the RBA’s inflation targeting mandate is even valid anymore, although that is a whole other discussion.

So where are the positives with a steeper curve? Thankfully for fixed income managers they now have term premia (the excess yield above a shorter-dated bond) available to them. For much of 2019, managers were only afforded extra yield in the range of 20-40bps for taking on nearly eight more years of duration risk. For strategies that rely on yield curve roll down, the increase in the slope of the curve is indeed welcome after a historically ‘tight’ 2019.

For long duration biased strategies, their returns typically favour decreases in long-term rates, although managers that have shown to persistently add value from duration will benefit from a correct call on directionality. All in all, market dislocation and the flood of liquidity have provided yet another peculiar but interesting time for active investors—retail and institutional alike.

by Joshua Nappa – Investment Analyst, Fixed Income

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

The Australian equity market experienced a very strong end to 2020, delivering an outsized 13.8% return as measured by the S&P/ASX 300 Accumulation Index in the December quarter. The recent advances contributed to the 2020 calendar year generating a surprising positive absolute return of 1.7% despite heightened volatility.

The impressive quarterly return was led by the largest index weighted sector financials with increasing optimism of a broad economic recovery predicated on recent positive developments from some of the front-running Covid-19 vaccine candidates, particularly Pfizer/BionTech and Moderna. Additional tailwinds were the federal government’s decision to ease lending restrictions, APRA’s removing a cap on listed companies paying out dividends, and an uptick in long-term bond yields, which in aggregate should lift profitability for the sector.

Over the December quarter, the four major banks recovered well from their lows earlier in the year, with ANZ gaining 32%, CBA jumping 29%, NAB up 27%, and Westpac rising 15%. The energy sector produced the largest sector gain of 26% supported by a stronger oil price and depreciating US dollar, while being highly leveraged to the re-opening of the economy.

A significant jump in the iron ore price was the principal catalyst for a re-rating of the three largest local miners, with Fortescue surging 44% higher, Rio Tinto climbing 21% and BHP rising 19%. The price of the key steel-making ingredient hit multi-year highs amid Brazilian miner Vale cutting production guidance and improved demand conditions in China as the government has undertaken a substantial infrastructure spending program to reignite their economy.

Some of the less economically sensitive sectors (i.e. Health Care and Utilities) delivered negative returns for the quarter. Key utility companies announced earnings downgrades (e.g. AGL, dragged down by lower wholesale electricity prices). Large index weight CSL led the healthcare sector down, with the company announcing the cessation of its Covid-19 vaccine, which was triggering false positives for HIV.

Value outperformed growth stocks by a staggering 18% in the December quarter

A rotation out of some expensive growth pockets into value sectors was clearly evident over the December quarter with further RBA stimulatory measures, including the cutting the official cash rate by 15 basis points in November and an additional $100 billion of bond purchases as part of its QE program. On top of the vaccine breakthroughs, additional stimulus was a trigger for a rally in many beaten-up cyclical-oriented sectors.

The small cap segment of the market experienced an almost identical return in the December quarter compared to its broad cap counterparts, returning 13.8% as measured by the S&P/ASX Small Ordinaries Index, with the small resources index delivering an even stronger return of 20.3%. The performance of the broad commodities complex—principally iron ore, copper and oil—all rallied strongly.

Presently, the Australian equity market is profoundly influenced by macro factors surrounding the management of Covid-19, with company specific fundamentals taking some form of a back seat. The unprecedented fiscal and monetary stimulus measures implemented over the past 12 months should continue over the medium term but gradually taper off on the basis that Covid-19 is well contained, and economic re-opening becomes a sustainable state of affairs.

While it is not expected to be smooth sailing, as the economy moves towards a solid recovery phase, the reflation trade is likely to occur with cyclicals benefitting on a relative basis over long-duration growth companies.

The Australian equity market is trading on a one-year P/E ratio of nearly 20 times, which is circa 30% above the long-term average of 14.5 times and prima facie looks stretched relative to history. However, based on the current environment, with policy and liquidity support underwriting economic activity for the foreseeable future, the market appears to be moderately expensive.

 The Lonsec Sustainable Managed Portfolios were launched on HUB24 on 8 December 2020 and investor capital was put to work immediately in improving societal and environmental outcomes. The Sustainable portfolios have been well supported to date, with an increasing number of investors looking to invest in not only a way that delivers solid returns, but also aligns to their values.

While we don’t yet have a full month of performance to report on, the portfolios have performed in line with our expectations over the first few weeks, generating positive returns for investors.

And looking forward, there couldn’t be a better time to invest sustainably.

Momentum on climate action is gathering pace as governments, companies and communities seek to move out of this COVID-19 induced haze and look towards a greener and more equitable recovery.  Europe and the UK have committed billions towards what some are terming a ‘Green Industrial Revolution’, encouraging innovation and private investment in clean technologies, creating hundreds of thousands of jobs, while at the same time protecting the environment. China too, has backed a ‘green recovery’, setting ambitious targets for reducing carbon emissions, re-forestation and increasing renewable energy sources including wind and solar. With the US re-joining the Paris agreement on 20 January 2021, two thirds of global polluters have now committed to carbon neutrality, or net-zero emissions by 2060 at the latest. These recent developments provide strong regulatory tailwinds for those wanting to invest sustainably.

And while some governments have been dragging their heels on the climate action front (Australia is looking increasingly isolated in its stance), locally companies are forging ahead with their own commitments to reaching net zero. According to Climate Action 100+, 43% of the world’s largest emitters (including Qantas, BHP and Woodside Energy) have now adopted some form of net zero emissions target. While the nature of those targets varies, we view this as an important step and highlights the positive impact capital owners can have through direct shareholder engagement.

Shareholders are voicing their concerns on a range of ESG issues from modern slavery to gender diversity as well as climate related issues. Public awareness of sustainability issues has never been higher.  As the Boards of AMP and Rio Tinto are now acutely aware, listening to and responding to broader stakeholder concerns is becoming increasingly important.

But for all this optimism, there is still much work to do, not only on the climate front, but across a range of other Sustainable Development Goals (SDGs) to which these portfolios aim to align themselves.  COVID-19 has exacerbated inequality around the world, health outcomes have diverged significantly, and poverty is on the rise particularly in some of the hardest hit developing nations. It is important that as we move into 2021, governments, companies and investment managers alike look to maintain that positive momentum and ensure no-one gets left behind as we build back better.

Now, let’s get to work!

Portfolio update

From a portfolio perspective, one of the ways we work to align the portfolio with SDG 13: Climate Action is through our investment in BNP Paribas Environmental Equity Trust.  The strategy is managed by Impax Asset Management, a London based manager who invests globally in companies that are active in the resource efficiency and environmental markets.  The top holding in the Trust is Linde Plc, a global leader in industrial gases.  In January 2021, Linde announced it would build and operate the world’s largest PEM Electrolyzer for Green Hydrogen. Once built the total green hydrogen being produced will be able to fuel approximately six hundred fuel cell buses, driving 40 million kilometres and saving up to 40,000 tons of carbon dioxide tailpipe emissions per year. This investment also aligns well to SDG 7: Affordable and Clean Energy.

On the fixed income side, the Pendal Sustainable Australian Fixed Interest Fund invested in the Australian dollar KfW Green Bond. KfW is a development bank owned by the German government Projects supported by this bond include the construction of a wind park, solar farm and energy efficient housing in Germany. This bond aligns well to a number of SDGs including SDG 7: Affordable and Clean Energy, SDG 11: Sustainable Cities and Communities and SDG 13: Climate Action.

With initiatives such as the Net Zero Asset Managers initiative, launched in December 2020, global fund managers are also committing to net zero. This initiative aims to secure further backing among asset managers to eliminate greenhouse gas (GHG) emissions from their portfolios. Three managers we are invested with have joined as founding members of this initiative; AXA Investment Management, Wheb and Atlas Infrastructure.

From 1 January 2021, Ausbil announced that it was removing fossil fuel exposure from the investment universe for the Ausbil Active Sustainable Fund.  This includes the exploration, mining and/or distribution of fossil fuels, such as oil, gas, oil sands and coal.  70% of the equity managers in the Lonsec Sustainable portfolios now exclude all forms of fossil fuel investments, the remaining 30% exclude at least thermal coal.

Role Role
Australian Equities Real Assets
Australian Ethical Australian Shares Fund ESG / Sustainable / Impact Resolution Global Property (Hdgd) ESG
Alphinity Sustainable Share Fund ESG / Sustainable ATLAS Infrastructure Australian Feeder Fund AUD Heged ESG
Ausbil Active Sustainable Equity ESG / Sustainable VanEck Vectors Australian Property ETF Passive
BetaShares Australian Sustainability Leaders ETF ESG / Sustainable
Global Equities Fixed Income
AXA IM Sustainable Equity Fund ESG / Sustainable Pendal Sustainable Australian Fixed Interest Fund ESG / Sustainable / Impact
BNP Paribas Environmental Equity Trust ESG / Sustainable / Impact Altius Sustainable Bond Fund ESG / Sustainable / Impact
Pengana WHEB Sustainable Impact Fund ESG / Sustainable / Impact PIMCO ESG Global Bond Fund ESG / Sustainable / Impact
BetaShares Global Sustainability Leaders ETF ESG / Sustainable Vanguard International Fixed Interest Index ETF Heged Passive

Outlook

The last quarter has seen a sharp rotation into some of the more cyclical and value orientated sectors of the market. We expect this rotation to be relatively short lived. Longer term, we see the thematics that have underpinned the strong performance of the ESG/Sustainability sector over the last 18 months to remain intact.  Companies that are focused on delivering solutions to the challenges facing society and the environment are particularly well placed in a low-growth world and one boosted by a green recovery. Regulatory tailwinds and green fiscal policy initiatives are now providing good support. Companies that perform well on ESG metrics, that is companies that understand and factor in the risk of climate change, companies that are well-governed and maintain their social license to operate by meeting stakeholder expectations, should also outperform. Opportunities abound as we emerge from COVID-19 pandemic with the chance to ‘rebuild better’.

Welcome to 2021! I hope you had relaxing break and found time to reset after a tumultuous year. As we enter 2021 it seems that it’s more of the same. COVID-19, US elections (and inaugurations) and growing tensions between Australia and China continue to dominate the news headlines.

Late last year we adjusted our asset allocation position taking a more positive view on equities relative to fixed income assets and cash. Our rationale for taking this view was based primarily on the belief that monetary policy will remain supportive for risk assets (i.e. interest rates will remain low), coupled with the likelihood of continued fiscal support by governments around the world and growing evidence of an economic recovery.

So, what are the numbers telling us thus far? Despite the doom and gloom in the news, US business in the US appears to be recovering despite softening payrolls (the number of US workers). Economic indicators such as the US ISM Manufacturing and Services Index are improving. Chinese business activity remains relatively strong and emerging markets are generally showing signs of economic strength. On the domestic front, jobs data has continued to improve, housing approvals are up more than 30% since June 2020 and exports are rising, dominated by Australia’s iron ore exports.

We are certainly not out of the woods yet and risks remain. COVID-19 and geopolitical risks can generate spikes in market volatility, but such events are out of our control. As per Lonsec’s investment process, we remain focused on the relative price of assets, policy settings and liquidity and other factors such as investment sentiment and the direction of shorter-term price momentum of assets. The risk of inflation is something we will continue to monitor in 2021 given the massive amount of economic stimulus we have witnessed.

I wish everyone a healthy and prosperous 2021.

IMPORTANT NOTICE: This document is published by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research).  LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406. Please read the following before making any investment decision about any financial product mentioned in this document.

DISCLOSURE AT THE DATE OF PUBLICATION: Lonsec Research receives a fee from the relevant fund manager or product issuer(s) for researching financial products (using objective criteria) which may be referred to in this document. Lonsec Research may also receive a fee from the fund manager or product issuer(s) for subscribing to research content and other Lonsec Research services.  LIS receives a fee for providing the model portfolios to financial services organisations and professionals. LIS’ and Lonsec Research’s fees are not linked to the financial product rating(s) outcome or the inclusion of the financial product(s) in model portfolios. LIS and Lonsec Research and their representatives and/or their associates may hold any financial product(s) referred to in this document, but details of these holdings are not known to the Lonsec Research analyst(s).

WARNINGS: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to general advice and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek independent financial advice on its appropriateness.  If the financial advice relates to the acquisition or possible acquisition of a particular financial product, the reader should obtain and consider the Investment Statement or the Product Disclosure Statement for each financial product before making any decision about whether to acquire the financial product.

DISCLAIMER: No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by LIS. The information contained in this document is current as at the date of publication. Financial conclusions, ratings and advice are reasonably held at the time of publication but subject to change without notice. LIS assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, LIS and Lonsec Research, their directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

Copyright © 2020 Lonsec Investment Solutions Pty Ltd ACN 608 837 583 (LIS). This document may also contain third party supplied material that is subject to copyright.  The same restrictions that apply to LIS copyrighted material, apply to such third-party content.

Efficient portfolio implementation is sometimes overlooked as a ‘nice-to-have’ rather than something that adds value to the investment process. This attitude is far less viable today given recent market volatility and product rationalisation, which have made the ability to implement timely portfolio changes essential for advisers and their clients.

The market downturn in March prompted many of us to reassess our investment strategies. We tried to understand where the pockets of risk were in our portfolios and identify opportunities presented by the market dislocation. Most of the key platforms in the market recorded a significant increase in portfolio changes during this period as managers of managed portfolios repositioned their allocations, taking into account their revised view of the world.

This shift in the way we viewed the world resulted in changes to the overall asset allocation positioning of portfolios, as well as changes to underlying investments. Lonsec was no different. From an asset allocation perspective, we increased our exposure to risk assets such as equities and identified a window of opportunity to gain exposure to assets that in our view were mispriced by the market, such as parts of the credit markets.

An example of this was the syndicated loan and high yield market, which experienced a significant blowout in credit spreads as the market priced in a significant uptick in defaults in these assets. We believe the market over anticipated a rise in defaults and that a pricing opportunity presented itself. Lonsec acted on this view by adding the Bentham Syndicated Loan Fund to the Lonsec Multi-Asset portfolio in late May. We have subsequently reduced our allocation to the fund given the strong return the fund has generated as we have seen credit spreads narrow.

The addition of Bentham offers an excellent example of how timely implementation affects return. As at 30 November 2020, Bentham added 7.38% for the five months since the fund was added to the portfolios. If implementation was delayed by a month, the return would have been only 5.70%, and if a two-month implementation delay was experienced, the return would have been even less, at 3.52%.


Source: Lonsec iRate Bentham Syndicated Loan Fund

A one- or two-month implementation delay is not uncommon outside of a managed account structure, where advisers may be following a model portfolio and having to issue ROAs to clients to implement changes.

Efficient implementation can also be additive where a product issuer decides to close a product. Such occurrences can be difficult to predict, but there are times when the risk of a product being wound up increases, particularly where a fund may be in significant outflow.

A recent example has been the winding up of the CFM IS Diversified Trust. The trust was held in the Lonsec Multi-Asset portfolios before being removed earlier in the year. The rationale to remove the trust was primarily driven by the inconsistent nature of fund returns and a recognition of the challenges faced by systematic risk premia strategies, which generally struggled to perform in a market distorted by central bank policy.

Recently, the product issuer made the decision to wind up the trust. In contrast to a traditional model portfolio approach, whereby clients may still be invested in the trust because the portfolio change has not yet been implemented, the managed account structure ensured that—in the case of Lonsec’s Multi-Asset portfolios—all clients invested in the managed portfolio were exited from the trust.

There are numerous ways to measure value. We believe that one of the key value propositions of managed accounts is the ability to implement portfolio changes in a timely manner, allowing clients to capture portfolio exposure as intended by the model manager. We believe that platform technology will continue to evolve to allow model managers to increasingly finesse portfolio implementation with a view of adding value to end clients.

IMPORTANT NOTICE: This document is published by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research).  LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406. Please read the following before making any investment decision about any financial product mentioned in this document.

DISCLOSURE AT THE DATE OF PUBLICATION: Lonsec Research receives a fee from the relevant fund manager or product issuer(s) for researching financial products (using objective criteria) which may be referred to in this document. Lonsec Research may also receive a fee from the fund manager or product issuer(s) for subscribing to research content and other Lonsec Research services.  LIS receives a fee for providing the model portfolios to financial services organisations and professionals. LIS’ and Lonsec Research’s fees are not linked to the financial product rating(s) outcome or the inclusion of the financial product(s) in model portfolios. LIS and Lonsec Research and their representatives and/or their associates may hold any financial product(s) referred to in this document, but details of these holdings are not known to the Lonsec Research analyst(s).

WARNINGS: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to general advice and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek independent financial advice on its appropriateness.  If the financial advice relates to the acquisition or possible acquisition of a particular financial product, the reader should obtain and consider the Investment Statement or the Product Disclosure Statement for each financial product before making any decision about whether to acquire the financial product.

DISCLAIMER: No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by LIS. The information contained in this document is current as at the date of publication. Financial conclusions, ratings and advice are reasonably held at the time of publication but subject to change without notice. LIS assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, LIS and Lonsec Research, their directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

Copyright © 2020 Lonsec Investment Solutions Pty Ltd ACN 608 837 583 (LIS). This document may also contain third party supplied material that is subject to copyright.  The same restrictions that apply to LIS copyrighted material, apply to such third-party content.

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.