26th February 2021
Last week I wrote about how our recent addition to certain UK equity funds was not an asset allocation call. Here I’d like to expand on our views on asset allocation and how we focus on bottom up opportunities. First, let me build the straw man so I can knock him down! Many funds have a rigid asset allocation framework. They have a benchmark which contains all the assets they can invest in, and the weights of the assets in this benchmark determine what a “neutral” weighting would be. Multi-asset benchmarks are notoriously difficult to conjure, but they tend to have lots of US equities and developed market government bonds because those assets are large and liquid.
If you are familiar with our investment process, you will know that we often talk about risk being defined as the probability of a permanent loss of capital. We believe the key input into this probability is valuation: the cheaper an investment at the time of purchase, the lower the chance one will lose money permanently. “Permanently” is a key word here, as we are not saying that the cheap asset will not display volatility, but that any downward move in price is likely to be temporary given the valuation support.
We also believe volatility is a dreadful “ex-ante” measure of risk. First (as with performance), past volatility is no guide to future volatility. Second, assets that have recently displayed high volatility have most likely just fallen in price and are therefore cheap. Third, volatility is a statistical measure that weights upside moves as highly as downside moves (i.e. one wants volatility if it involves a move upwards in price!).
Given our definition of risk, we look to find assets that are cheap to avoid losing our investors’ capital. In our joint aim of running diversified portfolios, we like to own many different assets – “different” meaning those whose prices do not all move together. So our starting point when looking at a potential investment is: “is this fund’s portfolio cheap?” and “would investing in it improve the portfolio?” If we decide a fund invested in UK equities is cheap, and we decide to raise cash by selling a fund invested in expensive investment grade bonds, does this mean we are increasing risk and making an asset allocation decision to reduce fixed income and buy equities? Over the very short-term, the expensive investment grade corporate bond fund may well be less volatile than the UK equity fund, but we believe that over a longer period, the latter is less risky since the probability of permanent erosion of capital is lower.
We often say that a bond fund can be more risky than an equity fund for this reason. Hence, it makes no sense to have a starting point which necessitates having minimum (and maximum) weights to certain asset classes. Not only do we want the ability to zero-weight asset classes, but we also do not want to be prevented from investing in something just because it has a certain asset class label.
In addition, since we are able to access so many asset classes thanks to our use of investment trusts, the very concept of being “overweight” (or “underweight”) some asset classes is anathema. Take ships for example. We own an investment trust that owns ships that are leased out to companies wishing to transport goods across oceans. Could someone please find me the multi-asset benchmark that can inform us what the neutral weighting to ships is? Or song royalties? Or battery storage?
The key point is that membership of an asset class does not necessarily inform the investor about how risky the investment is. It follows that rigid asset allocation is not a good starting point for portfolio construction.
Since our Funds’ objectives are wholly driven by the goals of the end user we believe having an asset allocation approach makes little sense. It is no use being “maximum underweight” an asset class if doing so still involves owning it, and we believe that owning it gets in the way of achieving the end-client’s objective.
But we can go further still in our criticism of an asset allocation approach. Imagine a company, whose stock is listed on the London Stock Exchange, whose operations are in West Africa, whose business is extracting ore from the ground and selling it to refiners in Europe who turn it into metal, which is then sold on to customers in Asia. The listing in London determines this stock is a UK equity, but it has nothing to do with the UK economy. If we allocated to a fund that owned this business, should this be viewed as an allocation to UK equities? No.
The current environment provides a very good testing ground for why comparing multi-asset funds on the basis of their top-down asset allocation alone may tell you very little about how much risk they are taking. In addition, one should be wary of making snap judgements about changes we might be making in our portfolios: e.g. thinking that an increase in equities at the expense of fixed income is necessarily an increase in overall risk. With all the shenanigans going on with GameStop and other so-called “meme” stocks in the US, with the alleged ongoing manipulation of the precious metals markets, with the explosion in thematic passive investing (as exemplified by Cathie Wood’s ARK Invest in the US) – there is a huge amount of valuation dispersion within asset classes. Most equities are expensive, some are eye-wateringly so, but there are certainly some parts of equity markets that are cheap not just relative to the rest of the market, but relative to their own history. This level of dispersion is unusual.
We are thus genuinely excited about some UK and Asian equity funds without being excited at all about the prospects for the broader market. And with hardly any parts of the “vanilla” fixed income market (by which I mean mainstream government and corporate bonds) being cheap, we are finding that our Funds are currently seeing small increases in equities, which is not a signifier for an increased appetite for risk.
Indeed, we believe that if a multi-asset fund is managed properly, the risk profile should never change. It should be the asset mix and the prospects for returns for each level of risk that changes. So I want to end by communicating how unusual the current environment is and how excited we are about the return prospects for our Funds. We believe that vast swathes of markets (equities and bonds) are extremely risky. We choose to zero-weight them. But there are pockets of outstanding value. We thus find our portfolios looking as different from our larger mainstream peers (and certainly to our passively-constructed peers) as they have ever been. This is because we eschew a rigid asset allocation approach and because we can access some investments others cannot. Our excitement should not be interpreted to mean we can repeat the successes of 2009-2018, but we certainly believe the value proposition of our Funds – that is the prospective after-fees returns vs other available alternatives – is exceptional.
Ben Conway – Head of Fund Management
This financial promotion is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. HA4264.
