Dean Cheeseman, Manager on the UK-based Multi-Asset Team, takes a look at the outlook and performance of the Core Income range and discusses value, volatility and the disappearance of the 'free lunch'.
The Core Income range had a strong Q4 last year, after a sluggish H1, what drove this better performance?
Q4 2018 saw markets sell-off sharply as fears around the US/China trade dispute, softening economic data and ongoing political tensions took centre stage.During this period, the Janus Henderson Multi-Asset Core Income range demonstrated its defensive characteristics and offered investors much needed downside protection.
Over the course of 2018, the Core Income range delivered very competitive total returns, both against broader equity markets and its multi-asset active peer group. While investors began 2018 confident to the point of complacency, they spent most of the year reappraising their expectations and repricing risk as more challenging news emerged on the growth, policy and political fronts. This process gathered momentum into the final months of the year, with some hair-raising moves in Q4, including a near 20% drawdown in the S&P 500 Index and more than a 40% decline in crude oil prices.
The Core Income range dampened the volatility and drawdowns of wider markets, with the cautious and active outlook established at the start of 2018 playing out overall. However, our focus on well run businesses with stable income streams saw our funds lag in the first half of the year as investors focussed on richly-priced growth stocks, but the more markets rallied and the more unfashionable high quality income-paying stocks became, the greater our confidence that a more volatile market dynamic was closer.
Favouring active managers within Investment Grade and High Yield Bonds hurt performance as spreads tightened to historically expensive levels in the first half. These managers more than made back their modest upside capture, however, by protecting capital in the sharp sell-off bonds experienced in November and December.
There are more volatility-generated opportunities for the active manager, both in terms of stock selection and asset allocation, to seek out returns by adding risk in dips but also to protect capital by selling into rallies. Therefore, we retain our deliberate stance to be active. As we saw early this year, one such rally has already started, with excellent performance from US equities and US High Yield. We expect that investment returns in most asset classes in 2019 will be better than last year but still anticipate an eventful and challenging year in the markets – an environment best suited to those flexible enough to shift nimbly between asset classes.
What do we do with our cautious clients? Would you keep them in cash?
As volatility in the markets increases, particularly as we saw in Q4 18, investor sentiment understandably dwindles. The issue for asset managers is balancing the increasing risks with maintaining a longer-term perspective around those risk assets likely to outperform.
The Core Income range is ‘risk targeted’, in that the funds stay within predefined risk boundaries, as determined by independent risk profiler, Distribution Technology. The Core Income range therefore remains compliant with its volatility bands day to day, with its positioning assessed independently by our Risk Team as opposed to being just ‘risk rated’ – an estimate of funds’ overall risk calculated at a single point in time. The Core Income range can use cash as a strategic asset for downside capital protection but not to the point that the funds fall foul of the lower volatility band.
Diversification is meant to produce less volatility over time but all multi-asset funds had a bad year last year, can you explain this?
Harry Markowitz is attributed with the phrase, “the only free lunch in finance is diversification” but in the short term, we fear that its rationale has temporarily faded. Within multi-asset portfolios, the two largest asset classes are equities and bonds but post a decade of quantitative easing-fuelled markets, both asset classes are trading very expensively relative to history.
The chart below illustrates this issue, with today’s equities in the ninth decile in terms of expense relative to history, while bonds stand at eighth decile. In previous periods when equities were richly valued, e.g. in 1999/2000 during the tech bubble, then bonds remained fair value; so when equities rolled over, the multi-asset portfolio is protected on the downside by the bonds offering support.
Relative expensiveness to own history
Source: Bloomberg, IMF Forecasts and Citi.
The challenge for multi-asset portfolios today is that since equities and bonds are both trading relatively expensively, diversification becomes increasingly important. The Core Income range makes use of a variety of diversifying asset classes, seeking low correlations to ‘traditional’ assets, with different return drivers and alternative sources of income to mitigate this structural diversification issue.
The Core Income range concentrates on risk factors over the performance (as they don’t tend to participate in the upside as much as other funds); what protection is the range providing against volatility?
While buy-and-hold investing was the right approach when markets were trending strongly higher, a more turbulent market regime demands a greater emphasis on volatility management and dynamic asset allocation. Actively-managed multi-asset funds should have plenty of appeal in this sort of environment, given the breadth of their opportunity set, flexibility and foundation of diversification.
The Core Income range’s focus on generating an attractive level of natural income can often lead to a structural bias to higher quality companies. We define ‘higher quality’ companies as proven businesses that have lower levels of leverage, generate above average levels of cashflow – much of which is returned to shareholders via dividends – and demonstrate stable levels of high earnings growth. These businesses typically have cautious and prudent management and we consider them strong stewards of our clients’ capital.
Higher quality companies have been proven to outperform over the longer term but will typically lag in strong, momentum-fuelled market rallies. Much of their outperformance can be seen in negative market periods when their higher quality characteristics are rewarded by the market. Q4 2018 was a great example of this protection in action, a period when the Core Income range outperformed its active peers as volatility rose.
Why is value important when blending Multi-Asset products?
The Core Income range also focuses on value, i.e. identifying companies that are ‘cheaper’ than the overall market. Value investing has been proven to outperform over the longer term, which the Janus Henderson Multi-Asset team is keen to exploit. ‘Value’ can be defined in many ways; our focus tends to be on dividend yield rather than cyclically-sensitive book-to-price measures. The benefit for financial intermediaries constructing solutions for their clients is that the Core Income range blends well with passive multi-asset solutions, which typically have a structural growth bias, to offer diversification by investment approach, as well as by investment instrument.