Alternative assets and KIDs – getting the right balance?
Replacing the KIDs
Readers will be aware from previous columns, including ‘Of testing markets and troublesome KIDs’ (IC, 11 Sep 2020), and perhaps from their own experience, of the real concern within the investment trust industry about Key Information Documents (KIDs). The EU’s core retail financial services regulations – known as Packaged Retail and Insurance-based Investment Products (PRIIPS) – had KIDs at their heart which every investment trust has had to produce.
These regulations were poor and even dangerous. The central problem has been that KIDs can be very misleading regarding the assessment of risk, the projection of returns and the comparison with open-ended ‘sister’ funds. There was no balanced approach. Little wonder the media, consumer champions and industry generally have been critical, believing them to be potentially harmful to investors. The Association of Investment Companies (AIC), the sector’s respected trade body, advised investors to ‘burn before reading’!
I raised the issue directly in meetings with the capable John Glen MP, the then Economic Secretary to the Treasury, and with Andrew Bailey, the then Chief Executive of the Financial Conduct Authority (FCA). Both realised the extent of the problem. The FCA launched a Call for Input consultation but the EU was unsympathetic to the investment trust cause. Last week, as part of The Edinburgh Reforms seeking to capitalise on the freedoms from no longer being in the EU, the Government proposed abolishing the PRIIPS Regulation.
KIDs will no longer plague the investment trust sector. This is excellent news. However, the FCA now needs to step up to the plate and speedily replace these confusing disclosure requirements with a more transparent framework which helps investors make better investment decisions and which treats investment trusts and open-ended funds fairly. The sooner this can be done, the sooner investors will finally benefit.
Seeking the right kind of diversification
My last column suggested policymakers remained behind the curve in not realising inflation would remain higher and more volatile than consensus forecasts recognised – the column ‘Preparing for inflation’ (12 March 2021) first detailing concerns. It also posed questions of investors’ equity strategy and other asset selection when seeking diversification. One of the challenges regarding the latter will be to ensure the balance of alternative assets chosen has sufficient correlation to inflation.
As highlighted previously, the more traditional 60/40 equity/bond portfolio benefitted from falling or stable inflation and reasonable if increasingly mediocre economic growth. Such an environment tended to favour fixed-interest bonds over index-linked bonds as the main source of diversification, and growth over value when it came to equities. But times have changed given the new environment of higher inflation and possibly slower growth, and portfolios need to adapt accordingly.
Bonds generally perform poorly during periods of rising and high inflation as they pay a fixed income – government bonds in particular because of the modest income generated. As we have already seen, investors tend to move on. While financial repression may affect this traditional relationship somewhat, and despite their recent setback, investors should only have modest exposure at best to gilts given the inflationary outlook.
Within the reduced bond exposure, higher-yielding corporate bonds offer better protection in part because higher inflation is usually associated with stronger growth, which should reduce the risk of company defaults. However, for reasons highlighted in the last column, economic growth may be harder to generate. Moreover, courtesy of QE and artificially low interest rates, the increased number of unviable ‘zombie’ companies may result in more defaults than expected as interest rates rise. Company selection will remain key.
In compensating for a reduced exposure to bonds, it will be important to achieve sufficient exposure to those alternative assets which benefit from inflation. There are some where the correlation is high and so the impact is more immediate, and others which usually benefit over time. When assessing the merits of the former, it is important to balance the risk to Net Asset Value (NAV) from higher discount rates, driven largely by higher government bond yields, against the uplift to NAV from a company’s assumptions regarding inflation.
An example of the former is infrastructure. HICL Infrastructure Company (HICL) possesses a 0.8 positive correlation to inflation. Recent results revealed a NAV of 164.3p, which represented an increase of 0.7% over the period. Higher long-term government bond yields and discount rates increased the portfolio’s discount rate by c.60bps to 7.1%, which in turn reduced the NAV by 8.9p. But this was more than offset by largely higher actual and forecast inflation given the company’s conservative assumptions.
Another example is International Public Partnerships (INPP), which has a correlation of 0.7% and seeks to invest responsibly in public and social infrastructure projects while providing inflation-linked returns by way of dividend growth and modest capital returns. The NAV at 30 June was 157.3p – an increase of 6.1% over the six month period. The key drivers were changes to near-term inflation assumptions and a revaluation of the Thames Tideway asset.
Renewable energy is another asset class with a high correlation to inflation. JLEN Environmental Assets (JLEN) which possesses a diversified portfolio of assets including onshore wind, waste & bio-energy and anaerobic digestion. Diversification will be improved further courtesy of an aquaculture facility in Norway. The recently reported NAV increased by 7.9% to 124.4p and this was helped by prudent assumptions regarding power price forecasts being upgraded to reflect the latest forward pricing and actual inflation.
It is important to recognise the various elements to each equation when assessing relative merits. An example is commercial property. This sector benefits courtesy of rising rent and income levels, but concerns about the economic outlook, leverage and rising debt costs presently weigh heavily.
Abrdn Property Income (API) has a well-managed exposure to UK property assets and strong record under its respected manager, Jason Baggaley – with whom I spoke recently. The portfolio focuses on industrial and office assets at the expense of retail, and so is better positioned than many. However, an expensive refinancing of its debt and economic concerns has impacted sentiment. This may be overdone given the 45% discount at time of writing, its dividend appears safe and the quality of its assets.
Commodities and gold usually shine when the inflationary genie is out of the bottle. The column ‘The case for commodities’ (10 July 2020) explains why the sector was on the turn – particularly the mining sector. The investment case remains intact. Gold will also continue to produce attractive returns, especially when the consensus realises inflation will be ‘sticky’.
Further assets with a more indirect link to inflation include the capital preservation trusts – Ruffer Investment Company (RICA), Personal Assets Trust (PNL) and Capital Gearing Trust (CGT). These tend to combine a defensive equity approach with decent exposure to index-linked bonds. The pricing of the latter is sensitive to consensus forecasts regarding inflation, which these respected managers believe the market continues to underestimate.
But what of the remaining exposure committed to achieving diversification? Rising interest rates allow for cash to better compete for investors’ attention – at least as a staging post and port in a storm. Many are critical of cash given high inflation erodes its value in short order, but it is a known quantity during market corrections and is therefore possibly the best ‘diversifier’ of all. The new investment landscape will warrant higher levels given increased volatility will be a new guest at the investment table.
Looking toward the specialist lending sector and particularly BioPharma Credit Investments (BPCR) and Sequoia Economic Infrastructure Income (SEQI). Sentiment is poor in part, again, because of economic concerns. Lending to businesses, sometimes because the banks will not or cannot, is deemed to be risky. However, these companies possess the required expertise, have proven track records, and stand on handsome yields and discounts which leave little to trust.
My column next month will focus on the equity strategy required given the new market regime.
Disclaimer: The information contained in this press release does not constitute investment advice or personal recommendation and it is not an invitation or inducement to engage in investment activity. You should seek independent financial and, if appropriate, legal advice as to the suitability of any investment decision. Past performance is not a guide to future performance. The value of investment company shares, and the income from them, can fall as well as rise. You may not get back the full amount invested and, in some cases, nothing at all.
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