Standard Life Investments' £25.8 billion Gars fund has had to field some difficult questions from investors after a difficult 2016.
In the first half of the year Gars saw lost money, only partially mitigated by positive returns in the third quarter.
‘Against a backdrop of gains for global equities and bonds, this left clients seeking clear explanations and action,’ the Gars team - headed by Guy Stern (above left) and Roger Sadewsky (right) - said in its annual review and outlook for 2017.
‘While Gars does not target returns specifically in line with equities or bonds, its objective is to generate positive and substantial returns with low levels of risk. This was not delivered in 2016.’
Last years the fund returned -2.3%, well below a peer group average of 1.6%.
This weighed against Gars' better long term record, which puts it 6.7% up over three years, against a peer average of 6%.
‘As performance picked up, we consistently received requests from clients to set out our steps to get the portfolio back on track. In particular, what is the return potential of Gars’ investment strategies and why do we have confidence in them?’
In its outlook Gars offered some insight.
The macro picture
Gars came unstuck on a gamble that global economic growth and inflation would recover from early 2016.
‘This time last year, the consensus among economists was also for accelerating growth and inflation. This view turned out to be wrong - or at least too early,’ the team explained.
After an upswing in activity towards the end of the year, as inflation rose, Gars' conviction in this stance has been reinforced.
‘There are reasons to be more confident this time. Commodity prices are now rising whereas they were falling going into 2016,' the team explained.
‘Additionally, interest rates have risen in anticipation of higher inflation, corporate earnings are rising and there is stronger conviction in global growth prospects.
‘In China, measures to stimulate the economy have supported growth and some of the imbalances in emerging markets have narrowed.
While Gars is confident global growth will be stronger and inflation will be higher this year, it accepts that risks to its thesis remain, especially from political uncertainty.
‘More detail on the Trump agenda will be revealed as the year progresses, offering a more complete assessment of the balance of growth-friendly/unfriendly policies.
'Elections in Europe – especially in the Netherlands, France and Germany – also provide the potential for surprise, as do Brexit negotiations.’
Gars expects the strategies it holds today to deliver a positive return in relation to this central view. It has also implemented a number of strategic changes.
Equity strategies and relative value equity strategies
To reflect its optimistic view of earnings growth, Gars has lifted equity exposure.
‘We like European equities because of their attractive valuation compared with other developed markets, as well as the supportive low interest rate environment in Europe and strong potential for earnings upgrades,’ it explained.
‘We also added to our exposure to US equities in response to the improved US earnings outlook. This has been brought about by improved economic growth, the potential for lower corporate taxes, stronger oil prices and, for financial services companies, rising interest rates.’
Towards the end of 2016, Gars also introduced a strategy to reflect its preference for emerging market equities versus Brazilian equities.
‘In US dollar terms, the Brazilian market rose by over 60% in 2016 benefiting from both higher commodity prices and the coming to power of President Temer who is expected to pursue a more pro-business policy.
‘However, that rally has left Brazilian equities looking fully valued, with little room for disappointment.’
Gars views the return prospects for selected parts of the bond market as positive.
‘The improving outlook for corporate profitability is particularly positive for our exposure to global high yield and US investment grade corporate bonds,’ it noted.
In contrast, the UK and European investment grade markets look less attractive to Gars after a strong 2016.
‘We therefore cut our corporate bond exposure in the UK and halved that in Europe in recent months. However, the remaining elements still offer useful performance potential, in our view.’
Gars focuses on the relative movements between government bond denominations, rather than on the expectation of a major shift in the overall direction of yields.
Gars has two core strategies in place to reflect this; the expectation that the yields of 10-year bonds in Australia and the US to continue to narrow and that the difference in yield between UK government bonds versus those in Germany and France will also fall.
‘These moves would reflect the divergences we expect to appear in both monetary policy and broader economic performance of these countries. For instance, we believe inflation expectations and interest rates will rise in the US, but remain subdued in Australia.’
Gars is bullish on include the US dollar, Indian rupee, Norwegian krone and Japanese yen versus the euro, the Swiss franc, Australian dollar, Korean won and Singapore dollar.
‘The rationale for each strategy varies enormously. To illustrate, the yen is a defensive currency whereas the strength of the rupee is more dependent on its country’s interest rates remaining high.
‘The won will likely fall due to pressures on both the local economy and the slowing Chinese economy on which Korea is highly dependent.
‘In the case of the Swiss franc, even allowing for its ‘safe-haven’ status, it appears overvalued.’
Towards the end of 2016, the fund increased its exposure to global real estate investment trusts (Reits).
'Reits provide a relatively high and reliable dividend yield. These dividends are underpinned by rents that, in the longer term, are well-protected against inflation, albeit they are sensitive to interest rates.
'These attributes make them a useful addition, given continued market demand for income and the potential for mounting inflationary pressures.’