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We initially look to see if one or a combination of more than one of our managed funds can meet the client’s needs. However whether we look to invest through our funds or directly the underlying assets will all be subject to the same Activus investment process. We start by selecting the building blocks of the portfolio: the individual strategies, companies, funds and fund managers which we believe will outperform over the long term. Activus’ principal focus is the universe consisting of the 500+ Closed Ended Investment Companies. We also consider 2,800+ Unit Trusts and Open Ended Investment Companies and ever growing list of exchange traded funds. It would be impractical to perform a detailed analysis of all potential investments, so we start by using quantitative filters to sort the wheat from the chaff. There are several characteristics we look for when filtering the Fund universe which are detailed in ‘Investment Metrics’.
When we have reduced the investable universe through quantitative filtering to a practical size, usually about 100 Funds, we then start the qualitative analysis which further narrows the eligible list.
We also search for potential investments which have not been chosen through our quantitative filters. This could be due to a change in investment strategy or manager, a company trading at a discount to net asset value where we believe catalysts exist for the discount to narrow or a company newly formed to make profits from a niche strategy where they have substantial prior experience.
We start by reading the manager’s monthly reports and most recent Fund annual reports. We will also search the internet for news on the Fund and manager. We sometimes discard Funds at this stage. Reasons could include a Fund being too narrowly focused on a sector or theme which we believe could underperform, a recent takeover of a fund management company where it is not immediately apparent that the Fund manager will stay, where a manager has recently left the company or a manager has taken on additional responsibilities which might detract from his management of the Fund.
We read the full Fund prospectus. In particular we are looking for policies on leverage and currency hedging, conflicts and alignment of interest, corporate governance and the company’s audit firm. We are not averse to leverage per se, we just like to know what is allowed under the Fund’s prospectus and how it is likely to be achieved. Similarly with currency hedging, we are largely indifferent to whether a Fund hedges its currency risk. Hedging currency exposure tends to be quite expensive and the exposure itself can often enhance the risk/return relationship by reducing long term volatility, however we are keen to know the policies that are in place and the resources the Fund has to manage its currency exposure. We look at the Fund manager’s other commitments, in particular if there are any conflicts which may materially impact his ability to manage the Fund. We also like to see the manager investing a substantial part of his own liquid net worth in the Fund.
It is important to have strong independent corporate governance, particularly for investment trusts, where the directors can play a major part in maintaining investment management fees at reasonable levels and will hold the investment manager to task for underperformance. The auditor plays a vital role in ensuring the accounting policies are robust and that the assets exist as stated in the accounts. We therefore prefer large multinational accounting firms who are less susceptible to Fund manager pressure.
We mostly invest with investment managers which have a substantial presence in the market, a lengthy track record and excellent operational controls. Where we are investing in a smaller company, we want to see excellent operational controls and a strong independent Board.
For investment trusts, we look at the stated policy for managing the share price premium or discount to net asset value. Because the shares are fixed in number and traded on the stock exchange, the share price can periodically rise above or fall below the underlying asset value, such premium or discount depending on the balance between buyers and sellers of shares at any given time. We prefer companies to actively manage the premium or discount, as it means we can acquire shares close to the net asset value of the underlying assets. However, where a company does not actively manage the premium or discount, it sometimes gives opportunities to acquire shares at a deep discount to net asset value. We would need a special reason to pay more than a marginal premium.
We will review as many previous annual reports as we can obtain. In particular we read the manager’s report, for instance what was the manager saying and doing in 2007 prior to the market crash the Chairman’s statement the Auditor’s report, for any specific notes
We will also review the various research reports and analysis provided by brokers, Morningstar, S&P, Financial Express and other media. Where the manager is responsible for more than one Fund, we will compare the strategies and performance of the Funds to ascertain if one Fund is likely to outperform another. We also like to see the manager discussing the twin threats of inflation and deflation and how the Fund will deal with these issues.
We end up with a list of 50 or so potential investments which are deemed eligible for investment pending further due diligence.
The approach described above is termed in investment circles a “bottom-up” approach to asset allocation. We then put those Funds to one side and take a completely different approach, called “top-down”. This is where we look at things from 35,000 feet to get a view of the macro economic events which are shaping the world. The composition of asset classes and strategies at any time will depend upon our view of the world and the client’s particular requirements or inclinations.
We pay attention to market sentiment. We also look at certain measures of value such as bond yields and equity price/earnings multiples. This can give us an indication as to the likely downside/upside risk and may in some instances lead us to be wary of certain asset classes at different times. If anything, we tend to be slightly contrarian. When things look bad, when people are fearful, we tend to be optimistic. When markets are rising and investors are greedy, we tend to be cautious.
We will produce correlation matrices for all eligible investments against one another and against various indices. This can produce some surprising results and often tip the balance in favour of one investment over another. We are not big fans of the so called “efficient frontier” and mean-variance optimisation as the models are extremely sensitive to the expected return of each asset which can not be forecast in advance.
Globalisation has rendered asset allocation by geographical region very challenging. Just because a company is listed in the UK does not mean that most or even the majority of its income comes from the UK. Correlations between developed and emerging markets have been rising for years. When considering an allocation to a geographic region, we therefore look through investment policies to discover whether companies in which they are investing are located in that region and where they source their income. It is quite different to invest in an Asia Pacific Fund which invests in local companies which derive their income locally to investing in an Asia Pacific Fund which invests in companies which may be based locally but derive a substantial portion of their income overseas.
Modelling the eligible Funds as a portfolio is the final stage. We examine a particular portfolio allocation to see its portfolio Sharpe, Alpha, volatility, maximum drawdown, correlation and historic return.
In addition to investments which meet our quantitative and qualitative filters, we seek opportunities where securities are mispriced. This could arise, for instance, where the shares of Funds which are listed on a stock exchange are trading at a discount to net asset value and we believe there are catalysts for the discount to narrow over a reasonable time frame. The discount can arise for many reasons, the sector might be out of favour, the Fund might have underperformed relative to its peers or it could be due to a general market sell-off. Catalysts for the discount to narrow can include a change of fund manager, the company purchasing its own shares, the fund manager closing a master fund to new investment therefore making the purchase of listed shares the only route for investors to gain access to the manager’s expertise.
Ultimately it is this combination of bottom-up analysis which produces the portfolio building blocks, top-down analysis which guides the overall selection and our pragmatic and experience based final asset allocation which produces a client portfolio we are comfortable with.