Minutes of the Clarion Investment Committee - May 2018

Economic Outlook

The Committee discussed in detail the current economic, political and investment climate, an overview of which is summarised below:

While the valuations of some assets are stretched, there are still pockets of value which provide opportunity for investors.
Quantitative Easing and a decade of low interest rates has distorted markets and pushed many investors into more speculative, higher risk investments in search of yield.
Some technology companies are now trading on high earnings multiples and some market commentators are drawing parallels with the tech bubble of 1999/2000 although in the majority of cases valuations are still below the levels reached at that peak. It remains a concern however that some tech companies have yet to justify their high valuations in terms of earnings and inevitably there will be disappointments when profits and dividends fall below market expectations.
The rise of passive investment funds and ETFs is likely to have helped fuel the misallocation of capital. Tracker funds do not consider fundamentals and allocate purely on the basis of a company’s market cap, which means that companies can attract new capital by increasing their market cap through the issuance of equity without questions being asked. As a result, some businesses which do not generate profits and/or cash flow, can access capital with ease and disrupt the market by pursuing more aggressive growth strategies than a more traditional business model would allow.
In the bond market, the long-term cycle of falling interest rates has now turned. Given that interest rates and credit spreads are still close to their historic lows, both investment grade and high yield bonds currently look overvalued compared to their historic valuations. Bonds are expected to have a period of either flat or weak returns and may not behave as defensively during periods of market falls as they did over the last 30 years.
Volatility in equities is expected to increase, however equities are more likely to benefit from the changing market environment over the longer term.
The UK equity market now looks attractive, as valuations continue to be relatively depressed due to political, and Brexit, risk.
The US continues to look more expensive, however given that strong earnings keep on coming through, the valuations of some US equities still provide opportunity.
Following the strong rises in European equities in 2017, valuations are looking stretched in certain areas particularly taking into account political risk.
Italy is accustomed to having unstable governments and the two opposition parties in Italy are expected to form a government. Some of their policies and appointments are being opposed by the current Italian president, and while all parties involved voice strong opinions in the press, there are rumors of talks and deals being made behind closed doors. Given that this is the first time the two anti-establishment opposition parties have been given the majority mandate, both have reasons to settle their current disagreements in order to form a functional government. However, even if they were to succeed, there are a lot of question marks about the future relationship between the two parties. The relationship with Brussels is also likely to be tested once discussions about the funding of the proposed expansionary fiscal policies begin. As it stands today, Italy is not expected to exit the EU, but tensions with Brussels are set to continue and while these political uncertainties prevail, Europe is likely to experience suboptimal growth.

The potential investment opportunities identified:

UK equities are expected to continue to deliver attractive returns given the high yield on the FTSE index and improving expectations.
Lower quality bonds and cash burning companies provide poor risk adjusted returns given the changing interest rate cycle and tight credit spreads.
While more volatile, equities are likely to benefit from inflation and rate rises, while bonds are expected to become higher risk in the future and may not provide the level of protection many investors expect from them.

Review Risk Management, Eligibility and Investment and Borrowing Powers

The Committee reviewed risk management, eligibility and investment & borrowing powers reports and confirmed that these were in order and no action was required.

The committee reviewed the risk data for the Clarion funds and agreed that the VaR ratios and stress tests for Clarion Meridian and Explorer were in line with expectations and within internal thresholds.

The relative VaR ratio for the Clarion Prudence fund was slightly above its internal higher threshold of 130; however it remains below the regulatory limit of 200. The relative VaR ratio compares the fund’s current VaR to that of the benchmark, which has been set using the strategy’s long term strategic allocations. Compared to its strategic allocations, the Clarion Prudence strategy is currently overweight to equities and holds an active exposure to international equities, which is not present in the benchmark. Since the beginning of 2018 volatility in equity markets has increased, which has triggered a spike in the relative VaR ratio. The Committee looked at the fund’s performance relative to its benchmark and agreed that the strategy’s risk and return profiles were in line with expectations. The Committee will continue to monitor the relative VaR ratio and do not propose to increase the portfolio’s risk further at this stage.

The Committee agreed that all portfolios are managed in line with expectations and raised no concerns.

Management of the Clarion Funds

MGTS Clarion Prudence

The fund’s 3 month performance was ahead of the sector. This was mainly due to the fund’s overweight to equities, and in particular to the UK, which was one of the best performing equity markets over 12 weeks. The fund’s returns have marginally lagged the strategic benchmark. The strategic benchmark has a 50% allocation to the FTSE 350 High Yield index, while the fund has a c.37% allocation to the IA UK Equity Income sector and a c.20% allocation to global equity funds, which are dominated by exposure to the US and Europe.

The Committee are pleased with the performance of the fund’s underlying bond strategies. Despite the steady down trend in longer dated bonds, all of the fund’s underlying short duration and index linked strategies produced positive absolute returns over 12 weeks. Also, all of the underlying short duration bond funds outperformed their respective sectors.

In equities, most of the UK equity funds outperformed the IA UK Equity Income sector, except for the Premier Income strategy. The Premier Income fund has a relatively flexible mandate and the manager allocates a significant portion of the fund’s assets to small and mid-cap equities. The fund’s recent weaker relative performance can be partly attributed to a weaker Sterling, which tends to benefit the earnings of more global, large-cap companies.

The Majedie UK Income fund was the best performing holding over 3 months, generating c.10% return in absolute terms and outperforming the IA UK Equity Income sector by c. 4%. While the Committee are pleased with the fund’s recent performance, Majedie announced that the current manager, Chris Reid, is leaving the company to pursue further education. Mark Wharrier will assume the manager responsibilities from November 2018 and in the interim the fund will be managed by Chris Field, the co-manager of the Majedie UK Equity fund.

The Committee are concerned that Mark Wharrier, who used to manage the BlackRock UK Income strategy, has a completely different fund management style compared to Chris Reid. Historically the BlackRock UK Income strategy’s performance was relatively similar to the performance of the IA UK Equity Income sector, while Chris Reid applied a more active strategy when managing the Majedie fund. The Committee agree that the Majedie fund’s performance and risk profiles could change significantly once the new manager takes over. The Committee decide to make further enquiries and will ask Majedie whether the underlying investment process of this fund is likely to change and will debate their findings at the next IC meeting. The Committee agreed to keep the fund in the portfolio at this stage, however potential replacement options will be investigated.

There were no other changes proposed to the fund and the Committee are pleased with the performance of this strategy as well as its underlying holdings.

The committee approved the strategy and confirmed it is in line with the mandate.

Clarion Prudence Fund Performance May 2018

MGTS Clarion Meridian

The fund performed strongly over 12 weeks and outperformed the sector by c.1.1%. Similar to the Prudence strategy, the overweight to equities and to the UK was the biggest contributor to returns.

Over the quarter all of the underlying funds have generated positive absolute returns except for the M&G Optimal Income strategy, which has lost c.0.5% over the period. The JPM UK Dynamic strategy was the best performer, and the Committee are happy with the strong performance of this fund, which was the latest addition to the portfolio.

The Committee are pleased to see some improvements in the performance of the Rathbone Income strategy, which lagged the sector earlier this year. The Committee hold a view that based on his long term track record the fund’s manager, Carl Stick has the skills and experience to successfully manage the portfolio over the longer term. The Committee also believe that the fund’s larger, more liquid holdings fell further in the recent market falls, as investors rushed to generate short term liquidity, while minimising trading costs.

The Committee raised concerns about the Invesco Perpetual European Income fund’s weak performance. This fund was initially purchased on the basis of its exposure to some more cyclical areas, such as energy, materials, financials and a significantly undervalued telecoms sector. The Committee’s expectations of these sectors outperforming in 2017 and 2018 have materialised, however despite the fund’s overweight position in these areas, its overall relative performance was weak, which indicates that the underlying stock selection was relatively poor. The above argument was also supported by the performance attribution data, while the manager’s commentary was not conclusive. The Committee made a decision to sell this holding and to reinvest 75% of the proceeds into the F&C European Growth and Income strategy and reinvest the remainder in the UK. The portfolio will now be 1% underweight to Europe compared to its long term strategic allocation and c.2% overweight to the UK, which is consistent with the Committee’s cautious view on the future performance of European equities.

Overall the Committee are happy with the performance of the Clarion Meridian fund and made no changes at this time.

The committee approved the strategy and confirmed it is in line with the mandate.

Clarion Meridian Fund Performance May 2018

MGTS Clarion Explorer

The fund has lagged the sector by c.0.4% over 3 months. This was primarily due to the overweight exposure to Asia and Emerging Markets as both regions lagged the UK and US over the period.

Fund selection was generally good across the portfolio, as only 3 active funds marginally underperformed their respective sectors by a maximum of 0.4%. The Jupiter European and Lindsell Train Japanese funds were the two best performers over the period, generating 6% – 7% returns and outperforming their benchmarks.

Most of the Jupiter European portfolio is allocated to companies with global earnings, which have not been significantly affected by the increasing political risk in Italy. On the contrary, their valuations have benefited from the recent weakening of the Euro, as overseas earnings increased in Euro terms.

The Lindsell Train Japanese strategy continued to perform strongly. The Explorer portfolio currently holds a hedged share class, which have done well against the sector, despite some of its relative returns being negatively affected by the recent strengthening of the Japanese Yen.

While slightly better over the shorter term, the performance of the Henderson Emerging Markets Opportunities strategy was below the IA Global Emerging Markets sector over 12 weeks. This fund has a near zero allocation to China and higher allocations to India and Latin America. This positioning was the main detractor from the fund’s returns over 12 moths, given that China was the strongest performing Emerging Markets country over the period, while India and Latin America lagged for various reasons. Historic drawdowns and standard deviations indicate that this is the lowest risk Emerging Strategy currently included in the portfolio and the Committee are comfortable with the longer term benefit it brings to the Explorer fund.

The Committee currently have no concerns regarding the Explorer fund and proposed no changes to the portfolio’s underlying holdings.

The committee approved the strategy and confirmed it is in line with the mandate.

Clarion Explorer Fund Performance May 2018

Management of the Clarion Models

Model E

Sell All 4.00% Invesco Perpetual European Equity Income Z Acc
Buy 3.00% F&C European Growth & Income 2 Acc (7.00%)
Buy 1.00% Vanguard FTSE UK Equity Income Index A (6.00%)

Model F

Sell All 5.00% Invesco Perpetual European Equity Income Z Acc
Buy 4.00% Jupiter European I Acc (4.00%)
Buy 1.00% Vanguard FTSE UK Equity Income Index A (5.00%)