Toby Nangle, manager of the Threadneedle Dynamic Real Return Fund, on the tactics he has used to navigate the ups and downs of global markets over the past five years
WELCOME
The Threadneedle Dynamic Real Return Fund has this year celebrated its fifth anniversary. At the helm of this vehicle since inception has been Toby Nangle, who explains in this guide how he uses a dynamic unconstrained approach to constructing a diversified portfolio that has been able to deliver an annualised return of UK CPI inflation plus 4% over the medium to long term. He also reveals where he believes the best investment opportunities lie today and how he is navigating core macro challenges and risk factors such as Brexit within his portfolio to ensure volatility is kept in check.
Over the last five years, global markets have performed well in the shadow of significant event risk, from the Chinese banking liquidity crisis of 2013 to the volatility caused by the threat of a global trade war (amongst other issues) earlier this year.
THE INTERVIEW
‘Everything we invest in has to earn its way into the portfolio’
Toby Nangle,
Columbia Threadneedle Investments
It has been a particularly difficult time for funds in the IA Targeted Absolute Return sector, as many vehicles have struggled to produce steady returns and protect investor capital amid market tumult. But one fund that stands out in the category as having consistently outperformed both the sector and its inflation-linked target is the £1.4bn* Threadneedle Dynamic Real Return Fund, managed by Toby Nangle since its launch in June 2013. The Fund aims to produce a return of UK CPI inflation plus 4% gross of fees over the medium to long term gross of fees, but with up to two-thirds of the volatility of the equity market, which makes it suitable for a wide range of investors - from pension funds to IFAs. Having recently celebrated its fifth anniversary, the Threadneedle Dynamic Real Return Fund has delivered a gross annualised return of 6.4% (5.4% net of fees) over five years to 31 August versus the UK CPI index return of 1.5%. Meanwhile, over five years absolute volatility has been at a steady 4.8% - some way below the two-thirds of equity volatility target.** The manager has achieved this through close collaboration with the group’s eight-strong Asset Allocation Strategy Group and in-house analysts, and by sticking to a disciplined approach throughout tougher time periods. Nangle explains: “Our reason for using in-house funds is about joining up the investment strategy. If we used another firm’s strategy, we would have less control from a risk perspective. It also means we can keep it very attractively priced for our clients, while managers using external funds typically have higher fees.” The portfolio is composed of direct investments, passive strategies and internal active fund wrappers such as the Threadneedle Japan, European Select and UK funds. This allows the firm to keep charges low.
One of the key aspects differentiating the Fund from its peers is the way Nangle approaches asset allocation. Unlike many of its peers, the Fund is not built around a strategic asset allocation, but rather follows a dynamic unconstrained approach. This means the minimum limit for every asset class is 0%, with allocation to equities permitted to rise up to 75%, bonds and cash to 100%, property to 20%, commodities to 20% and alternatives to 10%. “Everything has to earn its way into the Fund. The asset allocation is managed dynamically across the risk spectrum, from periods where we seek to protect our investors’ capital, to times where we believe risk assets will be well rewarded and as such we seek to participate in growth opportunities.” Nangle believes the traditional approach of combining bonds and equities in a portfolio is not necessarily the best way to improve risk-adjusted returns, citing 120 years of historic data showing that this relationship between equities and fixed income is a relatively new phenomenon. “The way in which bonds have been so successfully combined with equities in the past 35 years has been contingent on them delivering high returns in periods of equity market stress. But in half of the 20-year periods over the past 120 years, having duration instead of cash alongside equities has only dragged down risk-adjusted returns,” he says. “At the moment our portfolio is noticeably lacking exposure to government bond duration, simply because we believe there is a risk that this negative correlation [between bonds and equities] switches, and there will be poor returns coming from that part of the market.”
’No neutral’
*Source: Columbia Threadneedle Investments. As at 31 August 2018. **Source: Columbia Threadneedle Investments / Morningstar. As at 31 August 2018. The fund launched on 18 June 2013. Net performance calculated bid to bid, net income reinvested based on Z share class (GB00B93TQ868). Gross performance calculated offer to offer, gross of annual management charges, using Global Close prices. Equity volatility measured as MSCI World index. Please note the Fund may not achieve its investment objective. Past performance is not a guide to future performance.
Reducing volatility
Another feature that makes the Fund stand out from some of its peers is that it is a long-only and unlevered product, which means it does not take any net short positions. The reason for this, Nangle says, is to keep things simple and transparent. However, this does not mean he does not employ tactics to manage the volatility. A good example of this is the Fund’s investment process in the lead-up to the Brexit referendum and following the announcement of the outcome. Nangle says: “When we reviewed the portfolio ahead of the referendum, we came to the uncomfortable conclusion that we had a big bet on the ‘Remain’ vote; we had around 12% in European large-cap quality equities. “But rather than liquefy all these stocks, we worked with colleagues in our risk team to find the best way to take out this risk. “We did this by selling short EuroStoxx futures and a long euro/short sterling position on top of that, among a number of other trades. When the market opened on the morning of the results, it was pretty uncomfortable. But we went out and removed the EuroStoxx future, as this was to take us from the point of unknow to known. “We then took advantage of some opportunities that appeared such as UK large-cap stocks that had been hit.”
Investment discipline
For Nangle, one of the standout events of the past five years was also the period following the Chinese yuan devaluation in the summer 2015 and going into 2016, when markets were pricing in the risk of a potential global recession. Over this period, the manager took the opportunity to add some risky assets to the Fund, taking positions in European high yield and Japanese equities, reducing cash holdings and changing the currency mix. “All of this was very uncomfortable when the world was increasingly coming into disarray, but quite quickly we realised that the prospect of global recession was starting to get priced in,” the manager says. “We re-risked into a falling market, and then as the market rallied we took a bit off the table. Having a process that keeps us disciplined is at the heart of our funds.”
Fund Snapshot: Threadneedle Dynamic Real Return Fund
The Threadneedle Dynamic Real Return Fund was launched in June 2013. It targets UK CPI+4% (gross), which it has successfully delivered over the past five years. In addition, though the fund has seen periods of equity volatility during this period, it has been much more resilient in times of a sell off than traditional assets and has continued to outperform on both a short and long-term basis. On a five year annualised basis the fund has delivered ahead of its targets, returning 6.4%.
Source: Columbia Threadneedle Investments / Morningstar. As at 31 August 2018. Performance calculated offer to offer, gross of annual management charges, using Global Close prices. The Fund launched on 18 June 2013. UK CPI represented with 2/3 the volatility of global equities. Global equity volatility measured as MSCI World index. Past performance is not a guide to future performance.
Source: Columbia Threadneedle Investments. As at 31 August 2018. Data is shown is for the Threadneedle Dynamic Real Return Fund.
2014: We were concerned risk was not being rewarded so increased protection assets. We reoriented equity allocation and reinitiated a position in European high yield 2015: The Chinese currency devalued in August, so we reduced our Indian equity allocation in favour of Japanese equities and reduced our Australian government bond position in favour of Mexican government bonds 2016: We increased risk through increasing participate assets, and took European high yield exposure from around 10% to around 15%, and increased equities from 29%-33% Brexit: We reduced risk in the run-up to the referendum via UK small cap equities, European equities and European high yield exposure, while increasing our non-sterling allocation. Post the vote to leave we unhedged part of our Mexican Government bond exposure and increased our allocation to UK short-dated corporate bonds and UK large-caps. We also hedged half our UK equity exposure to US dollars 2017: We increased our risk through increasing participation assets such as Europe ex-UK equities and Japanese equities2018: We added to Japanese equities during a period of market weakness
How has the fund’s portfolio allocation changed?
Historic asset allocation since launch
Fund performance since inception
*The Fund launched on 18 June 2013. Since inception performance is from 30 June 2013. Source: Columbia Threadneedle Investments / Morningstar. As at 31 August 2018. Net performance calculated bid to bid, net income reinvested based on Z share class (GB00B93TQ868). Gross performance calculated offer to offer, gross of annual management charges, using Global Close prices. Past performance is not a guide to future performance.
Threadneedle Dynamic Real Return Fund (gross)
UK CPI +4%
How much of an impact do Brexit negotiations have on the portfolio and how do you navigate this risk?
What are some of the key challenges investors are likely to face during the rest of 2018?
The most important issue we face is on the trade side. We have a US administration throwing trade grenades at its major partners. Macro economists may say that the impact on GDP growth from these events will be relatively small, but this tells you nothing about the distribution of the impact on specific companies. This can be quite immense. I see people are worried, because they are not sure how to price things and this is being reflected in the rating of the market. It is hard to see how the trajectory of the trade distortions will affect the market ratings, and that is worrying. We are taking the approach of focusing the portfolio on favoured risky assets, avoiding a lot of corporate credit risk that could be particularly vulnerable, and not getting over-exposed too early to risky markets.
A key consideration for many investors today is around highly correlated assets moving in tandem. How do you look to avoid this and ensure the portfolio is suitably protected?
When we are putting the portfolio together we are mindful of historic correlation between assets, but it can change and does so all the time. We deal with this issue through continuous management of the investment process rather than using systematic option strategies (eg, perpetually buying put options on equity indices so as to gain downside protection)’ which we feel are relatively expensive and historically not very helpful. At the moment we have a variety of risky positions in the portfolio, but in aggregate they are not pushing the fund into an overall risky place. The correlation between those risky positions will typically be pretty high, but not as high as you would have thought. In our portfolio today the high volatility positions are in Japanese equities, European equities, commodities, an unhedged position in South African government bonds, and a portion in Asian emerging equity markets. These are all fairly risky and will all fall if there is a general risk-off sentiment in markets, but it is about managing the proportion of these in the portfolio. Overall, we are confident that the continual implementation of our investment process will continue to deliver strong positive returns over the medium-term.
Where are you seeing the best investment opportunities?
From a broad asset-allocation standpoint, we have a clear preference for equities over fixed income, given decent economic growth and gentle reflation coming through, both of which are supporting strong company earnings delivery. We think equity valuations look fair in the context of these earnings, and we are optimistic for continued profit growth over the next 12–24 months. Our largest equity positions are focused in those markets most operationally leveraged to the current reflationary environment, like Japan, Europe ex-UK and Asia. Europe has benefited from a lot of policy accommodation from the ECB without many fiscal tailwinds, and has had currency tailwinds coming through to help earnings. In the absence of a global economic crash, we expect this process of healing in the European economy to accelerate into the second half of this year, which will lead to a stronger earnings environment. In Japan, earnings have been phenomenally strong over the last couple of years, margins have expanded from extremely tight levels, and revenues have surprised on the upside. But every time this has happened, earnings expectations have not been pushed up much further, so all the strong performance has not resulted in pretty much any re-rating, unlike a lot of other markets. I feel quite comfortable with that. Japan has the growth characteristics we are looking for and our people on the ground tell us those are still on track. And if I am wrong about markets de-rating, I don’t see any reason why they should not re-rate, which would be even better. Perhaps a less well-known asset for many investors is our (so far, modest) position in South African local-currency government bonds that we initiated in June. The election of President Cyril Ramaphosa in December 2017 and his ambitious reform agenda was greeted with a punchy rally in South African rates, and we too have been encouraged by some of his policy initiatives. We took advantage of the broad-based sell-off in emerging markets (that all but wiped out the Ramaphosa-related rally) to take a position in 2026 bonds at attractive valuations.
The day by day commentary and expectations around the negotiations have quite a big impact on the portfolio. The target I am aiming to deliver is in sterling, and this is the most volatile measure of how Brexit negotiations are developing. We look at a variety of scenarios and how the portfolio will perform in each of these. Today, the most likely outcome seems to be that we get a withdrawal agreement, so this could all be a rehearsal for a more profound period of uncertainly in two years’ time. But there is also a not inconsequential possibility of a Brexit with no deal, which would be extremely bad for sterling. In this case, the fund would be able to protect investors by hedging sterling exposure. We also hedge around one-third of our European exposure back to sterling to reduce some of the volatility of sterling moves against the euro. But sterling weakness can also lead to good returns in European equities and some large UK stocks, because of the non-sterling base of these companies.
MARKET OVERVIEW
'Investors are worried as they are not sure how to price assets; that is reflected in the rating of the market today'
CONTACT US
Find out more at www.columbiathreadneedle.com/DRR
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Key risks Investment Risk – The value of investments can fall as well as rise and investors might not get back the sum originally invested. Investment in Funds – The Investment Policy allows the fund to invest principally in units of other collective investment schemes. Investors should consider the investment policy and asset composition in the underlying funds when assessing their portfolio exposure. Currency Risk – Where investments are in assets that are denominated in multiple currencies, or currencies other than your own, changes in exchange rates may affect the value of the investments. No Capital Guarantee – Positive returns are not guaranteed and no form of capital protection applies. Issuer Risk – The fund invests in securities whose value would be significantly affected if the issuer either refused to pay or was unable to pay or perceived to be unable to pay. Interest Rate Risk – Changes in interest rates are likely to affect the fund’s value. In general, as interest rates rise, the price of a fixed rate bond will fall, and vice versa. Valuation Risk – The fund’s assets may sometimes be difficult to value objectively and the actual value may not be recognised until assets are sold. Investment in Derivatives – The Investment Policy of the fund allows it to invest materially in derivatives. Volatility Risk – The fund may exhibit significant price volatility. Important information For use by professional and/or qualified investors only (not to be used with or passed on to retail clients). Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. Your capital is at risk. Threadneedle Opportunity Investment Funds ICVC (“TOIF”) is an open-ended investment company structured as an umbrella company, incorporated in England and Wales, authorised and regulated in the UK by the Financial Conduct Authority (FCA) as a Non-UCITS scheme. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. Subscriptions to a Fund may only be made on the basis of the current Prospectus and the Key Investor Information Document, as well as the latest annual or interim reports and the applicable terms & conditions. Please refer to the ‘Risk Factors’ section of the Prospectus for all risks applicable to investing in any fund and specifically this Fund. The above documents are available in English only and may be obtained free of charge on request from Columbia Threadneedle Investments at PO Box 10033, Chelmsford, Essex CM99 2AL. The mention of any specific shares or bonds should not be taken as a recommendation to deal. The analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Issued by Threadneedle Investment Services Limited. Registered in England and Wales, Registered No. 3701768, Cannon Place, 78 Cannon Street, London, EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.
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