Square Mile Research – Half Year Review 2020

28 July 2020

The unique challenges faced globally by individuals, companies and governments by the Covid-19 pandemic have been the material mover of markets in the first half of 2020. Given the uncertainty which surrounds the length and severity of the crisis, it is likely to remain a major contributor to investor and consumer sentiment for the foreseeable future.

The crisis is reshaping supply chains, disrupting business models and readjusting consumer habits. This has generated short-term winners and losers but will also create longer-term opportunities in which some companies will adapt and thrive in the new environment. Government policy responses will continue to affect equities and fixed income markets and a new awareness of socially responsible investments may also drive investor appetite.

As 2020 unfolds, it will also be likely that regulatory initiatives also become a significant consideration for companies and fund managers who will need to adapt to a more fluid environment.

UK equities

The first half of 2020 has been a testing period for UK equities with the FTSE All Share Index falling by over 17%. However, much of this occurred in Q1 when the index fell by over 25%, having actually bottomed on the 23rd March, registering a 34% decline over the year to that point. Indeed, the last week of Q1 proved to be the start of a ‘recovery’, which has continued into Q2. Nevertheless, at the year’s half-way point the UK remains, in GBP terms, the worst performing of the major equity markets, by quite some margin.

Index

Q1 Returns

Q2 Returns

H1 Returns

FTSE All Share

-25.1%

10.2%

-17.5%

S&P 500

-14.2%

20.8%

3.6%

TOPIX

-12.0%

11.7%

-1.8%

MSCI Emerging Markets

-18.4%

18.5%

-3.3%

MSCI Europe ex UK

-17.5%

18.1%

-2.6%

MSCI Asia Pacific ex Japan

-15.3%

18.8%

0.7%

Source: FE fundinfo. All returns in GBP.

Understandably, fund managers remain cautious for the rest of 2020. Against a backdrop of concerns around the UK consumer and implications of Brexit, the UK market has also seen a raft of UK companies cutting, or greatly reducing their dividends. Shell being the highest profile, announced a 66% cut in its dividend, the first time the company has reduced its annual distribution since WW2. Many managers maintain a preference for more internationally facing companies, which are less reliant on the domestic economy to drive their revenues, whilst continuing to benefit from the weakness of sterling. In contrast, value-orientated managers remain steadfast, citing the fact that the UK market is trading at a sizeable discount to other markets, particularly the US, but also compared to its own history.

Absolute return

The broad range of return profiles of absolute return funds over the course of the first two quarters of 2020 reflects the stark heterogeneity within the sector. For example, of the 115 funds within the IA Targeted Absolute Return sector, only 21 produced a positive return in the first quarter of 2020, while 27 funds were down more than -10%. The spread between the best and worst performing funds was a staggering 53.7% over this first quarter.

In the second quarter of 2020, as markets recovered strongly, 98 of these 115 funds posted positive returns, with only 13 delivering positive returns over both Q1 and Q2. This emphasises the importance of fund selection. Unlike funds in more traditional asset classes, absolute return funds can be unpredictable when merely taken at face value and may not be consistent in protecting investor capital through all market environments. 

Moreover, in times of crisis, such as what was experienced in the first quarter of this year, correlations across different asset classes and sectors can converge leaving very few places to protect investor capital. This can especially be the case for those funds with embedded directionality, such as unconstrained bond funds with a long credit bias, those global macro funds that are structurally long equities, and equity long/short funds which maintain a net long position.

Multi-asset

The key themes driving the dispersion in relative performance of multi asset funds over the past several years has been accelerated in the first two quarters of 2020. Most importantly, those funds positioned with a value orientation, either through holding value stocks or low levels of duration in fixed income, have continued to face significant headwinds as growth and duration has been rewarded. Some managers, unenthused by the risk-reward dynamics in fixed income markets, have sought other means of diversification through alternatives such as infrastructure, absolute return and real asset funds. However, the indiscriminate nature of the sell-off in the first quarter of 2020 has undermined the diversification of these funds, while duration continued to provide that much needed protection.

While multi asset portfolios have rebounded on the back of unprecedented monetary and fiscal intervention, managers remain cautious of the fundamental fragilities in the global economy. Looking forward, managers aim to maintain allocations to high quality businesses with the sufficient debt and earnings characteristics to weather the ongoing economic impact of the virus. Many have taken the decision to move up the capital structure, allocating away from equities and towards investment grade credit. This high-quality credit is supported by central banks, and companies are legally obligated to pay interest to bond holders therefore removing the uncertainty around dividend cancellations.

Passive

 

In recent years the greater focus on cost and scrutiny of how funds perform has intensified the active versus passive debate. We often hear the argument that investors should be either 100% active or 100% passive. However, at Square Mile we do not believe it is as simple as that and investors should consider exposures on a case by case basis.

Looking at the performance of ten IA sectors, we have considered the average active fund’s performance against the equivalent passive. As the table below indicates, active managers have outperformed the passive six out of ten times and highlights our view that it should never a binary decision to invest actively or passively.

 

 

Sector

Passive

Difference

IA Asia Pacific Excluding Japan

0.6

-2.7

3.3

IA Europe Excluding UK

-2.1

-2.4

0.2

IA Global

1.0

0.4

0.5

IA Global Emerging Markets

-5.3

-3.9

-1.4

IA Japan

0.3

-0.3

0.6

IA North America

3.4

3.6

-0.2

IA Sterling Corporate Bond

2.7

4.3

-1.6

IA UK All Companies

-17.7

-17.4

-0.4

IA UK Gilts

10.1

9.4

0.7

IA UK Index Linked Gilts

13.7

13.1

0.6

 

Source: FE Analytics and Square Mile

Data: 6 Months to 30th June 2020

For each sector, we used the equivalent passive fund from L&G

Looking at the IA Global Emerging Markets sector in more detail, the underperformance of active managers is largely due to them taking an underweight position to China, which has been a top performing region this year. In contrast, active managers have done well within the Asia Pacific ex Japan sector as managers have tended to focus on domestic growth companies, which have been the winners this year, outperforming the index’s heavyweight stocks.

The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice.