Volatility is now at all-time lows. Does this make you nervous?
“It does in many ways. When I look back at volatility over the last 20 to 30 years, we’ve had a number of periods of low volatility. In the mid-90s and in the mid-2000s. Low volatility eventually will be succeeded by volatility reverting to the mean, reverting to higher levels. Obviously when you combine that with what we see as valuations are pretty full in the market, that does make us nervous.”
“Many investors think that all is well with the economies, the global economy at the moment. They don’t see as much risk, I guess, than there was over the last couple of years. We think there still remains many issues to be resolved, be it in Europe within the sovereign debt market or be it just global growth in general is looking like it’s going to be a lot less than it was in the past.”
“Therefore if growth doesn’t come through then corporate profits will be impacted. Current levels where they are, record levels, they’re standing also on very high multiples. So that makes us nervous. As you said, with that low volatility it indicates that investors in general are more, I guess, optimistic.”
Are you expecting a correction?
“It’s very hard to ever make a prediction about short-term pullbacks. As I’ve said, we’ve seen periods of volatility like this in the past at extreme low levels. They’ve lasted for three years on the last two occasions we’ve seen it. We would say we’re two years into that but you never know what will cause a pullback. It might be an increase in interest rates or it might be something that’s completely not anticipated by the market. That’s typically what happens.”
“But I guess what investors need to do is be ready if such an event occurs. And that’s really what we’re trying to do with the portfolio. By focusing on the kinds of stocks that we do and stocks that have dividends that are well covered by cashflow, that are on reasonable valuations and that have strong balance sheets, that creates a portfolio that can be very resilient.”
“On top of that, when we do the cover/call strategy you create an income stream that’s more sustainable through that sort of volatile period and you have a cushion on the downside.”
What type of company can withstand increased volatility?
“For us it’s very much look for companies that first and foremost have very strong balance sheets. Because if you go through a period of turbulence if say interest rates started to rise and if they started to rise sharply then you really need companies that are well-placed in terms of their financial structure to go through that.”
“You won’t suffer any drawdowns or worst-case scenario you don’t have a situation where companies have to do rights issues. So for use you want to have very strong balance sheets in the company you invest.”
“Secondly you want to look at the earnings. And you want to make sure that the earnings are sustainable through any downturn. If they’re well covered, even if the stock price comes back somewhat, you’re still receiving the dividends and you’re still able to pay the income to investors.”
“For us we go further. It is difficult at the moment to find widespread opportunities in the market so we’re allowing cash balances to increase in the fund. While the typical equity fund would run with a cash balance of perhaps less than 5 per cent, we’ve up to 20 per cent cash in the fund at the moment.”
“In addition to that we’ve got some put options. So we buy put spreads on various indexes. In the UK fund it’s on the FTSE 100. In the Global fund we’ve got put spreads on the S&P and the Euro Stoxx and the FTSE 100 as well. And what that does is if there should be a drawdown it would give us further protection.”
“So for us and our investors it’s very much about a cautious approach. They want to get that income because right now they can’t get it elsewhere.”
“If you go back before the financial crisis you could’ve got a risk-free rate of 5 per cent. You could’ve got an income of 5 per cent. Today, those rates are down to zero, or close to zero. And therefore if you think about the investors that have been pushed up the risk curve, they’re very cautious investors and they’re suddenly finding themselves investing in high-yield credit or in equities.”
“So we’re trying to deliver for them the yield that they were able to get in a risk-free asset previously within an equity context.”
“There’s still volatility, there’s still drawdown risk, but you’re trying to reduce some of that by being very cautious on the companies you invest in, by allowing cash to increase and by using put index options for the measure of downside protection.”
How do you achieve a 7 per cent target yield?
“Firstly we’ve got a portfolio of stocks that deliver dividends. From those dividends we get 3 to 4 per cent and it’s from that 7 per cent that we use the cover/call strategy to enhance the yield. And that is a very simple strategy where we sell call options on each of the stocks in the portfolio and the premium is what we get to enhance the income.”
“The trade-off is that we give up some of the potential upside but what we have in the end is a 7 per cent yield with some capital growth.”
Does a higher yield equal higher risk?
“It’s actually less risk because what happens is when you take the premium, should the market suffer some weakness, even if it’s a flat market, you’ve got that cushion from the premiums. So on the downside you’ve got the cushion from the premiums, where on the upside you do cap some of your upside volatility, which is not in your favour, but overall you’ve reduced the volatility of the fund.”
Is your process different on the recently launched RWC Global Enhanced Dividend fund?
“It’s very much the same. The stocks are more, it’s more of a global mandate. So while the UK fund is obviously biased towards UK stocks, with the global fund we’re now able to invest more overseas, more in the US, more in continental Europe. It’s very much the same process. We’re looking for the same sort of stocks, so companies that deliver high return on capital, pay dividends, that are very cautiously financed, so have very strong balance sheets.”
“So we’re again getting the dividends from those companies that in the case of the Global Enhanced Dividend fund delivers a 3 per cent yield and then again we sell the call options in each individual stock to get us a 6 per cent yield.
