Emerging markets, Asia and alternatives are where Liontrust is looking to gain diversification after an uncertain 2016 “smashed everybody’s crystal ball”. 
As part of the series in which FE Trustnet looks at the model portfolios on offer to UK financial advisers, we spoke with Liontrust portfolio manager John Husselbee about the firm’s process, current positioning, recent performance and outlook.
Liontrust’s model portfolios are centred on two objectives: targeting the level of risk investors are willing to take and maximising returns.
Many investors use the investment triangle when choosing to invest: risk, return and time. However, many start with the return and work around the other two.
“Perhaps in the past a lot of emphasis has been on entering that triangle through the return gate and then over time receiving a return for some sort of risk. We’re very much focused on risk as our primary objective,” Husselbee (pictured) said.
Liontrust offers target risk portfolios from Risk Level 1 through to Risk Level 10 depending upon the client’s suitability to risk through the Wealth Solutions Service (WSS),
It offers these risk levels in a range of 26 portfolios – 10 growth, six income and 10 low cost model portfolios. This is typically in partnership with advisers to offer WSS as a full white label.
Separately, the firm also offer a broad range of target risk portfolios via our Model Portfolio Service (MPS) on a number of platform providers with 22 target risk portfolios – eight growth, six income and eight low-cost model portfolios.
The investment process has five main parts to it: strategic asset allocation, tactical asset allocation, fund selection, portfolio construction and review.
“On an annual basis we look at the investable asset classes and for us they are 20 asset classes in total – 10 equities, five bonds and it’s important to say that those five bond asset classes are global and then we have four alternative and cash itself as well,” Husselbee said.
“When it comes to the 10 equities we’re using the major markets – so UK, US, Europe, Japan, Asia and emerging markets, and in addition to that we also separate out smaller companies in terms of the UK, US, Europe and Japan.
“It terms of bonds we look at government bonds on a global basis, inflation-linked, corporate bonds, high yield and emerging market debt.
“When it comes to alternatives we consider property, hedge funds and absolute return funds, commodities and cash.”
Husselbee and fellow portfolio manager Paul Kim use a one-to-five rating system across its whole investment process, starting with the overall economic environment. A one-star rating signifies a state of capital preservation, while five stars is capital appreciation territory.
When that score is inputted into the screen it sets the asset allocation for the major asset classes to target weights.
“After that we then apply a score to each individual asset class from one to five and in doing so we are very much using the art of fund management – trying to be valuation-based in terms of the thinking that we want to be in things that are cheap,” he said.
“If we think something is cheap we are more likely to score it a five. In reality we tend to score things between two, three and four – very rarely have we scored anything a one or a five.”
Key Overweights
“The main things we consider is the path of growth and the path on inflation. Day-by-day there is a lot of noise in the market and a lot of noise which I think you can ignore,” Husselbee said.
As a result, the model portfolios have been upping exposure to Japan and Europe equities and more recently Asia and emerging market equities.
“When you look at emerging markets in 2015 we were probably scoring it more like a two and today we’re scoring it at a four,” the manager said.
“When we moved emerging markets to a four we would have done that in 2015. We didn’t start moving back into emerging markets straight away. We made three moves.”
The first was during 2015, when there were very strong growth concerns over China, as well as other major economies in the asset class such as Brazil.
Having made an initial investment at the start of 2015, the portfolios then added more in the summer, before making the final purchases at the start of 2016, when emerging markets were at their lowest valuation point for five years.
Performance of MSCI Emerging Markets over 5yrs
Source: FE Analytics
“We were underweight emerging markets effectively but we were scoring it as a market that we wanted to be in. It was cheap compared to its own history, cheap to other markets and at that point it’s a case of timing ourselves into this and finding a good entry point,” Husselbee said.
“Now that we have put the money into emerging markets and we are up to target we just have to wait and be patient.”
The other asset class the portfolios pay attention to is the alternatives sector, with hedge funds and absolute return funds used to offer diversification previously found in bonds.
“Within bonds it is the rate normalisation that is a large fear within the portfolios. That doesn’t mean we totally abandon bonds. To totally abandon bonds is to say that you no longer believe in diversification,” the manager said.
“Diversification is one where you will accept that you have a blend of asset classes and in that blend over periods of time some will go up and some will go down.
“Absolute return and hedge funds: we see them as providing low correlation to traditional asset classes - then we divide them into return enhancers and risk reducers.”
The portfolios remain somewhat invested in bonds, to add further diversification but with a higher upside.
“On balance that means you have to do something with the money that you traditionally have in bonds and so therefore you are looking to balance between getting a different type of return and also getting a different type of risk reduction or defensive play in your portfolios,” he explains.
In an upcoming article FE Trustnet will look further into this dynamic and reveal the three absolute return/hedge funds the portfolios are using.
Key Underweights
“What we have been doing for a number of years is bringing back the US and the UK – reducing our scores on that as they have become more expensive,” Husselbee said.
As the below graph shows, over the last decade, both markets have risen, though the S&P 500 has rocketed 195.77 per cent higher while the FTSE 100 is up 67.62 per cent. Both are near their all-time highs.
Performance of S&P 500 and FTSE 100 over 10yrs
Source: FE Analytics
“Everything we are doing is very much driven by valuation and the UK – particularly when it comes to the FTSE 100 of course – has been reaching record highs and clearly a lot of that has been driven by the weakness in sterling.
“So I think when it comes to the UK – and particularly large caps which obviously drive a lot of the market – they’ve gone quite a long distance in quite a short period of time and I think that there is better value elsewhere.
“That said, small-caps and mid-caps have lagged but they have started to pick up so there may be some value to be had there in the UK.”
In the US, the manager says while equities outperformed again last year, “it’s unlikely to be one of the better asset classes of 2017”.
“I think as often said – most of the news is in the market. The US clearly has improved in terms of growth and the election of Donald Trump into the White House is one that has been seen to be pro-business, but I wonder how long investors will be willing to pay up for US large caps,” he said.
“So it’s purely a valuation call that the US and the UK look expensive whereas at the other end of the spectrum we think Asia and emerging markets look cheaper and in between all that you have Japan and Europe.”
Recent Performance
With 26 portfolios – 10 growth, six income and 10 low cost model portfolios - in the Wealth Service Solutions offering and 22 target risk portfolios – eight growth, six income and eight low cost model portfolios - in the Model Portfolio Service examining performance can be difficult.
We have chosen to look at WSS Growth Fund 5 as it most closely demonstrates a balanced approach to investment and compared it with the FTSE All Share index, which represents 98-99 per cent of total UK market capitalisation and is a standard industry benchmark.
As the portfolio is risk targeted, the fund is focused on hitting its risk profile, meaning its volatility is of vital importance.
Indeed, over the period, it experienced 6.43 per cent volatility compared with the FTSE All Share’s 10.13 per cent.
This lower volatility is expected given the portfolio has a broad list of asset classes including global fixed income, which accounts for almost 18 per cent of the portfolio and cash (5.69 per cent).
However, while this is below the expected level of volatility for the fund (9-15 per cent), this reflects the manager’s current lean towards capital preservation.
On the return side – which is seen as secondary for the fund – over the past three years, the model portfolio has outperformed the index, returning 25.38 per cent against the FTSE All Share’s 19 per cent and has broadly returned the same over five years (11 basis points behind the index).
Performance of model portfolio vs FTSE All Share
Source: FE Analytics
However, Husselbee says that it is important to note the returns of cash plus inflation as well, as this is the benchmark for all of the portfolios before adding an appropriate level of risk.
As such, the fund has outperformed cash plus inflation by 47.75 percentage points – reflecting the level of risk taken by investors buying the growth five portfolio but has been 5.29 percentage points more volatile.
Investment Outlook
“When we are constructing our portfolios we very much think of inflation and growth,” Husselbee said.
“If you know where inflation and growth are you know which asset classes you should be overweighting and underweighting at the point of that cycle.”
UK CPI inflation rate since 1956
Source: Bank of England/Liontrust
“When investing over any medium to long term time period it is essential to take into account the effects of inflation.
“Investors’ expectations and needs change during high inflation periods versus low inflation periods and thus it is important to use inflation adjusted returns when performing analysis over longer time periods.”
However, with Brexit sending the pound into freefall, a rising oil price and an uncertain landscape in the US, Husselbee concedes that 2016 “smashed everybody’s crystal ball” though he still expects global inflation to rise in 2017.
“Short-to-medium term politics always plays a part in investment management but actually over the long term when you look at the numbers it really doesn’t matter who is in power – financial markets have behaved independent of that.
“They behave in line with the outlook for inflation, the outlook for growth and that over the long-term sums it up for me, I don’t think you can overcomplicate it more than that.
“Short-term and medium-term you do get those concerns, you get that uncertainty, but that also creates opportunity to add to parts of the portfolio where you think there is good value to be had.”
He says the overvalued areas, such as the UK and US, remain in danger of a sell-off, with the US particularly worrying as it is used by some as a proxy for global markets.
“However, we have some cash in the portfolios so that gives us an opportunity of five or 10 per cent to add to our favoured areas in that respect.”