Politics are a “nuisance” but the biggest issue for absolute return investors remains the low interest rate economic environment, according to Church House Investment Management’s James Mahon.
The co-manager of the five crown-rated SVS Church House Tenax Absolute Return Strategies fund said the heightened political risks from Brexit to the election of Donald Trump were not pressing issues for the fund.
He said: “Politics makes it more difficult [to make a positive return month-on-month] because of the potential for volatility, but I say potential because funnily enough there hasn’t been that much and that in itself is surprising.”
Indeed, as the below chart shows, the UK market has been on a relatively steady climb since the initial shock of last June’s referendum result.
Performance of index since EU referendum
Source: FE Analytics
Mahon said: “Politics is a nuisance but in practice it always seems to be there, especially at the moment.
“The French election suddenly turned out to be alright after all and Germans should be alright but then of course the Italians might choose a quick election and that could put the cat amongst the pigeons again.
“There always seems to be potential problems from politics so it is something to keep an eye on and watch but we aren’t going to invest our fund on the basis of it.”
Instead, he said the biggest issue facing investors looking to eke out a positive return month-on-month is the economic background.
“We’ve had the inflation figures last week with CPI at 2.9 per cent and RPI at 3.7 per cent. Those are both quite punchy numbers and yet the 10-year gilt yield is less than 1 per cent,” the fund manager said.
“And the Bank of England is very happy sitting on its hands and right down the bottom of the interest rate range and something is wrong there and I feel very uncomfortable about that.
“For an absolute return fund that puts us in a tricky position as at its root an absolute return fund should be compounding interest.
“But clearly that’s not open to us because central banks around the world are desperately pumping liquidity into the market and we have this huge distortion of inflation where it is and where base rates are.”
He said that this means the risk investors need to take to make a positive real return is much higher than it has been in the past, with fixed interest in particular becoming more risky.
“Fixed interest is yielding virtually zilch and to buy any fixed interest with any sort of duration in it at all is to embrace an awful lot of risk and the potential reward is very small so I struggle to do that quite frankly,” Mahon added.
As the below chart shows, the Bloomberg Barclays Global Aggregate index has risen by 125.27 per cent over the past 10 years, making investment in the asset class more expensive for those who do want to access the low yields on offer.
Performance of index over 10yrs
Source: FE Analytics
Despite this, the SVS Church House Tenax Absolute Return Strategies fund – which Mahon manages alongside FE Alpha Manager Jeremy Wharton – has more than 30 per cent exposure to fixed interest, which he said he accesses through floating rate notes.
“In practical terms the biggest slice of what we’re doing is buying floating rate notes,” Mahon said.
“Partly because they actually offer us better returns but also because they have a hedge against rising interest rates built in the structure of the note so that suits us on both counts.
“As a fund we don’t really like complexity if we can avoid it – we are happy to embrace it if we have to but we prefer not to – and a floating rate note in this instance is simple but has the hedge so we like that.”
He said he is principally using high grade, AAA-rated notes which are “in effect quasi-cash” though this is shown in the fund’s cash exposure.
“The way we split this up if you like is that into the cash bucket go AAA floating rate notes with short dates so things we can convert into cash in an hour or so,” Mahon said.
In the fixed interest portion of the fund, he is using floating rate notes that aren’t AAA-rated or that have other characteristics – such as those that are dollar denominated.
“After that we do have a book of credit. It’s very short duration and we tend to the slightly more esoteric when there are opportunities,” he said.
Turning to equities, the fund manager said it is not easy to see value across the board, opportunities can be found in certain markets.
He said the market has had a “cracking run on both sides of the Atlantic”, making opportunities in the US and UK harder to find.
Performance of indices over 10yrs
Source: FE Analytics
Indeed, as the above chart shows, the FTSE All Share is up 71.52 per cent over the last decade while the S&P 500 has rocketed 189.95 per cent.
He noted: “If you look at the example of America, clearly we are seeing some pretty fulsome pricing of stocks and I feel a bit uncomfortable with price action in tech.
“Tech stocks have led the market up and we had that period where they were all jumping and then you get these periods where you get a sharp reversal.
“It all feels like it has run a bit far a bit fast to me so I think it’s a market to stand back a bit and requires patience.”
The fund has just under 11 per cent of its portfolio held in international equities, but Mahon said he is looking at both Europe and emerging markets.
“We have modest amounts in emerging markets. Europe we have a bit. We attempted to get some more but couldn’t find things at the right price,” Mahon said.
“We’ve still got a certain amount of private equity but are inclined to reduce it because it has had a tremendous run.
“In the UK some of the smaller cap area of the market seems to still offer a bit of value so we do have a certain exposure there but I can’t point to a strong theme. It tends to be stock by stock at the moment.”
The final area Mahon has considered adding to is property, where he said attractive valuations can now be found.
“We’ve been in and out of property but have been inclined to pick up some more UK property recently largely through listed vehicles which seem the cheapest way in,” he explained.
“It is simply because of the pricing. The good Reits [real estate investment trusts] – the likes of Land Securities or Great Portland – have de-geared in anticipation of problems.
“Yet they have shifted from being on quite a big premium to their underlying assets to quite big discounts to underlying assets in anticipation of property prices falling. There may be some falls but when everyone has anticipated it this might be time for another look.”