Mar 31, 2018 - post hoc ergo propter hoc fallacy abounds in finan- cial markets. Humans delight in explaining their surr
First Quarter Report March 2018
Capital Gearing Trust plc
General Commentary March 2018
The following article was written by Peter Spiller and published by the Association of Investment Companies as part of the recent celebrations of the 150th anniversary of the first investment trust launch.
Congratulations to Foreign & Colonial Investment Trust on achieving 150 years. It helped to develop an industry that has served investors well; performance of closed-end funds has been notably better than that of open-ended funds, at least over my half century in the City. Interestingly, investment trusts in the nineteenth century seem to have held plenty of bonds as well as equities, much like multi-asset funds today. In the twentieth century, exchange controls, high inflation and high rates of tax put paid to such an asset allocation; equities were the only game in town, that flexibility perhaps suggesting that active management worked effectively. It was also good news for investors because in the twentieth century, equities produced fabulous returns, around 6% above inflation. In our judgement, the most successful investment funds going forward will be those that take advantage of the new opportunities that have opened up over the last 35 years; thus having an asset allocation that looks more like those that prevailed in the 19th century than the 20th. Obviously, investment funds are once again free from exchange controls and there are numerous opportunities to invest in either specific overseas market funds or using the expertise of fund managers to analyse where the best opportunities lie through a global fund. But on top of that, entire new asset classes have sprung up. Hedge funds and private equity were not available 35 years ago, although investors should be aware of high fees of both classes. Infrastructure funds in PPI, solar & wind power assets; loan funds; and property, both traditional and niche, all provide opportunities for diversification of equity risk and of income.
For me, though, the most significant newcomer to the universe of potential investments is the index-linked government bond market. These offer some protection from what looks like the main threat to savings over the next few years, namely resurgent inflation. And with the absence of exchange controls, the US Treasury Inflation Protected Securities market is easily available and is far better value than its UK equivalent. So generalist funds, which can pick and choose from all these choices look an attractive home for long term savers. Over the 35 years of running Capital Gearing Trust, I have found that forecasting short term movements in the price of any asset class, especially equities, is a fool’s game. However, in the long run, values do revert powerfully towards the mean and therefore an asset allocation that is overweight good value assets, and underweight poor value, will over time produce higher returns with modest volatility. The Daily Telegraph reports that £100 invested in Capital Gearing Trust in 1982, with the (modest) dividends reinvested is now worth £22,976. Conditions now are far less propitious than then – indeed the opposite end of the value scale for equities and bonds – and capital preservation looks more important until the prices of financial assets that have been inflated by QE return to more ‘normal’ levels. If that sounds a bit gloomy, it certainly does not undermine the attraction of investment trusts. Over the 35 years that I have run Capital Gearing Trust, almost all the exposure to equities and infrastructure have been through investment trusts, including Foreign & Colonial. They have produced far better returns than their underlying markets and I would just like to thank the boards and fund managers of the funds that we have invested in.
Capital Gearing Trust plc Fund Information as at:
Share price:
31st Mar 2018
£38.50
Investment objective The Company’s dual objectives are to preserve shareholders’ real wealth and to achieve absolute total return over the medium to longer term
Fund information Market Cap. Yield Total Expense Ratio Benchmark
Largest fund/equity holdings
NAV return history (total returns) £222m
1 month
-0.7%
2017
5.1%
Vonovia
2.7%
< 1%
3 month
-2.8%
2016
13.0%
Vanguard FTSE Japan ETF
2.6%
0.89%
6 month
-1.4%
2015
4.2%
North Atlantic Smaller Co.s
2.5%
RPI
Year to date
-2.8%
2014
5.2%
Deutsche Wohnen
2.0%
1 year
0.2%
2013
1.5%
Ishares Core FTSE 100 ETF
1.6%
NAV performance since January 2000 (total return)
Largest bond holding
500 400
UK I/L 0.125% 22/11/19
8.2%
US I/L 2% 15/01/26
3.9%
US I/L 0.25% 15/01/25
3.8%
US I/L 2.375% 15/01/25
2.5%
Sweden I/L 0.25% 01/06/22
1.8%
300 200
Currency exposure 100
Capital Gearing NAV
MSCI UK All Cap
UK RPI
Jan-18
Jan-17
Jan-16
Jan-15
Jan-14
Jan-13
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
0
GBP
53%
USD
30%
EUR
8%
SEK
5%
JPY
3%
Other
1%
Fund/equity breakdown
Asset allocation
Property
17%
Conventional Gov’t Bonds 2%
Equities
13%
Pref Shares / Corp Debt
16%
Private Equity/Hedge Fund
3%
Funds / Equities
38%
Loans
4%
Cash
5%
Infrastructure
1%
Gold
1%
Index Linked Gov’t Bonds
38%
Capital Gearing Trust plc March 2018
At the heart of the investment process through which the fund is managed is an attempt to assess the prospective returns of all major asset classes and then allocate to them accordingly. The hardest asset class to forecast is equities. As with most things, history is a good place to start. Robert Shiller, the Nobel Prize winning economist, maintains a data set of US stock market returns going back to 1871. The data reveal that total shareholder returns from owning US equities over the period, with dividends reinvested, were 6.5% real. This was made up of 4.3% from dividends, 1.7% from real earnings growth and 0.4% from changes in valuation. The contribution from changes in valuation, to state the obvious, can be either positive or negative. However valuations cannot continue to rise indefinitely so a prudent investor should expect, at a maximum, no contribution from this element.
Bearing these observations in mind, what returns can a rational investor expect from US equities from here? The remaining elements of return are dividend yield, presently 1.9%, and real earnings growth. Real earnings growth historically has correlated with the proportion of earnings the companies in the index retain as a whole and correlated to the level of GDP growth. Taken together this means that the best case for US equities might reasonably be to return 1.5-3% per annum assuming no changes in valuation and no contribution from price volatility.
The proposition that US equities should return less in the future than they have in the past is not unreasonable. There are a number reasons for this, including inter alia: i) until the second world war the US was essentially an emerging economy whose rapid industrialisation was coupled with a hunger for capital; ii) the The final source of return (0.2% per annum*) was the cost of owning US equities, both taxes and expenses, positive impact of stock-market fluctuations on rein- have fallen dramatically; iii) future real interest rates vesting dividends. The magic of compounding means are likely to be somewhat lower than in the past. that reinvesting dividends in very low priced stocks Even accepting that returns are likely to be lower in (e.g. during the bear market from December 1968 to the future, current valuations appear to be so high December 1974 when the real price of the S&P500 that those reduced expectations are likely to be disfell by 57% and the cyclically adjusted PE ratio fell to appointed. It is said of the global economy that “when 8.3x) counts for more than the obverse of reinvesting America sneezes the rest of the world catches a cold”; meagre dividends in very high priced stocks. the same is true of asset prices. For as long as US equiThis tells investors that those 6.5% returns were gen- ty markets offer poor prospective returns the overall erated in part by those gut wrenching falls in the stock weighting to equities in the fund will be constrained. market. That is fine for an investor with an infinite *Numbers do not add due to rounding time horizon – a university endowment perhaps – but is much less palatable for an individual to see a >50% fall in the purchasing power of their savings in a matter of months.
Capital Gearing Trust plc March 2018
Over the past year the fund’s risk assets (equity, property and alternatives) performed very well delivering returns of 7% which reflected satisfactory outperformance of both the MSCI UK All Share and MSCI All World index of 0% and 2% respectively (all quoted in sterling). Unfortunately this outperformance was offset by sterling’s relative strength and the US dollar’s relative weakness which, combined with rising real yields, meant that substantially all of the gains in the risk assets were offset by losses in the holding of US TIPS.
of a renminbi denominated oil futures contract in Shanghai.
None of these explanations alone is entirely convincing. Taking the first as an example, the all-time peak of the DXY dollar index occurred in December 1984, a time when the US was running – at the time – unprecedented current account and fiscal deficits, albeit from a much lower starting debt/GDP ratio. The most convincing explanation, though little more than axiomatic, is that the dollar is falling because the recent bout of global synchronised growth has The weakness of the dollar has confounded many ob- spurred a desire for investors to sell dollars and acservers, including the managers of your funds. While quire overseas assets. the graveyard of prognosticators is well populated with currency forecasters, there have been a number This episode offers a timely remind that explanations of relationships which have worked very well in the can always be found to fit any narrative and that the past. Chief among these is interest rate differentials, post hoc ergo propter hoc fallacy abounds in finanfor example, between the 2Y Bund rate vs. the 2Y US cial markets. Humans delight in explaining their treasury rate and the EUR/USD exchange rate. Over surroundings. This epistemological approach is very successful in explaining the natural world, however the past year this relationship has broken down. the prices of securities traded on public markets are A number of explanations have been put forward in the product of the actions of many thousands of indisupport of this. The first is that markets are concerned viduals subject to – all too human – frailties. by the growing fiscal and current account deficits in the US and the weakness represents a reluctance on Risk is not related to volatility but primarily is a functhe part of the rest of the world to finance them. The tion of price: expensive assets are risky, cheap assets second is the prospect of better growth in Europe rel- are not. While the moves in the dollar over past year ative to the US and the concomitant normalisation of have been painful they have reduced the risk of the monetary policy for the Euro-area. Third is the sign portfolio and it is hoped will offer the prospect of futhat emerging economies, particularly China and ture positive returns, particularly since recent data Russia, are seeking to “de-dollarise” threatening the point to global synchronised growth stuttering. dollar’s status as the global reserve currency. In support of this last point, commentators cite the launch
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