Children of the Revolution – Part 1 – Best Performing Trusts in a Crisis
The COVID-19 pandemic is far from over, but we have perhaps seen the end of the first act.
Most of the developed world is in various degrees of ‘lockdown’; anxiously watching poorly reported – and often poorly understood – numbers for indications that their government’s strategy is working.
Meanwhile equity markets saw one of their worst ever quarters in Q1 2020, as whole swathes of the economy were shut down by government diktat.
‘equity markets saw one of their worst ever quarters in Q1 2020’
The speed with which the situation developed was remarkable; and it is fair to say that all managers would have been surprised, even if they had other reasons for being bearish.
We take a look at how and why certain investment trusts have done well in absolute and relative terms amidst the carnage, and ask if the causes of the crisis can provide any indication how the situation might end, and which trusts might outperform.
Good luck to anyone that just tries to copy an old playbook in this crisis … We think we had the last crisis all figured out, retrospectively, and so we think we’re so smart in the next one. It just doesn’t work this way. – Mark Spitznagel, hedge fund manager
One of the worst quarters in stock market history
The FTSE 100’s fall of 23.8% in Q1 2020 was its worst since Q4 1987, when it fell 27%.
This all transpired following 20 February, when the likely scale of the pandemic in the US and Europe became clearer.
‘the sell-off has been brutal and indiscriminate’
Given the tendency for correlations between stocks to spike to 1 during a crisis, the sell-off has been brutal and indiscriminate.
For equity trusts, sector and stock selection has therefore had limited impact – although it has had some, as we discuss in the next section.
The trusts which have done best in absolute terms have been those which had built-in protection against sharp market falls or are set up to profit from volatility. (We have excluded from our analysis those which are mostly invested in unquoted investments.)
Both trusts publish weekly NAVs, and between 21 February and 27 March BH Macro’s NAV rose an astonishing 25%.
The FTSE All Share fell 24.7% over this period. BH Global made an almost as impressive 17.2%. While we are impressed at the scale of the return, we are not particularly surprised at the two trusts’ success.
BH Macro focuses fundamentally on rates (bonds and currencies) trading by a group of star traders, including founder Alan Howard.
Alan and his colleagues look for trades with option-like payoffs, which have minimal downside and huge upside. When there is little volatility – as between 2013 and 2017 – these positions won’t pay off.
However back in January 2019 we reported how Brevan Howard believed the market environment was changing in their favour, as volatility returned to the rates markets. Q1 2020 certainly saw volatility.
It is important to note that Brevan Howard’s rates traders do not need to hold a particular view on the direction of the market, or the outcome of the pandemic, to continue to profit from extreme volatility: they merely look for trades with asymmetric payoffs, irrespective of market direction.
BH Global is a more diversified fund housed within the same stable.
As well as an allocation to the same master fund into which BH Macro feeds, BHGG has direct allocations to key traders at Brevan Howard as well as to volatility and systematic trading funds. The shifts in BHGG’s allocations mean that, at times, it can differ substantially from BH Macro.
BHGG has just enjoyed the best first quarter in its history, with its rates portfolios paying off and major contributions being made by the volatility fund and across the other asset classes invested in.
Despite this excellent performance the fund’s GBP shares trade on a discount of 4%, while BH Macro has been trading close to par.
We regard any substantial gap in discounts between this pair as an anomaly, which makes BHGG look attractive in relative terms.
As the world has seen rates hit the floor in response to the pandemic, it seems that volatility in the rates market could be set to reduce. In which light the more diversified approach of BHGG could also appeal.
We do wonder, however, whether the seeds of a big move up in rates are being sown, and this could be our fate in the medium term. That is the view of the managers of Ruffer Investment Company (RICA), the standout performer in the AIC Flexible sector.
‘Ruffer view high levels of inflation as the inevitable end of our debt binge’
Ruffer view high levels of inflation as the inevitable end of our debt binge. Being positioned for inflation has not helped in recent years, and in fact was not the key to Ruffer’s outperformance in the recent sell-off.
It was their call options on the Vix and long CDS positions (paying off when credit spreads widen) that drove their positive NAV return of 3.5% in the massive drawdown.
The CDS position, which was the largest in the fund going into the crash, returned 100% as a result of the sell-off. While this position remains in the fund, the call options on volatility have been sold down.
In addition Duncan MacInnes and Hamish Baillie have been picking up gold miners and building up cash, waiting for a better time to buy into equities.
The managers have long been warning that equity market valuations were stretched and these positions were designed to pay off when the piper demanded to be paid.
We discuss this further in the updated note published this week. Duncan and Hamish both think that the fiscal expenditure being plotted to steer us out of this crisis will only compound the inevitable inflationary period the world economy will soon enter, and so they have been adding to their large position in index-linked bonds and increasing their exposure to gold.
Also worthy of mention as an absolute performer is Pershing Square.
The listed vehicle of Bill Ackman owns a portfolio of just ten stocks, all long at the moment, and so wouldn’t have been expected to do well in the crash.
However, Bill had astutely built up CDS positions shortly prior to the major sell-off, which more than made back any losses on the equity book. PSH publishes weekly NAVs, and between 18 February and 31 March the trust’s NAV was up 3.9% as the S&P 500 fell 19.2%.
Ackman’s long-term track record is exceptional, and indeed his NAV performance in recent years has also been extremely good and underappreciated, with the share price languishing on a wide discount to NAV.
Optimists will be pleased to know that he has since started buying more of his portfolio and has reopened a position in Starbucks, which he sold out of earlier in the year.
A totally different playbook
One of the unique features of this crisis has been the speed with which it has developed and the sudden stop brought to the economy by government orders.
This is well illustrated by the weekly initial jobless claims in the US which hit 6.6m last week, the highest on record and almost twice the previous week’s which was itself over three times the previous record highs seen in 1982 and 2008. In other words, this sudden stop is unprecedented.
‘One of the unique features of this crisis has been the speed with which it has developed’
As such it is unsurprising that the trusts that are up in absolute terms are those which had insurance-like trades, including options which can drag on returns in the good times but make huge returns in the sort of unexpected events that we have just lived through.
In all the cases discussed so far, the manager benefitted from this insurance without having foreseen the events – with the possible exception of Bill Ackman who added his CDS positions when reading about the impact of the virus in China.
If we turn to the more ‘vanilla’ equity funds, even the best performers have had a torrid time.
As this was not a normal recession, i.e. this was not caused by economic events, no analysis of economic data could have given signals of what was about to happen and very few were deliberately positioned for this.
There are however, some interesting patterns in what has done well which might have some implications for the market in the months and years to come. First is the defensive performance of technology.
The internet of everything – technology’s impact
Technology is often thought of as being a ‘risk-on’ industry. Successful technology stocks tend to trade on higher multiples than the market, making them widely considered to be growth stocks.
However, trusts with high weightings to technology have done better in this crisis. The MSCI ACWI/Information Technology sector fell 17.8% in the drawdown, compared to a 20.6% loss for the MSCI ACWI as a whole.
In the global sectors some of this better performance has come from currency – many global technology companies are US listed, and this has benefitted sterling investors in particular.
However, this pattern has also been evident in other sectors too, illustrating there is something else going on.
We must stress that we are not just referring to those businesses listed in the technology sector by the index providers, but also those internet retailers and service providers which often appear in the consumer discretionary or communications sectors after reclassifications in the past few years. Amazon, for example, was down just 6% in the sell-off.
‘trusts run by Baillie Gifford in particular have done relatively well in the US, Europe and UK sectors’
As a result, trusts run by Baillie Gifford in particular have done relatively well in the US, Europe and UK sectors, even when adjusting for the unlisted investments some of them hold.
In each of these sectors, Baillie Gifford’s trust did significantly better than its closest peer in the drawdown.
In the AIC UK All Companies sector, Baillie Gifford UK Growth (which reports no unlisted holdings) has massively outperformed, down 26.1% compared to an average loss of 35.6% and a worst performance of -40.7%.
Losses in this sector have been exacerbated by the mid-cap focus of many trusts and the focus on the UK domestic economy which had become a consensus area following the December election result.In the AIC North America sector, Baillie Gifford US Growth’s NAV was down just 17.3% in the drawdown to end March.
Marking down the unlisted positions in line with the losses on the listed portfolio gets us to an estimated decline of 19.8%. This is two percentage points better than the next best result, and compares to a sector average decline of 25% (the worst performer was 31% down).
The best-performing AIC Europe trust was Baillie Gifford European Growth, down 17.4% and almost two percentage points better than the next best result, while the sector average was a 21.6% loss and the worst performer lost 31.6%.
Even Scottish Mortgage, which entered the crisis month with 8% gearing, was a relative outperformer in its AIC Global sector.
Adjusting its 20% in unlisted positions by the same reported NAV loss of 14.7% gets us to an estimated loss of 18%; this compares favourably to the 19.1% average of the reported losses in the peer group. Some trusts outperformed Scottish Mortgage though, which we discuss below.
Why has tech proven to be defensive? We think there are two main reasons. One is the online economy has proven to be critical to keeping our societies running during lockdown.
‘the online economy has proven to be critical to keeping our societies running during lockdown’
Online learning, online meetings, chat services and ordering systems have seen a surge of users.
In our view, there is no going back from this. In particular, consider online shopping: the people who have discovered online groceries shopping are the aged who have been told to self-isolate to a greater degree and would have been less likely to use these services before.
Are they all going to go back to lugging shopping bags home on the bus?
Unlikely, in our view. There will be a permanent change of lifestyle for many people, and the online economy will be essential to this shift. When this is all over, will all the commuters around London go back to spending four hours a day on the train, or will Zoom and its peers retain their new users?
The second reason is around the logistics businesses built by Amazon and its peers.
Even a cynic has to be impressed by how Amazon has shifted its network to provide essentials to the self-isolating.
‘a permanent change of lifestyle for many people, and the online economy will be essential to this shift’
It is seen as so dominant and so important in this sphere that the UK is handing it the task of delivering testing kits to citizens, which are likely to be their ticket back to a normal life in the fullness of time.
Accordingly, Amazon is almost behaving like a defensive consumer staples company on the downside and a high growth consumer discretionary on the upside, a potent combination.
With regulatory attack from the Democrats in Congress now looking less likely, it is in a strong position; as is its Chinese peer Alibaba, which has also taken on a key role in delivering essential supplies and testing kits in its home country.
Amazon is a major holding in Mid Wynd (MWY). MWY has been another relatively strong performer in the AIC Global sector, down just 16.3% in the drawdown.
When we spoke to the managers recently they told us that many of the themes they had built into the portfolio had helped relative returns in the crisis; and were only likely to be strengthened as a result.
Alongside the growing online economy, healthcare has been a helpful theme, as has their bearish view on air travel. The managers believed before the crisis that air travel would come under pressure for environmental reasons.
In our view it is likely to be some time before the travel sector returns to previous levels after the crisis, if it ever does. We will be publishing a note on the trust next week. Please click here if you want to be notified.
However, the top performer in the AIC Global sector has been Manchester & London (MNL).
MNL has benefitted from both key factors discussed so far. It is highly concentrated, with the top seven stocks (58.2% of the portfolio) essentially a list of technology winners from the crisis: Amazon, Alphabet, Microsoft, Alibaba, Facebook, Tencent and Salesforce.
It has also benefitted from having a short book which paid off. MNL shorts ‘old economy’ stocks. Although it doesn’t list the individual names, in the February factsheet there were shorts on oil and gas exposed stocks and on low quality and low credit rated names, all of which will have paid off.
The trust lost just 14% in the drawdown. We will be publishing a note on the trust next week. Please click here if you would like to be notified.
Cheaper and cheaper – the underperformance of value continues
Another key reason explaining which trusts have performed in relative terms is exposure to the value style.
There are a few reasons for this. Chiefly, value managers have increasingly been buying financials, energy and materials, all areas which have been particularly hard hit.
Banks suffer from lower interest rates hitting their margins, from an inevitable spike in non-performing loans and, we would suggest, in the long run may take another step to being viewed as a utility which deserve greater state interference.
Energy and materials suffer from the shutdown in manufacturing, as well as from the coincidental price war between the Saudis and Russia.
If the outcome of this crisis is less air travel, greater focus on domestic supply chains and a shift online, demand for energy and certain raw materials could also become structurally lower.
‘The sector average was a 29.8% loss and the worst performer was down 55.7%’
The sector average was a 29.8% loss and the worst performer was down 55.7% (the worst large cap trust was down 44%). These are two trusts which hold stocks often considered ‘defensive’ – high quality with defensive revenue streams – but which also have a relatively low tilt to value stocks.
The worst performers include those with a greater value tilt (as well as some which are geared and have a greater exposure to UK domestics).
In the Asia and emerging markets sectors, the key has been to be overweight to China and underweight to India.
Alongside this the same trends have been important – towards high tech businesses and consumer and business services distributed online, and away from the value sectors of energy, materials and financials.
Thanks to the region being earlier into the pandemic than the West, with China already starting to lift its lockdown, the drawdown in this period has been much better than in the developed world – albeit still in the mid-teens.
The comparison is perhaps not fair given a lot of the market losses were taken earlier.
However, particularly creditable performers have been Witan Pacific and Schroder AsiaPacific in Asia. (We updated our note on the latter last week.)
In the emerging markets sector, Fundsmith Emerging Equities has done well thanks to its highly defensive portfolio (and notwithstanding its exposure to India).
JPMorgan Emerging Markets has also outperformed, with low gearing and high exposure to internet and tech names. We recently wrote on the long-term case for Asia in a strategy note, and note that it may be the region is already emerging from the economic lockdown.
In Part 2 we will look at how and where the recovery will come. For more visit our friends at: