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John Stopford (Investec AM): “We Are Finding Value in Government Bond Markets where Central Banks Have Tighter Interest Rates”

How to invest in a post-QE world? According to John Stopford, Head of Multi-Asset Income at Investec Asset Management, investors may be concerned about how different asset classes are going to react when the effects of the quantitative tightening begin to be felt. “Ten years ago, the global financial crisis hit, and the central banks responded by flooding the system with liquidity. Markets have been a rush ever since. Investor did not have to think too hard about what they owned. All asset classes have gone up. But what would happen when quantitative easing begins to turn and unwind? Is there a risk that bonds and equities will sell-off together? The answer is probably yes,” explained Stopford.

“Most of us got used to an investment world where movements in the US equity market were negative correlated to movements in US bond market. This has been the norm for the last 20 years or so. But, from 1984 to 1998, the correlation between the S&P 500 Index and the US 10 Year Future was positive. During that period, bonds and equities went up and down together. Investors need to understand that if there is a common driver that pushes both bonds and equities in the same direction, then both will tend to have a positive correlation behavior. In this decade, the common driver has been the monetary stimulus, that essentially pushed all the assets up. Investors need now to be more selective and look for mispriced assets rather than assuming that owing big pockets of beta is going to win the day”, he continued.

In developed markets bonds there are some areas that are starting to look more attractive and are more likely to offer at least some protection if equities sell-off. “Essentially, it is about valuation and finding government bond markets with reasonable yields in real and nominal terms. We are beginning to find some value in government bond markets in US, Australia, New Zealand and Canada, where central banks have begun to tighten or already have tighter interest rates. The Fed’s tightening is being felt mostly elsewhere rather than in the US, which is dangerous because it allows the Fed to fall into a false sense of security and continue to ratchet monetary policy tighter”.

The Fed usually tightens until something breaks

In the past, the Federal Reserve has typically tightened interest rates until they reach a point in which they have tightened too much. This point is usually when the yield curve gets inverted. “The Fed looks at the US economy, which is booming, they look at US inflation, that is in line with target inflation, they look at unemployment, that at 3,9% is well below the sustainable rate of unemployment and they decide to go tightening. Meanwhile, the pressure is happening outside the US, for example in Turkey and Argentina. Emerging markets are beginning to feel the pressure of the liquidity tightening, but as long it is not yet impacting in the US, there is nothing that will stop the Fed from carrying on,” he stated.

Over the next year, investors should not be worried about a recession. Typically the latest stages of an economic expansion in a bull market are very rewarding. By the second half of 2020 though, the market outlook may get more complicated.

“Now, the Fed is tightening interest rates and they may be the cause of a bear market. But other central banks have just started tapering their quantitative easing programs. They are tightening liquidity, but they are not rising rates yet. They are not giving themselves ammunition to fight the next battle. In the typical recession, central banks cut rates by 4% to 5%. What are central banks going to do now? The one-month deposit rate in Europe is still negative and the European Central Bank is talking about raising rates after the summer of 2019. If a recession may hit in 2020, how high will be European rates by then? Meanwhile Japan is still pursuing quantitative easing but tapering a bit. There is a big question mark about what policy makers are going to do. In the past, they came out with creative ways of adding liquidity, but there will be less ammunition to fight the next crisis”.

Regarding credit vulnerability and the rising uncertainty in the markets, Stopford believes that the risk premiums are compressed at this point in the cycle, but this is something that it is beginning to change. “The yield premium offered by the US High Yield in terms of spreads, a compensation for credit uncertainty, and the equity volatility measure of VIX have typically moved together. But due to the higher level of uncertainty, it seems that they may decouple a bit. Equity volatility is going to remain suppressed for much longer and credit spreads will start to increase as the market is beginning to worry more and more about future defaults.

A challenging environment makes selectivity crucial

The US dollar remains the world reserve currency, even if there are some currencies like the renminbi, the euro or the sterling pound that are candidates to become reserve currencies, but they all have some flaws. “The dollar remains the principal world currency. Trade is still around 80% denominated in dollars. It is not surprising that the US remains the most liquid capital market and it is the place where borrowers go if they want to borrow. The quantitative easing has facilitated an explosion in debt outside the US denominated in dollars. The problem is that dollar funding conditions are now tightening, and lot of that monies are just stock in the US because that is where the economic growth is and where the returns are. Borrowers finance themselves through global trade. When the global economy is expanding, borrowers that are earning dollar revenues can service their debt tend to have excess of dollars at that point and diversify their investments, generating reserves and putting downward pressure on the dollar. On the contrary, when global trade goes into recession, there is a shortage of dollar revenues, dollars are used to fund borrowings and the price of the dollar goes up. By now, global trade is under pressure, with new protective policies and tariffs.”

On the other hand, the Japanese yen is easily the cheapest developed market currency in the world. “Japan has been running an aggressive quantitative program for some time. Japan is essentially a capital exporter. The Japanese have excess of savings and they tend to send those excess savings to other markets to earn a return. When they hit a crisis, they stop sending their capital abroad, therefore, the yen tends to have very good defensive characteristics. If equity markets collapse, Japanese investors temporarily become more cautious and the yen will tend to go up. We need to think more cleverly about how to diversify investors exposure in the current environment”, he concluded.

David Herro (Harris Associates): “Active Managers Need to Be Grateful for Passive Investing”

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According to David Herro, Portfolio Manager and Chief Investment Officer of International Equities at Harris Associates, an affiliated of Natixis Investment Managers, active managers need to be grateful for passive investing. As more money flows into passive investments, more investment decisions are made irrespective of price and value and more market inefficiencies are created.

“As an active investor, I actually need passive investors to have a field on which to play. When market inefficiencies are created, I can exploit these opportunities as a long-term value investor by taking advantage of these market distortions, and that is why I am very grateful to passive investing. This means there may be some short-term pain and our challenge as an active investor is to spend more time with clients while we are going through these periods. We have to explain to clients that they do not have to act irrationally based on short-term pricing events,” said Herro.

“If you are an active manager, you are not going to match the performance of the index quarter to quarter. If clients want someone who is going to match the performance quarter to quarter, that is not us. There is always a trade-off between trying to match the index and achieving long-term results. As an equity investor, I can invest in businesses that theoretically have an extremely long duration, and I am trying to take advantage of the shelf prices, knowing that the fundamentals are not changing anywhere near the prices. I need more than one or two quarters to do that, sometimes maybe a year or two. The active manager has to be out front and communicate that active management needs time to work. Additionally, transparency with clients is key. Each manager is kind of a tool in a tool box and clients need to know what type of tool you are as a manager and how you are intended to be used. Active managers need to be who they profess to be, so clients know how to use your skills properly,” he added.

As Herro explained, when active managers do not resist the temptation of performing short-term, they start becoming quasi-passive managers and start taking short cuts, despite collecting an active fee. As a result, when the cycle turns, those managers are not going to obtain their alpha back.

“We utilize discipline and patience in our strategies. This is something that is lagging in the investment world because some of the clients are short-term oriented. But I am glad that at our company we take the time to achieve long-term returns. Our system is designed to significantly and measurably outperform over 5, 10 or 15 years. We always try to take advantage of market dislocations, when share prices move in a vastly different direction or speed than the underlying intrinsic business value. When volatility comes back, it provides more dislocation to markets, which enables us to exploit future return possibilities. For example, on the last day of the third quarter this past September, the Italian government proposed a budget that significantly deviated from commitments agreed upon by all euro zone members. In general, there was an extreme dislocation in the European financial sector. The next day of trading, the European financial stocks were trading at an average down of 2% to 3%, and even quality Italian financial institutions were down 7% to 8%. Clearly, in our view, the business did not magically become worth 8% less, but because of some political discourse there was an extreme volatility in prices in a very narrow sector and we were able to take advantage of it.”

The hidden costs of passive investment

When securities are bought and sold, just in the dealing and exchange of the investment instruments, there is a margin between the bid-ask spread alone. Money is made just in the business of buying and selling spreads. “Whether it is through hidden costs, bid-ask spreads or not being able to get investments at the right price, these are all forms of hidden costs that might make ETFs less competitive,” said Herro.

New disruptive players

Herro believes that eventually tech giants like Amazon or Google will possibly get into financial services. “They will probably offer all kinds of products. They may offer passive products, but they may even offer some artificial intelligence type of product. To me, as an active manager, the more players the better because they create market inefficiencies. They have money chasing certain characteristics in size, location or industry, instead of value characteristics. As long as they can not develop a model that delivers long-term value returns, this is additive to our business,” he concluded.

How A First-Of-Its-Kind Credit ETF Became A Bond Market Stalwart

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Cómo un ETF de crédito, pionero en su tipo, se convirtió en un incondicional del mercado de bonos — CC-BY-SA-2.0, FlickrPhoto: Jeroen Berndsen. How A First-Of-Its-Kind Credit ETF Became A Bond Market Stalwart

A trio of 2018 milestones show that iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) is now an indispensable investment tool.

Two decades ago few options were available to retail investors looking to assemble baskets of corporate bonds. One option was to call a broker, who in turn picked up the phone and worked orders through dealers on Wall Street.

This process was often difficult and expensive. And it could take weeks–sometimes longer–to build a diversified bond portfolio. Instead, most people paid active managers to trade and manage bonds for them in mutual funds.

Then came iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), the first-ever exchange traded fund tied to corporate bonds. Credit ETFs trade heavily now, but looking back to 2002, it’s hard to appreciate how novel LQD was at the time. It tracked a well-known index of investment grade bonds, providing diversification and trading efficiency.

Suddenly, individual investors could access the broad corporate bond market. A mix of 100 corporate bonds could be purchased for just pennies in bid/ask spread and 0.15% per year in fund expenses.

Adoption borne from crisis

Many institutional investors became aware of LQD during the financial crisis. As bond markets seized up, LQD continued to trade on exchange throughout the day, providing real-time markets and price discovery–especially during the memorable week roughly one decade ago that Lehman Brothers declared bankruptcy.

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LQD’s trading volumes have climbed as investors recognized the fund’s utility. Liquidity, as measured by average daily volume, has grown steadily; liquidity spurred more liquidity, and encouraged additional adoption by institutional investors. The experience of LQD has been mirrored in other corners of the corporate debt market, where iShares iBoxx $ High Yield Corporate Bond ETF (HYG) has become a de facto proxy and trading instrument for the high-yield bond market. Indeed, HYG’s trading volume as a percentage of total daily volume in individual high-yield bonds rose to 19% in October, a record.[1]

Milestones abound

Sixteen years after the launch of LQD, the ETF has $34 billion in assets under management. It trades $725 million on average each day, up 38% from a year ago.[2] In stressed market conditions, it has traded even more, recently as much as $2.1 billion.[3] As volumes grow, investors can now use LQD to quickly obtain diversified exposure to more than 1,000 bonds with a single, on-exchange trade.

Investors’ predilection for LQD continues to surface in notable ways. Last year was the first time that LQD’s average daily volumes surpassed that of the most liquid individual investment grade bonds, including Verizon and JP Morgan.[4]Adoption by insurance companies, whose portfolios rely on stable fixed income exposures, recently made LQD their most heavily owned ETF across industry portfolios.[5] Earlier this year, LQD broke the record for the single-largest “block” trade in bond ETF history, a signal that large, institutional investors are confident about their ability to trade and manage risk with LQD in size.[6]

What do investors get with LQD?

Beyond liquidity, LQD offers investors a highly diversified exposure to the investment grade corporate bond market across more than 1,000 bonds. LQD seeks to track a broad index, providing investors with access to bonds in all major sectors, including communications services and industrials. That makes the product potentially suitable for investors seeking broad exposure to the investment grade corporate bond market.

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For investors with more targeted views, the LQD family suite offers choices to access the investment grade corporate bond market more narrowly. The iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD) offers access to bonds with shorter maturities; the iShares 5-10 Year Investment Grade Corporate Bond ETF (MLQD) offers access to bonds with medium maturities; and the iShares 10+ Year Investment Grade Corporate Bond ETF (LLQD) offers access to bonds with longer maturities. The iShares Interest Rate Hedged Corporate Bond ETF (LQDH) allows investors to seek to mitigate interest rate risk and express a more direct view of bond issuers’ financial health, and the iShares Inflation Hedged Corporate Bond ETF (LQDI allows investors to specifically hedge against inflation risk while still owning LQD’s corporate bond exposure.

We believe that even more milestones lie ahead for LQD and bond ETFs in general as a growing chorus of investors recognize the benefits that bond ETFs provide in terms of access, efficiency and liquidity. Taken together, the iShares suite of investment grade bond ETFs are indispensable tools for investors of all types and sizes to access and manage risk in the investment grade bond market.

Build on Insight by BlackRock

[1] Bloomberg, BlackRock, FINRA TRACE; HYG’s one month rolling exchange volumes as percentage of high-yield cash bond volumes hit a record on Oct. 31, 2018; (HY OTC 144a volumes are included in the HY cash volumes).

[2] BlackRock as of Sept 28, 2018.

[3] BlackRock; Bloomberg (Daily notional trading volume hit a record Oct. 11, 2018)

[4] BlackRock, TRACE, as of 9/28/2018

[5] S&P Global Market Intelligence data compiled April 10, 2018.

[6] BlackRock, TRACE, as of 9/28/2018

In Latin America and Iberia: this material is for educational purposes only and does not constitute investment advice nor an offer or solicitation to sell or a solicitation of an offer to buy any shares of any Fund (nor shall any such shares be offered or sold to any person) in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that some or all of the funds have not been registered with the securities regulator of Argentina, Brazil, Chile, Colombia, Mexico, Panama, Peru, Portugal, Spain, Uruguay or any other securities regulator in any Latin American country and thus might not be publicly offered within any such country. The securities regulators of such countries have not confirmed the accuracy of any information contained herein. The provision of investment management and investment advisory services is a regulated activity in Mexico thus is subject to strict rules. For more information on the Investment Advisory Services offered by BlackRock Mexico please refer to the Investment Services Guide available at www.blackrock.com/mx.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

The Fund is actively managed and does not seek to replicate the performance of a specified index. The Fund may have a higher portfolio turnover than funds that seek to replicate the performance of an index. There is no guarantee that interest rate risk will be reduced or eliminated within the Fund.

LQDI: The Fund’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective.

Investing in long/short strategies presents the opportunity for significant losses, including the loss of your total investment. Such strategies have the potential for heightened volatility and in general, are not suitable for all investors.

The Fund’s use of inflation hedging instruments is intended solely to mitigate inflation risk and is not intended to mitigate credit risk, interest rate risk, or other factors influencing the price of investment-grade corporate bonds, which may have a greater impact on the bonds’ returns than inflation. There is no guarantee that the Fund’s positions in inflation hedging instruments will reduce or completely eliminate inflation risk within the fund.

LQDH: The Fund’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective.

Investment in a fund of funds is subject to the risks and expenses of the underlying funds.

There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Diversification and asset allocation may not protect against market risk or loss of principal. Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This material is strictly for illustrative, educational, or informational purposes and is subject to change.

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with Markit Indices Limited.

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Michael Power (Investec AM): “USA Blames China for its Economic Problems, But Could the Real Culprit be Closer to Home?”

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China is no longer a copycat economy. By 2029, China’s GDP is expected to surpass United States’ GDP. China is expected to become the largest economy on the planet overtaking the United States, and there is a great unease at all levels, but particularly on the political level. According to Michael Power, strategist at Investec Asset Management, this change is coming and there is not much that can be done to stop what will materialize in the next ten years.

“What is happening now is that China is starting to use its immense brain. The volume of research and development that it is taking place in China means that China no longer needs to be a copycat economy. According to R&D Magazine projections for 2018, US R&D spending is expected to increase by 2.9% to 553 billion dollars, while China R&D spending is expected to increase by 6.7% to 475 billion dollars. Meanwhile, Asia collectively is close to spend half of the R&D budget of the world, spending 43.6% of global R&D,” said Michael Power.

“The big question that has been asked by Donald Trump is: Is China playing fair? Is it cheating its way to the top? Is it a giant game of corporate espionage what has allow China to almost catch up, and very soon, perhaps to overtake American economy? But there is nothing new here. It was the same way United States behaved towards Britain in the late XIX century. For over 100 years, the United States did whatever it was necessary to bring new ideas or people to the United States. The other thing to notice is that the problem with China has been that the rest of the world wants more from China that what China wants from the rest of the world. Back in 1784, in the very first trade mission that United States ever did to China carried things like ginseng, lead or woolen cloth, their real profit came on their return, when they brought Chinese tea and porcelain to the Americas. And this pattern still exists today,” he added.

Meanwhile, Trump protectionism is potentially endangering the entire structure above which US corporations have been built over the last 20 years, and that is a supply chain that is rooted in Asia. Supply chain are critically to the structure of big technological companies and Donald Trump is potentially rocking this structure with trade war disputes.

“Supply chains have the oldest logic of trade at their heart, which is buy low in Asia and sell high in the United States. Trade deficits essentially represent the revenue side of the story, but they miss the profit side. When you look at the revenue story, it is easy to see the imbalance and how it is going to affect to ‘Main Street America’. But ‘Wall Street America’ does look at the profit side and it is a completely different picture. The United States run a 14 billion dollar of current account surplus with the Eurozone and it also runs a 14 billion current account surplus with Canada. Of course, it does not run current account surpluses with Japan, China and Mexico and ultimately the reason for that is that US corporations have not created enough big markets in these three zones to counteract the trade deficit that it runs with those regions. Until it does, it will run collectively a large current account deficit.

In 2017, the US goods deficit with China was about 375.2 billion dollars, 55% of the goods imported by US from China were computers, electronics and electrical equipment. But more interestingly for me, is to have a look at where US has surpluses with China, and at the top six categories, only transportation equipment, on the second place, is remotely industrial. The other five categories being farm crops, oil and gas, waste and scrap, minerals and ores, and forestry products. The exports on transportation equipment are centered in the deal between Boeing and China, and I worry about this because the Chinese are setting up, with the help of Bombardier, their own aircraft industry centered in a company called Comac, which will soon release its challenge to both Airbus and Boeing in 2023, at which point the second item of account surplus for US could be in danger.”

Additionally, the program “Made in China 2025” is heavily investing in 10 sectors where China is hoping to become world leaders. They still intend to become leaders in these sectors, but they are not advertising the fact anymore. Another question that should be consider is that the inputs that United States gets from China are coming from companies that are not owned by Chinese companies, but from foreign companies. In particularly, if we talk about electronics, they are usually Taiwanese companies. The assumption is that Chinese owned companies are the ones exporting their goods to the US but that is not strictly true.

An alternative explanation

China has always been blamed by Trump’s administration as being at the root cause of the problems of US’s economy. But, could the real culprit be closer to home? The big technological companies have been extracting profits from global revenues and managing them in a very tax-efficient manner, facilitating domestic buy-backs to extract wealth. “Ireland plays a key role in engineering tax arbitration for big technological companies. All the iPhones coming out of Shenzhen that are not sold in United States, are sold to a company on Ireland. And then this company sells them to its final destination, anywhere in the world. This company in Ireland pays about 370 dollars per unit from Foxconn for an iPhone, and then they sell it for 1,200 dollars in average in Europe, the uplift is close to 800 dollars. Only 0.7% of that uplift is paid in taxes in the European countries, the rest is declared as profit in the form of intellectual property back to the United States. This is a problem that Europeans have already addressed recently, that is in the heart of how Apple has become spectacularly profitable, 99.3% of its margin is declared as profit. There is this giant shell game that technological have been playing for a while and people are beginning to understand now. Combined, corporations in the United States have 2.1 trillion dollars in cash, and 45% of it belongs to big technological companies. Additionally, about a 62% of those 2.1 trillion dollars is held offshore, 1.3 trillion dollars in cash are held overseas. As of the end of June, Apple had 285.1 billion in cash overseas. Additionally, the ten top holders of cash are new economy companies: Microsoft, Alphabet, Cisco Systems, Oracle, AT&T, Amgen, Qualcomm, Gilead Science and Amazon,” explained Power.

“The Big Tech use this cash offshore to show better consolidated balance sheets, so the banks are happy to lend them, at least in the United States, where they borrow huge amounts of money. For example, Apple is borrowing domestically a 43% of its offshore cash pile. Then, they use that debt to buy-back shares, but because the debt is based in the United States, they can claim interest deduction on that debt, and on that part shield a good portion of US profits. The result is that we have seen buy-backs ballooned since 2009, and this has been a big underpin of the performance of the S&P 500. In fact, since 2011, US corporation’s debt has risen fastest than cash. Buy-backs have been so critical to performance of equity markets that the only buyers in first half of 2018 have been companies of United States. Everybody else have been a net seller. The result is that stocks have risen, and the United States equity market represents more than 50% of the MSCI All Country World Index. Due to share buy-backs, the number of shares in issue has been reduced and earnings per share have grown. However, if the culprit behind the last financial crisis was home equity withdrawal, will the culprit behind the next crisis corporate equity withdrawal? As Jack Ma, Ali Baba’s CEO, questioned at the World Economic Forum: Has China grown mostly on revenue and the US on profit? The point to understand is that revenue is shared within a very vast amount of people, whereas profit will just be shared among the 1%, and it helps explain, but not entirely why there has been increasing concentration of wealth and an increasing growth of inequality in the United States,” he concluded.

When Spreads Widen One Can Add to Existing Positions at Lower Prices to Earn Greater Returns

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M&A performance was crimped in October as market volatility caused most spreads to widen. This presented an opportunity to put cash to work by adding to existing positions at lower prices to earn greater returns. Since our first investment product dedicated to merger arbitrage in 1985, we have invested through periods of heightened market volatility. Our conservative investment discipline consisting of no leverage, position size limits and a preference for strategic, fully-financed transactions allows us to add to high-conviction positions at times of market stress to earn higher risk-adjusted returns.

More specifically, in October:

The spread on the Rockwell Collins (COL-NYSE) deal with United Technologies widened from about $5 to $12, despite winning approval from U.S. antitrust regulators. “Arbs” expected Chinese antitrust (SAMR) approval to come quickly after the DOJ, but the approval has not yet been received and the delay has resulted in a wider spread. On his October 23 earnings call, United Technologies CEO Greg Hayes said that SAMR approval had been delayed because the Chinese were waiting for U.S. clearance, which itself was delayed until early October.
NXP Semiconductors (NXPI-NASDAQ) traded lower given the market volatility and a decline in semiconductor stocks broadly. Although we made progress in reducing our position prior to the market selloff, our remaining position clipped performance in October. After reporting results after market hours on October 31, the stock rallied more than 10% to $83.

In October, we also realized gains on transactions that closed including Boeing’s $4 billion acquisition of aerospace supplier KLX Inc. and Conagra’s $11 billion acquisition of Pinnacle Foods. On October 30, WestRock received DOJ antitrust approval for its $5 billion acquisition of KapStone Paper and Packaging, and the deal subsequently closed on November 2. We are building our pipeline of deals with notable new transactions announced in October including:

Red Hat, Inc. (RHT-NYSE), a developer of software and services used to manage IT infrastructure, agreed to be acquired by IBM for $190 cash per share, or about $32 billion.
Endocyte, Inc. (ECYT-NASDAQ), a biopharmaceutical company developing therapies for the treatment of cancer and inflammatory diseases, agreed to be acquired by Swiss drugmaker Novartis for $24 cash per share, or about $2 billion.
Imperva, Inc. (IMPV-NASDAQ), which develops data center security software, agreed to be acquired by technology investor Thoma Bravo for $55.75 cash per share, or about $2 billion.

We continue to find attractive opportunities investing in announced mergers and expect future deal activity will provide further prospects to generate returns uncorrelated to the market.

Column by Gabelli Funds, written by Michael Gabelli

To access our proprietary value investment methodology, and dedicated merger arbitrage portfolio we offer the following UCITS Funds in each discipline:

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GAMCO Merger Arbitrage UCITS Fund, launched in October 2011, is an open-end fund incorporated in Luxembourg and compliant with UCITS regulation. The team, dedicated strategy, and record dates back to 1985. The objective of the GAMCO Merger Arbitrage Fund is to achieve long-term capital growth by investing primarily in announced equity merger and acquisition transactions while maintaining a diversified portfolio. The Fund utilizes a highly specialized investment approach designed principally to profit from the successful completion of proposed mergers, takeovers, tender offers, leveraged buyouts and other types of corporate reorganizations. Analyzes and continuously monitors each pending transaction for potential risk, including: regulatory, terms, financing, and shareholder approval.

Merger investments are a highly liquid, non-market correlated, proven and consistent alternative to traditional fixed income and equity securities. Merger returns are dependent on deal spreads. Deal spreads are a function of time, deal risk premium, and interest rates. Returns are thus correlated to interest rate changes over the medium term and not the broader equity market. The prospect of rising rates would imply higher returns on mergers as spreads widen to compensate arbitrageurs. As bond markets decline (interest rates rise), merger returns should improve as capital allocation decisions adjust to the changes in the costs of capital.

Broad Market volatility can lead to widening of spreads in merger positions, coupled with our well-researched merger portfolios, offer the potential for enhanced IRRs through dynamic position sizing. Daily price volatility fluctuations coupled with less proprietary capital (the Volcker rule) in the U.S. have contributed to improving merger spreads and thus, overall returns. Thus our fund is well positioned as a cash substitute or fixed income alternative.

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Class A USD – LU1216600913
Class A EUR – LU1216600673
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Disclaimer:
The information and any opinions have been obtained from or are based on sources believed to be reliable but accuracy cannot be guaranteed. No responsibility can be accepted for any consequential loss arising from the use of this information. The information is expressed at its date and is issued only to and directed only at those individuals who are permitted to receive such information in accordance with the applicable statutes. In some countries the distribution of this publication may be restricted. It is your responsibility to ﬁnd out what those restrictions are and observe them.

Some of the statements in this presentation may contain or be based on forward looking statements, forecasts, estimates, projections, targets, or prognosis (“forward looking statements”), which reﬂect the manager’s current view of future events, economic developments and ﬁnancial performance. Such forward looking statements are typically indicated by the use of words which express an estimate, expectation, belief, target or forecast. Such forward looking statements are based on an assessment of historical economic data, on the experience and current plans of the investment manager and/or certain advisors of the manager, and on the indicated sources. These forward looking statements contain no representation or warranty of whatever kind that such future events will occur or that they will occur as described herein, or that such results will be achieved by the fund or the investments of the fund, as the occurrence of these events and the results of the fund are subject to various risks and uncertainties. The actual portfolio, and thus results, of the fund may differ substantially from those assumed in the forward looking statements. The manager and its affiliates will not undertake to update or review the forward looking statements contained in this presentation, whether as result of new information or any future event or otherwise.

Marc Pinto (Janus Henderson Investors): “Companies that Are Benefiting from Disruption Are in the Growth Category”

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According to Marc Pinto, Portfolio Manager at the Janus Henderson Balanced Fund investment team, the three characteristics that differentiate his portfolio are: the growth orientation in the equity sleeve of their strategy, the dinamically managed allocation between equity and fixed income, and the fact that the equity team and the fixed income team maintain a very collaborative working relationship.

The latter being especially noticeable when the investment team makes decisions on asset allocation, where equity and fixed income teams must compete for capital, taking into account the opportunities offered by their markets.

Additionally, the investment team has a three-way approach for disruption. They think about the companies that have been disrupted, the companies that are creating the disruption and the companies that will benefit from it. Currently, the team identifies two major disrupting forces, the e-commerce and the cloud computing. In these two trends, the investment team assess who are the winning and losing companies, and how to invest on the right side of each trade.

E-commerce

Consumers are clearly benefiting from all the innovation that is going on in the world. Technology is providing consumers more bargaining power, anyone can go to a store and compare the price of the product offered online at Amazon.

“People have said that traditional retail stores have become the showroom for Amazon, and that is true to a certain degree. However, the smart retailers have chosen to be the showroom for their e-commerce model. At Janus Henderson, we have invested in those retailers that have done a good job migrating the physical store aspect s of retail sales to e-commerce, proving an incentive to buy through them and not through Amazon”, explained Marc Pinto.

“The e-commerce penetration is still low. The retail e-commerce is going to continue growing as a percentage of total retail sales. The question is, how do traditional retailers survive in this environment? For example, Nike, the sportwear brand, is one of our largest positions in our Balanced portfolio. A couple of years ago, Nike realized that developing a direct relationship with the customer will give them a huge opportunity to essentially know their customers better. Additionally, the direct relationship with consumers would allow Nike to bypass the middleman and capture its margin, avoiding having to compete for shelf space at retail stores.

NikeID is Nike’s direct to consumer offering, where basically customers can go online and get a pair of customized training shoes, choosing the colors, putting their names on them, and shipping them directly to their homes. Nike does not incur in any retail margin and can sell them at a more expensive price. It is a very profitable business, NikeID represent now 15% of their business and it is growing around 30% to 40% per year.

Traditional retailers who have figure out how to nail the on-line and traditional retail models are the ones who will be successful on the future. These businesses have to invest a big sum of money in terms of technology to create a seamless model where customers can go into the store and decide what they want to buy and how they want to buy. Another example of a traditional retail company that has managed to have an integrated model of e-commerce and traditional retail business is Home Depot. Their website is offering the possibility of knowing the exact inventory that they have in every store and their location within the store. They have an integrated inventory management system and they have created a customer friendly portal where customers can know in real time how much of every item they have in a store. It is not technology for technology sake, is technology to make the consumer experience better”, he added.

Migrating to the cloud

Another big source of disruption are the cloud computing and the software as service players. Amazon Web Services, Salesforce, Microsoft Azure are some of the companies that are going to benefit from the migration to the cloud. “Players on the cloud are doing really well. As investors, the big question we have is about valuation levels and when it is the right time to get in. But as growth investors we definitively want to be invested in these companies”, said Pinto.

“In this case, the losers are the companies that are providing the traditional hardware and their prices. Companies like HP, IBM or Oracle are still supplying hardware to a lot of offices, but their demand is at risk to decline as cloud spending becomes a bigger portion of the business. Total IT spending is going to start flattening because the cost of deployment in the cloud is substantially less than it is for buying traditional hardware and software. Some estimates point out that the cloud deployment is 10% the cost of the traditional IT infrastructure deployment. There is going to be a massive deflationary pressure on IT spending when every company migrates to the cloud. Companies will benefit form a massive reduction on their technology costs and they will be able to spend those dollars in other areas”.

Is the growth trade over?

Since January 2009, the returns of the growth component of the S&P 500 have consistently beaten the returns of the value component of this index. With only 2016 being an exception, growth stocks have outperformed value stocks in the last 9 years. Because it has been such a long period without alternance, investors are beginning to be worried about the possibility of a mean reversion to value.

“We think that this is happening for good reasons. This is not a question of market rotation or even low rates, there is a logic behind the outperformance of growth stocks. What is driving this discrepancy of growth versus value is that the companies that are disrupting are the growth companies; and the companies that normally are being disrupted are typically value companies. The companies that are benefiting from disruption are in the growth category. More companies are going to be in the growth space as they will continue to do well”, he concluded.

Investec AM Gets Back to Their Roots and Celebrates its Annual Investment Conference in Cape Town

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In Cape Town, where Investec Asset Management story began 27 years ago, the international asset management firm with South African origins hosted the 11th Investec Global Insights conference and brought together 220 delegates from eleven countries around the world.

Richard Garland, Managing Director of the Global Advisor division, welcomed the attendees explaining what are the key elements that make Investec Asset Management a unique asset management firm. According to Garland, being a global asset management firm with emerging market roots differentiates the firm apart from competitors.

“The most important thing is where did we come from. There are many asset managers who start in London, New York, Boston or Los Angeles, but neither came out of the future. And, why do I say the future? It is because Africa is the future. We learned how to run money in the most difficult continent in the world for running money, and then we went global. We grew out of South Africa, an emerging market, to become a global asset manager”.

Some other characteristics that Garland believes differentiate Investec AM from competitors are: stability and continuity, multiple alignments of interests, a multi-specialist framework and culture.

“Over the years, we still have the same sales people and the same fund managers. This is core to who we are. The top 50 to 60 people at Investec Asset Management own equity from the company, our interests are aligned with the client interests. We work with a multi-specialist frame, we do not have only one investment style, we do not have only one investment team or philosophy. We have different ways of running money, which means we always have investment strategies or funds which will work for your clients in any environment.”

A top-level view: Interview with Hendrik du Toit

Following his introduction to the firm, Richard Garland interviewed Hendrik du Toit, Joint-CEO of Investec Group. Hendrik was one of the founders of the company in 1991, 27 years ago in Cape Town, where Investec AM was a small start-up asset manager offering domestic strategies in an emerging market.

From the early days, Hendrik remembered some chaos. But the firm was able to build up a mid-caps strategy and buy their growth in the next decade. They were able to build a track record based on multiple expansion, something that allowed them to reach new clients.

Du Toit stated that being a mid-size asset manager firm can be an advantage to compete against the large-scale asset managers. “This is an industry in which size is one of the components of strength and not necessarily the defining. It is about quality and excellence, it is not about size. In the banking industry balance sheet matters, it is an important source of strength. But in the asset management industry, you only need to be big and strong enough to deal with the regulatory barriers. When asset management firms become bigger, they lose control on what is going on in the business and only worry about the politics on the board room.”

When asked about entering the passive management business, Du Toit specified that there are only going to be two, or three at the most, serious global passive managers. “If you are in a race where prices tend to zero, only one or two scale players can live with one or two basis points. BlackRock and Vanguard, the discount players that make real money in the passive investment business, have a huge active business. ETFs have brilliantly market themselves as a passive investment and they tell the world they are cheap, when they are rather expensive. The managers make money out security trading and the commission fee and sell the illusion of a 100% liquidity when you are actually investing on very long duration assets. ETFs are a useful tool for all, we use them in our multi-asset portfolios, but they are not a competitor. In the end there are certain risks that provide the returns the clients need in a low yield world. You need to allocate your money where the winners are, otherwise you are going to stay with the losers. The promise of active is not that we are going to always outperform some index, which are difficult to beat. Instead, the promise of active is that we are going to allocate capital sensibly and try to capture the huge opportunities that the 4th revolution is bringing to capital markets.”

According to Hendrik, there are massive investment opportunities in China’s growth, in the renewable energy transition and in the food industry; and you need to be an active manager to capture them.

Demerger of Investec Group and listing of Investec AM

In September, Investec Asset Management announced that the firm will become a separately listed entity. After the separation of Investec AM from the remaining Investec Group, Hendrik du Toit will lead the new listed entity as Executive Chairman.

“Investec’s banking and wealth group are largely based in two countries: South Africa and UK. Whereas most of the growth of the asset management business comes from the Americas, Asia, Western Europe and the whole continent of Africa. Geographically, we are thinking differently. Also, client niches were totally different, we do not have direct clients as the banking and the wealth group do, we work with intermediaries. We focus on our client’s relationships and that turns into long-run revenue and profit growth,” stated du Toit.

“The strategy is going to remain the same. We are going to help clients who want to take active risks to achieve the returns over and above target benchmarks in chosen markets with our skillsets. All our portfolio managers have different but complementary skillsets. There is an addressable market of 25 to 30 trillion dollars and we would like to keep growing on our current shape. We will obviously add some private market illiquid asset offer or any other business that is active and difficult to do.”

Sustainability

Concluding the interview, du Toit mentioned the importance of considering environmental, social and sustainability criteria when investing. “I grew up in Africa and I have seen what climate change can do to communities. I have seen what overfishing, deforestation, and polluted rivers can do to places. It is not debatable that 7 billion humans have an excessive impact on this world. We also know that we have to combine development and job creation with protection of the natural resources of our world. We are long-term investors. We are supposed to invest for the next generation and the generation after. We must think about the consequences of our capital allocation. We are fortunate to be the stewards of capital and we have a long-term liability to choose where to allocate the capital. Companies will be sued and will go bankrupt for environmental liabilities”.

John Dickie: “Investors are Realizing that by Sticking to the Public Markets they are Limiting Themselves”

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Nearly four out of every five institutional investors globally are allocating capital to alternative assets and private equity represents a large chunk of that capital, Preqin’s data shows. Aberdeen’s John Dickie, Co-Head of U.S. Private Equity at Aberdeen Standard Investments, talks with Funds Society about the outlook for private equity investment and fundraising in the second half of 2018/year ahead.

In John’s opinion, it is a very good time to be raising money, and there is a lot of interest globally in private equity given that it has performed quite well and has continued to outpace the public markets. John also notes that investors increasingly appreciate that there are hundreds of thousands of private companies in the U.S., whereas, there are less than 4,000 public companies in the U.S., so “investors are realizing that by sticking to the public markets they are limiting themselves to a very small portion of the total investable universe.”

However, he believes that “GPs have to have an edge to catch LP’s attention.” At a high level he sees strong interest in the lower middle market, “given that returns in that part of the market have been better” than larger funds.

When looking to invest with a GP John and his team at Aberdeen Standard Investments focus on two main areas:

Quantitatively, they need to fundamentally believe the GP’s team are good investors and have a great track record of improving the operations of businesses they invest in. They also look to how they source investments.
Qualitatively, “we look for people that we trust and value as partners, that value our input, and that are building great firms culturally, with multigenerational layers and appropriately shared economics,”

Co-investing is here to stay

John believes co-investing is an important tool for LPs to enhance returns and to minimize, or even eliminate, J-curves. However, he observes that there are many firms that have been reckless with co-invest. “So, whenever the next downturn comes, many LPs will not be happy.”

At Aberdeen Standard Investments, the firm has built a team with professionals that have GP experience, which allows them to keep up with the GP due diligence activities, and to dig deep into companies.

What will the market look like?

According to John, we will continue to see the big firms get bigger, but there will also be more small firms. “The largest firms are going to continue to attract capital from all over the world and continue to grow, but a number of middle markets firms are going to continue to have spin outs,” he said, adding “we are observing a huge number of spin offs and first time funds. A lot of LPs will back first time funds but NOT first time investors.”

The reason why he believes that emerging or new private equity fund managers are attractive is that “you can allocate capital to a team of people that are highly trained from a well-respected organization that have, in many cases, 10-15, sometimes 20 years of PE experience, but now they get to do it for themselves. The passion of having your own firm with your closest partners leads to an incredible incentive in alignment where these teams are hungry to succeed and have a successful fund. We think that can be a pretty interesting dynamic.”

Club Expats Challenge: No Plastic Bags in November

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Club Expats, the reallocation service that many of our friends and colleagues in the asset management industry have used when arriving to Miami says: “Help us reduce the number of plastic bags that end up in the ocean”.

Rebeca Calvet, founder of the Club Expats in Miami has a great challenge for us that can help reduce the trash in our beaches… and at the same time raise awareness for this problem and money for The Seed School of Miami. She is proposing to make November a plastic bag free month.

By joining this challenge you pledge to donate one dollar to The Seed School of Miami for each plastic bag you use. I made a trial and, being very careful my family used 22 plastic bags in an average week. In a month this would account to 88 dollars for The Seed School of Miami, the less plastic we use, the better for the environment. If we fail to reduce our plastic waste The Seed School will get their donation. This is a win-win situation. You can join the pledge, or simply donate through this link.

These are the facts:

Americans use 100 billion plastic bags a year, with the average American family taking home almost 1,500 plastic shopping bags each year.
Up to 80% of ocean plastic pollution enters the ocean from land.
At least 267 different species have been affected by plastic pollution in the ocean.
100,000 marine animals are killed by plastic bags annually.
One in three leatherback sea turtles have been found with plastic in their stomachs.
Plastic bags are used for an average of 12 minutes.
It takes 500 (or more) years for a plastic bag to degrade in a landfill. Unfortunately the bags don’t break down completely but instead photo-degrade, becoming microplastics that absorb toxins and continue to pollute the environment.

This facts have been sourced from the Center for Biological Diversity

Andrew Gillan (Janus Henderson Investors): “We Have Already Started Asia’s Century. The US and Europe Are Losing Ground to China and India”

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According to Andrew Gillan, Head of Asia ex Japan Equities at Janus Henderson Investors, there is a huge amount of disruption in Asia, the world’s growth engine, but this also means that there is a huge amount of opportunity for investors. Gillan, who is based in Singapore and has an extended on the ground experience, explains that the main rationale to invest in Asian equities is that, over the long-term, Asian equities have had the capacity to generate a higher return than other markets. Even through the Asian Crisis in the late 90s and through the 2008 Financial Crisis, the MSCI AC Asia Pacific Ex Japan Index has generated greater returns than the MSCI AC World Index, obtaining 8,1% of annualized gross returns vs 7,4%, from December 1987 to August 2018.

The relevance of Asia in technology and disruption

With a population of 1.4 billion of people, China has 772 million of internet users (55% of the population); 717 million of smartphone users (51%); 753 million of mobile internet users (53%) and 527 million of mobile payment users (37%). Meanwhile, in the US, with a population substantially smaller and a higher percentage of internet, smartphones and mobile internet users, there is less room for potential growth.

“The relevance of the information technology sector in Asia has grown considerably in the last two decades, and now represents a 26% of the benchmark index. Meanwhile, Financials, that right now comprise about 32% of the index, are very susceptible to disruption. In ten years, they will probably have a lower weight. Tactically, our strategies are overweighting Financials now, in part because the Fed is rising interest rates, but from a long-term structural perspective, we have been underweighting Financials when investing in Asia”, says Andrew Gillan.

“In terms of allocating geographically to the region, I could say that we have already started Asia’s century. Tailwinds for Asia, in terms of population growth and demographics are very powerful. The US and Europe are losing ground to China and India. By 2030, Asia is expected to make up to 66% of the world’s middle-class population, a powerful reason for accessing the consumer in these markets.

Another matter that is worth highlighting is the effect of the online grocery markets on bricks and mortar retail sector. China’s online grocery market is expected to reach 30 billion USD this year. This market has been growing at an annual rate of 73% over the last six years”, he adds.

Managing disruption

The Janus Henderson Asia Pacific Capital Growth fund is a truly active strategy, investing only in 40 companies or less. It does not have an overwhelming style bias, mixing quality and value stocks, and its is liquid, the volume of asset under management allows the portfolio management team to be nimble in their investment decisions.

“About 70% of the stocks in the portfolio are considered core companies, with superior and consistent return on equity and cash generation ratios and with very strong franchises, for example: Alibaba or Tencent. The other 30% is the dynamic part of the portfolio, those are the stocks that we believe give us a good positioning to navigate markets. We hold positions in companies that we consider to be disruptive or adapters to the industry changes, or if we think that market conditions are changing in the short-term, we focus on companies that have a compelling valuation or are cyclicals”, explains Andrew Gillan.

Embracing disruption

Janus Henderson’s team embraces disruption in investment decisions. They define disruption as an entirely new product, service, or process that creates significant incremental value over the long term. They do not limit it to the Artificial Intelligence or the Technology sector, but they extended it to traditional sectors, like consumer, insurance, banking and IT services.

“We normally identify the disruption potential in companies through the leading indicators of potential disruption. These may be a visionary leader or a management team that is willing to change an existing ecosystem or trying to challenge a different business model. It can also be the “right” corporate culture, a track record of innovation, a good long-term strategy and vision, strong financials to organically fund required investments, or strategic and timely mergers and acquisitions. We believe that successful disruption will lead to high and sustainable return on equity over the long-term”, he says.

“Similarly, if we apply the same disruption potential to our investment process, we can say that we assess the management, financial and franchise quality. Additionally, we have frequent interactions with the companies that we invest in, something that we think is the key way to identify and look for the impact of disruption on investments. We are probably more quality investors rather than disruption investors, as we believe that quality companies have higher chances of becoming disruptors or being protected from disruptions”.

Not all disruption is profitable

Clearly, not all disruption is profitable. More than 40 bike-sharing service companies have sprouted in China since 2016, because it is a business with very low barriers to entry. However, the bike-sharing market in China is undergoing a significant consolidation, with more than 20 start-ups going to bust as of February 2018.

“There are only going to be a few winners, and not surprisingly, they will be the companies that are backed by the “big guys”. That is the case of OFO, a company that secured 866 million USD in a new round of financing led by Alibaba, or the case of Mobike, a company adquired by Meituan Dianping, China’s larger provider of on-demand online services, at a valuation of 3.7 billion USD. The companies with the bigger and deeper pockets become the winners”, he concludes.