The P1 models have rebounded more strongly than corresponding benchmarks over the quarter, the return of most portfolios year to date is just under -5% (17th June), slightly behind benchmarks. Relative performance has predominately been driven by the movements of UK equities and the pound, both of which hindered our overweight positioning in the first quarter but have been a tailwind over the last three months. Against the IA benchmarks, portfolios are approximately 14% overweight to UK equities, with corresponding underweight to US equities. This is predominately as a result of our use of the PIMFA asset allocation framework, which has a much more significant home bias.
In particular, we have typically run with a strategic overweight to mid and small cap companies, most prominently in higher risk portfolios. These were areas that were especially hard hit in the selloff, although have rebounded strongly. We continue to maintain our belief that these areas will deliver outperformance over time, both through the dynamism of the underlying companies but also from the ability of active managers to add value in this area of the market. Unfortunately, this may lead to periods of relative underperformance, however, historically these have proved to be short lived, and liquidity driven, as has been shown so far this year. We remind ourselves of the Brexit referendum driven selloff in mid and small cap UK equities, which was followed by a multiyear outperformance, surpassing any underperformance experienced in the short term.
Portfolios have also been impacted by the relative underweight positioning to US equities and Government bonds. For a long time, we have been averse to having direct allocations to government bonds, influenced by the low returns on offer and the unwillingness to expose portfolios to rising rates. While this view has impacted negatively in the short term, there is a limit to the capital returns achievable from government bonds from the current level. We remain conscious that following all of the fees incurred by investors, there is likely to be a negative absolute return from holding Gilts over the long term and we are therefore only comfortable in holding them when we have a very negative outlook and believe that yields are headed lower.
Positively, portfolios have been bolstered by the use of diversifying alternatives as well as some strong performing individual funds. All real assets suffered heavily through the selloff and there were few places that were not impacted by liquidity driven selling. Indeed, even US Treasuries suffered periods of dry demand during the worst of the selloff. Historically defensive holdings such as infrastructure suffered as investors looked to sell anything in favour of cash. However, some absolute return funds, that have been difficult to hold over the recent past, have proved their worth this year. The JPM Global Macro Opportunities, which is used widely across many portfolios, proved beneficial, rising when most other assets fell.
As before, below are the condensed key decisions and rationales.
- Reduce equity exposure in favour of high yield
- Upside opportunity in equities much less clear following significant rally
- Spreads on HY bonds remain wide. Support from deleveraging and CB support
- Will dampen portfolio drawdowns if another selloff were to occur, without constraining upside
- Strategic Asset Allocation reduction to UK Equities
- Small reduction to UK weighting where it is most extreme
- This is also reflected in TAA changes
- Maintaining geographic positioning within equities
- We do not currently have any extreme positioning within international equities
- Other fund changes
- Removal of Aviva Multi Strategy Target Income
- Removal of Somerset Emerging Markets Dividend Growth
- Addition to infrastructure within alternatives
Core Asset Allocations
While all assets have appreciated, it has been equities that have led the rally. With valuations where they are and considering the substantial risks ahead, it is difficult to envisage a scenario where there is another 10-20% upside, while a 20% drawdown is a distinct possibility. We have therefore looked for the best ways to dampen the downside risk to portfolios while still providing opportunities for gains.
Typically, the simplest way to reduce risk is to increase fixed income exposures at the expense of equities. While we remain negative on government bonds, the spreads on offer from investment grade and high yield bonds appears attractive relative to the risks. Furthermore, these assets should provide a reasonable return even in a more mundane economic scenario. Indeed, in a reasonable base case scenario, we would expect high yield to outperform equities. Therefore, such a change should mean that only in the most extreme positive scenario would portfolios be disadvantaged from an addition to high yield at the expense of equities. This asset allocation change has been made to the moderate risk level and above, where the equity exposures are highest.