235. Why investors need to rethink the way they build a portfolio

19 January 2023 (pre-recorded 10 January 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’re discussing an absolute return fund today from Ruffer, whose managers tell us how they managed to produce positive returns in 2022 during a difficult market. They also explain the correlation between equity and bonds and how they’re positioned going into the new year. 

I’m Staci West, and today we’re joined by Ian Reese and Duncan MacInnes, managers of the Elite Radar LF Ruffer Diversified Return fund. Thank you both for joining us today.

Ian Reese (IR): 

Hi. Good afternoon, Staci, and thank you very much for having us.

[INTERVIEW]

SW: Now, the fund came into its own in 2022 and managed positive returns in a very difficult environment. So, maybe talk us through what worked for you.

[00:26] IR: Sure. And, as you say, 2022 was a very difficult period for investors, and primarily that was because <laugh>, all conventional or many of the conventional assets which portfolios rely upon, namely bonds and equities, fell during the year. 

We had anticipated quite a rocky period for financial markets, ever since signs that rising inflation was likely to be more persistent than the market had feared. So, we had increased what we call ‘unconventional protections’ in the portfolio and I’ll separate those in two strands. 

First of all, we hedged the interest rate risk in the portfolio. That might sound somewhat technical, but essentially it allowed us to not sell our inflation-linked bonds, which we think are a core longer-term holding, but by hedging out the exposure to rising nominal yields, we were able to weather what was a very challenging period for fixed income, much better.

Elsewhere in the portfolio, we had protection against declining equity markets. So, think of such examples as put options on stock market indices, and the like. And we also had protection against a widening in corporate bond spreads – think of this as the perceived riskiness of corporate bonds rising, which appreciate in value. 

So, those are the assets which appreciated over the year. We maintained a relatively defensive position throughout. We finished the year with our lowest ever equity weighting, so, we were pretty conservatively positioned, but those equities that we did hold, contributed positively during the year. So, it depends which market you look to for your reference performance, but it was not an easy period for returns and we are pleased that actually we were able to contribute positive returns in an asset class which had a very, very difficult period.

SW: And then how active were you in that period to manage the positive returns? Considering we had a significant number of large events happening that moved markets in the past 12 months, were you particularly active during that period?

[02:47] IR: Yeah, so I mean, we are an active manager. If you look throughout our history, we are not afraid or haven’t been afraid, to make large moves to the portfolio over short periods of time. And 2022 is no different and perhaps more special because there were <laugh>, as you say, quite a lot of things going on in a short space of time.

More gradually throughout 2022, and as I mentioned at the beginning, we had been reducing our equity exposure, so it had been, let’s call it 40% at the start of the year. We closed the year at 12.5%. So that was a broad running, downward … equity weighting reduction throughout. 

The more exciting shifts in the portfolio that we’ve been doing [are] namely around the … I’m trying to think of the right way to describe it! … the debacle in the UK bond market towards the end of September and early October. We were purchasing relatively small amounts, but still potent sizes of long-dated index-linked gilts, which, if you caught the bottom, comfortably more than doubled in a short period of time. That was a trend I think.

[04:07] Duncan MacInnes (DM): I think Ian’s being too modest there <laugh>  … maybe that’s the difference between the two of us! … Yeah, so we, as you said, we were adding to inflation-linked bonds at the very end of September in the middle of the, the debacle of the Truss-Kwarteng [Liz Truss, former UK Prime Minister, & Kwasi Kwarteng, former Chancellor of the Exchequer] budget. 

We did actually have an order on for a lot more on, I think it was the 29th of September. We were trying to buy a quite big position that morning and that was the Wednesday morning, I think, after the gilts had fallen 20 odd percent on the Monday, 20 odd percent on the Tuesday. And then they were down 15% on the Wednesday morning when we were trying to buy them. And one broker said that we were the only active buyer of UK duration in the world on that morning, but unfortunately, they weren’t that liquid, and the market really dried up in the hours before the Bank of England intervened. So, we did get a couple of percent into the portfolio, but we wanted to get more if only someone would’ve sold them to us. Sorry, Ian carry on…

[05:16] IR: … No, more broadly, if you like, that was quite a UK-centric view. An asset class, which we already held and were taking advantage, if you like, of a disorderly market. 

What we did do outside of the UK and in the form of the UK, sorry, the US bond market, we added to long dated exposure both in TIPS [Treasury Inflation-Protected Security, a US Treasury bond that is indexed to an inflationary gauge to protect investors from the decline in the purchasing power of their money] and conventional bonds in the US. And if I focus on the TIPS, which for people who aren’t familiar, are inflation-linked bonds, inflation-linked Treasuries, their real yield was approaching almost positive 2%. We felt that was a, you know, very attractive starting point, if you like. And looking around the world at that point in time, your equities were down, let’s call it 20%, your bonds were down a similar amount, you know, [in] sort of round numbers. And we felt that the relative attraction over adding duration through bonds was more attractive than adding to equities at that point in time, given the concerns that we have and still carry over the, you know, the future path of the US and global economy. Those were two of the bigger ones. 

We also added a bit to gold at a very similar time, which again, you can think of as a very long duration asset. And just before the turn of the year and now something we’re considering adding to, is we’ve introduced exposure to oil through sort of exchange traded contracts, which complements, I would say, the existing energy exposure that we have to energy equity such as BP, with more of a direct play on the commodity.

SW: There’s been much talk of a new environment of higher inflation, et cetera. And while this fund and the strategy don’t quite go back as far as the 1970s when we had a similar economic environment, you do actually look back over the last hundred years of data to model certain scenarios. So, how has this helped you understand how the fund might perform and what assets to invest in today?

[07:23] DM: So, first to sort of set the stage as to what we mean when we talk about investors being in a new environment or a new regime, because that’s quite important. Basically, our view is that the world enjoyed 40 years of one particular economic order from 1980 to 2020 where globalisation brought cheap goods, cheap energy, cheap labour, and cheap capital. And to say that that was an understatement or a tailwind for multinational corporations and asset prices is a huge understatement. It was enormously beneficial. 

But that particular global order seems to have ended in our eyes. And the new global order is defined by great powers in strategic competition – thinking about Cold War 2, China versus the US and so on – and the primacy of stakeholders over shareholders. So, that all boils down to a decade looking forward, where we see 3% to 4% average inflation not the 2% or less that we’ve been used to in recent years. And that comes with more inflation volatility, more economic growth volatility, and therefore more market volatility. So, that’s what we mean when we’re saying it’s a completely different regime. 

But back to your question, we’ve been around since 1994, so we’ve got sort of 28 years’ worth of performance, battle testing and history. But from Bloomberg and a variety of other data sources and sort of proprietary analysis, we also have about a hundred years’ worth of data for the full range of asset classes that we can invest in. And what we use this for, is sort of stress testing the portfolio as a jumping off point for discussion on the risks that we’re taking. 

But what our work showed, is that in inflationary periods – so, when inflation is above 3% – stocks and bonds are positively, not negatively, correlated. And that was really the key insight that allowed us to navigate the last couple of years and to avoid the bond bear market. When inflation is above three [per cent], stocks and bonds move in the same direction – they don’t have that offsetting characteristic that most people see because most people look at 20 or 30 years of data, and in that time, stocks and bonds have almost always been negatively correlated, which has created this amazing effect that held up balanced portfolios for so long, until inflation returned. Because really that 20 or 30 years was only looking at one particular type of economic regime, and it resulted in investors being blindsided. And you had last year, which was this failure of diversification, where cross asset correlations were surprising to most people anyway, or surprisingly high to most people.

SW: And that correlation that you just mentioned is one thing that surprised investors in 2022, was that the asset classes, as you mentioned, moved together and they became more correlated than you would typically expect. So, just moving forward from that, do you think that this will change in 2023 and have you managed to find any uncorrelated assets?

[10:34] DM: Well, <laugh> ‘Will it change in 2023?’ is the trillion-dollar question! I think it won’t be quite as stark and as painful as last year, but I think it does continue to be an enduring problem for investors. 

So, when we spoke a year ago the presentations that we were giving at the time were called “Remind me why you own bonds?” But now that we have higher interest rates, I think there are going to be moments, as Ian has hinted at, where duration and bonds become attractive again, but probably not as long-term holds. 

We do think that investors need to rethink the way that they build their portfolios, their portfolio construction, because assets move differently in relation to each other, in an inflationary environment than in a low inflation environment. 

So, what does that mean in practice? We think that – like we have in the last couple of years – investors have to be much more active, much more nimble going forward; buy and hold does not work, that was a strategy for the old regime. 

We keep saying to people that investing for inflation volatility and investing for inflation are not the same thing, and please don’t mix them up, and that would be the lesson of 2022 as well, to some degree. 

Sometimes you need to pay for protection. And this is where we found uncorrelated assets is in our unconventional assets, so, interest rate hedges that Ian mentioned, equity puts, credit protection, these were the key drivers in performance last year, but also over the last couple of years. And the willingness to use them and the ability to use them is probably the main differentiator between us and much of the rest of the market.

Cash, we think is an important asset. At times it’s king. It’s very uncomfortable to hold cash in an inflationary environment, but actually it’s often essential, because it allows you to move very quickly and respond to opportunities like the inflation-linked Gilt sell-off in late September, that we just talked about. 

Lastly, as a principle to … sort of a foundational principle to build your thinking on, we think that portfolios will need to be focused on being resilient rather than optimised. And we’ve spent several decades as an industry iterating towards ever more optimised portfolios, but actually I think that’s probably not a good idea in such uncertain times as we face in coming years.

SW: And then just finally maybe a little bit about how the fund is positioned today for that resiliency that you mentioned. So, where are you finding the opportunities today?

[13:14] IR: Sure. So, I mean, at a big picture level, we would say the portfolio is robustly positioned. Our equity weighting still remains at the lower end of our historic weighting and also alongside a low equity exposure, we have some protection should equity markets fall. So, we’re not trying to take a lot of risk in an equity market recovery. 

We see better opportunities instead of owning equities, in other asset classes; we mentioned the recent purchase of fixed income and also oil if you like. So, if, for example, China’s reentry into the global economy after two or three years of lockdown has a powerful effect on demand and economic growth, we think that oil and other commodities are primed to benefit. So, we do think there are attractions there.

I mentioned the fixed income, you know, we’ve gone from having our duration of the bond portfolio fully hedged to now one of four years. So, should yields fall, there are returns to be made there. 

And I think that the overarching picture that we see, is one of a world where there’s much greater dispersion across economic indicators around the world. So, the path for growth and inflation in the US is likely to be quite different to Europe and China etc. And why I highlight that – and I go back to what Duncan said about cash giving you the opportunity to be nimble and opportunistic – we do think there will be opportunities; we invest in liquid assets, we can move the portfolio quickly and we do expect there to be, you know, as Duncan said, a period of higher volatility. That can sound bad, but it also does present opportunities and sort of waiting and ready to deploy cash when we feel that, you know, prices are sufficiently attractive in our favour.

SW: Ian, Duncan, thank you very much for making time to talk to us today. That was very interesting and lovely to have an update from you both on the fund and your views for the next 12 months looking forward.

DM: Thanks for having us. 

IR: Thank you, Staci, thank you.

SW: The LF Ruffer Diversified Return is an absolute return vehicle which has the protection of investor capital at the heart of its process. It fits the mould of what an absolute return fund should look to do – protect investor assets first and then grow the value of the fund, whilst retaining that focus on capital preservation in all market conditions — just as the managers have explained and demonstrated. To learn more about the LF Ruffer Diversified Return fund, visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.