Nanuk New World Fund + Lunch

What’s the fund?

This month we are taking a closer look at the Nanuk New World Fund. Nanuk is one of the only Australian fund managers dedicated solely to identifying investment opportunities and risk associated with environmental sustainability and resource use.

Nanuk Investment Management was established in 2009 The investment team have extensive experience across global equity markets and is led by Tom King OAM, who is an engineer by trade and spent several years working as an investment adviser to the Packer family. Paul Chadwick, who was most recently head of Global Macro strategies at GMP Australia. Paul is supported by Tim Ryan, who founded Orion Asset Management and has over 36 years’ experience, as well as Eric Siegloff, who was deputy CIO of ING’s European multi-asset investment management division. Nanuk has offices in Sydney, London and New York and offers three wholesale funds to investors seeking sustainable, environmentally focused investment strategies.

Why Nanuk?

Nanuk is one of the only Australian fund managers dedicated solely to identifying investment opportunities and risks associated with environmental sustainability and resource use. The team is dedicated to becoming world leaders in the space and is one of just a few groups globally who have the experience and capability to deliver returns and meet their self-directed mandate. The investment process is focused around remaining active and aware of the changing nature of the environment and the impact that businesses can have on it, with a fundamental value driven approach to identifying investment opportunities. Nanuk believes that resource constraints and environmental challenges like climate change, pollution and water scarcity necessitate significant changes to business practices globally and that these changes will present significant long-term investment opportunities and risks.

Where does it fit in your portfolio?

The fund meets the requirements of the Thematic Bucket as its sole purpose is to invest in listed companies around the world that are associated with the broad theme of environmental sustainability. More specifically, they seek to invest in companies involved with clean energy, energy efficiency, industrial and manufacturing efficiency, waste management, pollution control, food and agriculture, advanced and sustainable materials, water, healthcare and technology. There is growing expectation that businesses in both the developed and developing world will commit to having a more positive impact on the environment and community they work within and Nanuk is a first-mover in this sector.

Why invest?

The New World Fund is one of the only truly global managers in Australian that focus solely on investing into sustainable, environmentally and ethically aware businesses. Recent performance has shown that it is those companies focused on investing sustainably that generate the greatest returns over the long term. Whilst the team is small, they leverage off extensive relationships and broker networks to obtain research and insights into the investment universe. The fund applies both negative and positive screens to the identification of its investment universe which includes around 1,600 ‘sin stocks’ that are involved in oil, gas, coal and similar industries. The fund will invest into around 60-70 stocks at any given time which are selected using a fundamental approach based on a combination of basic valuations with a macro/thematic overlay which considers the growth opportunities in the various sectors. The fund has grown to $200m under management and continues to attract additional capital from both institutions and retail investors as the importance and value of new technologies and energy efficiency seemingly grows by the day. The fund is long-only, it cannot short companies, which means it will be volatile and an investment term of at least five years will be required. The fund offers daily liquidity, charges a management fee of 1.2% and is only available to wholesale investors.

What does it invest in?

 We have provided more detailed information in the section that follows, but summarise the current allocation of the fund as follows:

 

How has it performed?

The short-term performance has been exceptional, with the fund delivering 28.8% for the 9 months to 30 September 2019. This exceeded both the MSCI World Index, 21.3% and the FTSE Environmental Index, +24.8%. Longer term returns are also strong, with the fund averaging a return of 17.6% per annum over the last three years and 14.6% since inception, both ahead of all benchmarks. The strategy has benefitted from the increasing efficiencies available to businesses investing into more sustainable technologies and the increasing direction of capital towards these companies in the face of global climate action.

We were lucky enough to be joined by the Chief Investment Officer, or Portfolio Manager of the Nanuk New World Fund, Mr Tom King, at our latest client round table. Rather than focus on the funds recent performance, which has been exceptional, Tom put forward his views on the outlook for both the global economy and the sustainability revolution that is the core of his investment approach.

The presentation began with Tom drawing attention to the likes of Apple, who had reported overnight, and the fact that the first smart phone was created just 12 years ago. He noted very few, if any people, could predict how important and ubiquitous the smart phone would become in our daily lives. It was this underestimation of the acceptance of new technologies that Nanuk is seeking to identify but in relation to the sustainability of our very way of life.

The presentation opened with a fairly straightforward summary of those areas where the sustainability revolution was likely to impact the economy the most:

  • The transition to clean energy;
  • Improving industrial efficiency;
  • The production of food;
  • Healthcare technology and treatment;
  • Energy efficiency;
  • The use of scarce water resources;
  • Recycling of waste and pollution control; and
  • Advanced and more sustainable materials.

Without going into extensive detail, rather we direct you to the slides available https://sponge-capybera-dlkm.squarespace.com/s/SEMINAR-Second-Wave-Oct-2019.pdf, we highlight a number of particularly pertinent points that were made during the presentation.

  • At a time when many are suggesting the oil sector is heading for a renaissance and that the adoption of electric vehicles (EV) was overstated, Tom explained Daimler’s recent decision to stop development of all internal combustion engines. Tom suggested that by the mid 2020’s there will be more EV than internal combustion cars on the roads around the world.
  • Whilst explaining the evolving cost curve of energy production in Australia and around the world, he highlighted that under nearly all conditions, nuclear power is and will remain too expensive to power our economy. In fact, most renewable energies were actually cheaper than running existing coal and gas fired stations, as shown in the table below. This included the cost of the associated battery storage required to support renewable sources.

The questions naturally moved towards the value of pumped hydro power, like Snowy 2.0, however, it was clear from the discussion that firstly, it is an expensive way to produce power with large amounts of loss, and secondly, there were very few unused sites available to build similar projects.

The discussion moved towards the importance of action being taken on CO2 emissions, with some interesting facts including that the global herd of cattle emits as much greenhouse gas pollution each year than the US as a country. More importantly though, he estimated that the time taken from the point of adoption of pollution targets to the point of no return for technology, has been around 10-20 years in history.

A table discussion began around why Australia had not been successful in establishing our own manufacturing facilities for the production of batteries at a global scale, with many believing we should be getting started now. Tom put it down to the lack of an integrated vertical supply chain compared to the likes of China and the comparatively expensive cost of labor and energy which are the two key inputs.

Tom provided some analysis around the history of technology improvements and highlighted that the forecasts of the production cost reduction of most technology, including renewables, was excessively conservative. For instance, forecast cost reductions for lithium batteries in 2030 were actually hit in 2017, 13 years ahead of schedule. Solar was subjective to a similarly conservative expectation of adoption:

In moving towards his darker outlook for the future, he outlined the key contributors to greenhouse gas emissions from the UN, which were as follows:

Tom noted that these technologies generally formed part of the first wave of sustainability and were the so-called low hanging fruit, like solar energy and electric vehicle adoption. He outlined his 8 themes of the second wave as follows:

  • Electricity – transition to renewables and storage;
  • Electrification of transport
  • Fossil fuel to electricity by hydrogen capture and feedstock changes
  • Production changes in agricultural, diet changes and waste reduction
  • Improving the energy efficiency of buildings
  • Improving waste reduction and recycling
  • Many small changes to water efficiency.

 

  • The likely winners of these many transitions were:
  • Solar, wind and energy storage
  • Smart energy grid technologies based around demand response
  • Electrification of heat
  • Hydrogen (power to gas)
  • Sustainable materials
  • Recycling
  • Controlled environmental agriculture
  • Plant based protein
  • Waste management and processing
  • Electric vehicles including buses
  • Rail transport
  • Big data and AI
  • Advanced manufacturing

 

  • And the likely losers:
  • Fossil fuels including oil, coal and natural gas
  • Centralized electricity grids
  • Petrochemicals and plastics
  • Traditional ‘Portland’ cement
  • Blast furnace steel production
  • Air transport
  • Crop based biofuels
  • Agricultural chemicals
  • Beef/lamb

Tom brought the discussion back towards his conclusion, that the sustainability revolution was inevitable. He noted that the election result in Australia was not based on climate policy, but various other matters and highlighted that some 85% of Labor voters wanted action on climate change but just 16% of Coalition voters. Looking more closely, the trend is being driven by millennials and young people, meaning every election will see more voting for action. Tom suggested that the approach taken by the French Government in recent trade negotiations, effectively forcing their trade partners to undertake similar action on the climate if they wish to benefit from the French economy.

Finally, the presentation was concluded through a discussion of many of the underlying investments but with an important precursor. This was that the Nanuk fund was not established to bet on unknown technologies with shareholder capital but to back proven technologies as they become ubiquitous in our lives. He noted that solar panel shares are on average down 90% over the last 10 years, even as solar panel installation has reached mass levels.

As we have highlighted on several occasions, the Nanuk strategy is an example of how businesses around the world get on with the task of tackling major issues, solely because it is in their best interest.

Marley Spoon

This column has been quite successful with our most recent smaller company reviews. Webster, which we suggested was a buy at $1.60 received a takeover offer of $2.0 per share, whilst iSentia is up from 25c in August to 42c today. This week we take a closer look at meal delivery app, Marley Spoon (MMM).

Who is Marley Spoon? MMM is a recipe and food deliver service. This means that the company delivers a box of fresh food, including vegetables, meat and snacks, along with a recipe to its customers on a weekly basis. It is the primary competitor to Hello Fresh in Australia. Many may of heard of Youfoodz, which is a prepared, re-heat meal deliver service, Marley Spoon is the complete opposite. It’s customer receive the exact amount of food they require and cook fresh meals using the contents of their box.

The offering has become increasingly popular with millennials and busy professionals alike as it provides a lower cost and generally healthier alternative to the options available on Uber Eats and Menu Log. With a young child, I’ve been recently converted to the recipe and meal kit delivery, buying as many as three to four meals per week. It allows my family to avoid the regular trips to the supermarket but most importantly minimise the amount of waste that typically comes from this.

The company operates across 6 different countries, including the US, UK, Belgium and Germany. It was listed in 2018 but founded in 2014 in Germany, where it is also listed. It operates in a fast growing, but incredibly competitive sector and hence regularly posts large losses. Into 2019 the company has delivered 25 million meals across the world.

What happened? 2019 has been a busy year for MMM. The company reported 54% in revenue compared to the previous year and importantly forecast that they would deliver their maiden operating profit in 2020. For a technology company just 5 years old this is a remarkable result. To add to this good news, earlier in 2019 the company announced it had entered a strategic partnership with Woolworths. The deal involves Woolworth’s investing $30m into the business and both teams working together to learn from each other. The investment means WOW will own 9% of the equity along with preference shares. On the one hand, Woolworth’s world leading supply chain will be invaluable for MMM in their fight for market share with Hello Fresh. On the other hand, Woolworth’s will gain valuable insights into the meal delivery market and if the company is particularly special, just buy them out. MMM has a market cap of just $60m.

Financials: The injection of capital from Woolworths and later Silicon Valley-based Union Square Ventures has let the company focus on improving their product and not about raising more capital. The results are already being seen by investors. Net revenue increased 55% from $39.5m to $61.4m euros, whilst active customers hit 172,000 after increasing 38%. The fastest growth is coming from the US, which saw revenue double (98%), Australia was also strong at 44% and Europe just 20%. The benefit of the business model is that it is based on repeat orders and loyalty, with 91% of revenue coming from repeat customers. The company focuses on its contribution margin, being the profit before market and administration fees, where it leads its competitors at 33% in Australia and 24% globally. This improving contribution margin has resulted in the EBIT margin, or earnings margin, reducing from a loss of 49% in 2017, to just -28% today, with the likelihood of a profit in 2020. Following the capital injection the company has limited debt but still relies on further equity raises in to continue expanding it’s business. As with most fast growing technology-based companies, the biggest expense is marketing and advertising.

Our view: The experts say you should buy shares in companies you know and understand. Having used Marley Spoon, I would have to agree. The company is one of just two real competitors in the sector in Australia and both are growing incredibly quickly. That being said, it is very much a microcap company that will rely on further capital injections to remain viable and is therefore not for everyone.

The reasoning is simple; the company provides a service that makes people’s lives easier. But it doesn’t end there. It offers people healthier and highly cost effective options that allow them to continue cooking their own meals, but in a substantially shorter time. The company is acutely aware of the huge amounts of waste that occurs in the grocery and restaurant sector and is focused on minimising this via portion control and a ‘source-to-order’ supply chain. This means they only buy enough ingredients for their current customers, no more no less. So you can eat well and feel good about your impact on reducing waste. In our view, the partnership with Union Square and Woolworths has taken Marley Spoon to another level and represents an exciting opportunity.

A closer look…..

As we have highlighted on many previous occasions, the extraordinarily low interest rates around the world are forcing investors to take on more risk just to sustain (rather than grow) their income each year. Now, this is all well and good if these investors have undertaken due diligence and understand what it is they are investing in. Unfortunately, this isn’t always the case. With this mind, we wanted to take a closer look at the very popular Neuberger Berman Global Corporate Income Trust. We have broken our analysis down into a few simple sections:

Who is Neuberger?

Neuberger is a New York based fund manager with expertise across most sectors of the market including equities, fixed income and alternatives. They were established in 1939 and have over $455bn under management globally with closer to $7bn under management in Australia, primarily with institutions. It’s important that investors do not confuse size with security, as whilst the manager itself is extremely successful and huge by Australian standards, they do not control the performance of the underlying investments.

What is the fund?

The Corporate Income Fund is a specialist income focused fund that invests solely into senior bonds issued by global listed companies. This includes secured and unsecured senior debt which are both positioned at the top of the capital structure and first in line in the event that an issuer defaults on their obligations or moved into bankruptcy.

What does it invest in?

The Corporate Income Fund invests into what is commonly referred to as ‘junk bonds’, ‘high yield’ bonds or unrated credit. At present, the portfolio holds less than 1% in what are considered investment grade bonds, with a rating above BBB with the remainder allocated as follows:

The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The geographic and sector allocations are as follows:

What are the risks?

In our view, the risks of this investment are substantially higher than many of both its investors and the financial planners who recommended it truly understand. The fund invests bonds issued by institutions that fall many rungs below the likes of the Commonwealth Bank on the credit ratings scale. For instance, the largest current holding is Petrobras bond, lending money to the Government-backed Brazilian gas and oil producer.

More importantly investors are exposed to an immensely higher risk of default on the loans made through this fund than through the likes of a Bond Fund issued by PIMCO or Schroder’s. Yet the managers are extremely clear with this fact in all their publications reporting that essentially none of the underlying investments would pass the investment grade requirement. This represents a substantial risk to investors for many reasons, but primarily, the risk of default is substantially higher. The table below shows the probability of default for various bonds rated by market-leader Standard and Poor’s (S&P) over many decades. As you can see, the CCC rated bonds, which makeup 11% of fund today, have a 26% probability of defaulting in the first year of their issue, which increased to 50% (yes 50%) after just 8 more years. This is substantially higher than the .08% probability of one of Australia’s banks going bankrupt.

The managers rely on a substantial amount of diversification to reduce the impact of any one issuer defaulting, however, in many cases this sector of the bond markets is already highly leveraged. For instance, the largest exposures are to cyclical or struggling sectors including energy and media all of which are being disrupted on a daily basis.

Our View

Be careful what you wish for. To be honest, we don’t believe an investment of this risk level is suited to the majority of superannuants, pensions and mum and dad investors that make up its share register. The fund was opportunistically listed at a time when Australian investors were seeking alternatives to fully franked dividends under the threat of a Labor Government; to this we say well done. The managers were able to leverage off this concern to raise close to $1bn in ‘forever capital’. If you were not aware, the benefit of an LIC or LIT (listed investment trust) for managers is that the capital raised will remain forever, there are no redemptions or purchases, the units are simply traded on the stock exchange. So Neuberger have effectively locked in 0.85% of management fees on $1bn in perpetuity.

PIMCO Global Bond Fund

What’s the fund?

This month we are taking a closer look at the PIMCO Global Bond Fund. The fund is a traditional, long-only bond fund meaning the managers buy and hold the individual investments. There are no short positions and the funds positions are actively managed. The underlying investments are generally limited to investment grade bonds issued by Government, Semi-Government institutions, corporates and mortgage securities.

PIMCO is renowned as one of the world’s premier fixed income managers. PIMCO or Pacific Investment Management Company was founded in 1971 in Newport Beach, California and has grown to invest $1.84 trillion on behalf of individuals and institutions across the world. PIMCO employs over 2,700 investment professionals across 17 offices spanning the globe.

PIMCO are widely known for creating the ‘absolute return’ approach to fixed income investing, as opposed to simply letting markets be markets. The firm’s investment approach is very much driven by Macroeconomic views. These are constructed, collated and challenged through an intensive investment committee and review process. It involves regular Cyclical Forums, which seek to anticipate 6 to 12 month market trends, as well as the annual Secular Forum which projects trends over the coming 3 to 5 years. The firm then relies on individual experts to provide bottom up perspectives on individual securities, companies and sectors.

The fund is managed by the highly experienced Andrew Balls, who is the Chief Investment Officer for Global Fixed Income. He is based out of London, has been with PIMCO for 13 years and previously worked as a correspondent for The Financial Times newspaper.

The Australian fund has been running since April 2004 and has over $6.4bn in assets under management. The fund is benchmarked against the Bloomberg Barclay’s Global Aggregate Bond index. In addition to the core Global Bond Fund, PIMCO have recently launched an ESG or Environmental Social Governance overlay which seeks to ensure its investments have a positive impact on the world.

Where does it fit in your portfolio?

The Global Bond fund is a diverse, actively managed portfolio of global fixed income securities. The fund’s benchmark is the Bloomberg Barclay’s Global Aggregate Index which seeks to measure the returns of a diversified pool of bond issues by companies around the globe. The fund meets the requirements of the Capital Stable Bucket, being to generate a return of CPI+3% per year and ensure that your investment will retain its value in difficult market conditions, as it invests primarily in investment grade bonds and actively manages the risk in the portfolio. The underlying assets include bonds and similar fixed income securities issued by developed and emerging market Government’s, Semi-Government institutions, Corporates and high yield issuers. Management have experience investing over four decades and various major events from the Global Financial Crisis, to the Asian Crisis and various global conflicts.

Why invest?

With term deposit rates now falling well below 2%, but the risks to sharemarkets seemingly growing by the day, what you do with your Capital Stable allocation will have a larger effect on your returns.

The PIMCO Fund offers a core global bond exposure, diversified across emerging and development markets, corporates and governments. The nature of the underlying fixed income investments mean the fund will provide a hedge against equity market volatility and benefit from increasing demand for lower risk assets or a further compression in bond yields.

In recent months, experts suggest that this may be a time to be reducing exposure to bond markets. Yet, this oversimplifies the operation of bond markets and the all-important yield curve. The benefit of PIMCO’s strategy is that it is benchmark unaware and they are able to take active positions based on their long-term expectations for individual economies, markets and companies. This affords the managers flexibility to reduce the duration of their portfolio, currently around 7 years, and target specific periods on the yield curve where they believe opportunities are presenting. Duration is a measure of a bond’s sensitivity to movements in interest rates, as opposed to term to maturity which is the average term of each bond within the portfolio. Both are measured in terms of years, with a higher duration meaning any changes in interest rates will have a greater effect on the value of the portfolio.

PIMCO’s flexible mandate means they can be exposed to the potential for rate increases or decreases in various periods in the future. One such opportunity, is the threat of a slowing US or global economy in the next 3 to 5 years, which is likely to trigger a strong period for bonds. The fund currently holds its largest overweight position in bonds of this maturity, meaning investors stand to benefit if their assessment is correct. The fund also applies a number of ESG screens across the portfolio excluding companies involved in weaponry, pornography and tobacco and embracing those committed to improving environmental and social practices.

What does it invest in?

The PIMCO fund is wary of its benchmark index, but is not required to replicate it. The managers charge a management fee of 0.69%, and are paid to make major investment and allocation decisions on your behalf. The benchmark holds over 24,000 individual holdings by 4,500 issuers based all over the world. The managers seek to identify the best risk-reward opportunities from this universe whilst maintaining a core fixed income exposure through Government bond holdings. Some of the important details on the underlying portfolio include:

  • Credit ratings: 91% of all investments are held in investment grade debt rated above BBB. The average rating is A+.
  • Duration: The portfolio is predominantly weighted to Developed Government Debt, where 3.9 years of the 7.4 total duration are sourced and with a focus on the US, 3.3 years duration. More broadly the portfolio is allocated as follows:
  • Yield curve: The yield curve explains the relationship between the term to maturity and return offered for various bonds, with the general expectation that the longer the term, the larger the yield or return. The fund is currently diversified as shown below. As you can see, the largest weightings are to longer term bonds, specifically those with 5 to 7 and 10 plus years to maturity.

The most important and comparable details for the underlying portfolio are as follows:

  1. Fund duration – 7.41 years – reflecting a high level of exposure to interest rate movements and the expectation that further rate cuts or increases will have a substantial impact on the value of the portfolio. This is broadly in line with the benchmark duration of 7.19 years.
  2. Yield to Maturity – 1.88% – reflecting the income that would be received by investors if the underlying bond portfolio was held to maturity. Whilst low in historical terms, this compares favorably to the many negatively yielding Government bonds around the world.
  3. Average coupon – 2.64% – reflecting the interest paid by the underlying bonds.
  4. Average maturity – 11.04 years – reflecting the average maturity of all bonds within the portfolio based on their size.

How has it performed?

The fund has performed incredibly well in the short-term, benefitting from continued moves by global central banks to 0% rates around the world. The 12 months to 31 August saw the fund deliver a return of 8.6%, albeit a little below the 10.0% delivered by the benchmark over the same period. The funds underperformance was due primarily to their focus on higher quality, investment grade bonds rather than the broader investments that form part of the benchmark.

Longer term returns have also been strong, 4.29% compared to 3.87% over the last three years and 7.79% per annum over the last 10 years. Obviously, the returns in the future will be determined by movements in interest rates and bond markets but with a worsening global outlook, inflated valuations in equity markets the fund is well positioned to benefit from a period of volatility. Most importantly, it shows little correlation to equity markets.

What income does it provide?

As with all managed funds, the PIMCO Fund must distribute all income and realised capital gains each year. Therefore, distributions are dependent on both the performance of the underlying investments and whether any investments are actually sold or mature. As an actively managed strategy, the fund regularly turns over their underlying holdings and also receives distributions from most investments on a quarterly basis. The result is a long history of quarterly returns with averages as follows:

  • 3% for 12 months;
  • 9% for 3 years;
  • 1% for 5 years;
  • 4% for 10 years.

Gold Returns!

Our unconventional investment idea of holding physical gold in a mainstream investment portfolio is quickly becoming a very conventional idea. In recent months, gold has gained momentum, rising 20% and taking its return over the past 12 months to almost 30%. Gold is once again a front page story for many investors. Gold, as an investment asset, has enjoyed a complicated relationship with many investors and their portfolios. It’s often viewed as a ‘hedge’ against both inflation and stocks (gold tends to have an inverse relationship with the stock and property markets). In fact, during the majority of major stock market crashes gold has provided excellent returns (see table below).

Apart from the substantial geopolitical tensions currently affecting the world,  something  else more substantial has changed. Historically, many investors avoided gold, or other physical commodities, as they didn’t produce any income. Investors would compare such investments with, say, an investment in a yielding term deposit. This was fair enough, but times they have changed, and the U.S. long-term real yields have moved into negative territory as of June. As mentioned in our lead article, over a quarter of developed market sovereign debt is now negative yielding. Falling real yields have historically been highly positive for gold. When real rates are positive, there is an opportunity cost for holding non-yielding assets such as gold. But at the moment the opportunity cost is nearly zero.

If you hold cash, you’ll get one percent if you are lucky (and rates are going lower) or hold gold and have something that will make your portfolio less risky.

It isn’t just private investors that have rekindled their interest in gold, as central banks bought 224 tones of gold in Q2 2019, representing a 47% year-on-year increase. Net purchases over the past 12 months are up 85%, with the largest buyers being Poland, Russia, China and Turkey. Couple this demand with jewellery (48% of all demand) then the demand side of this asset looks very strong. The supply side has issues that is also adding to the pricing pressures.

There are many ways to get exposure to gold. There are gold miners, such as Newcrest Mining Limited (NCM) that provide a leveraged-type exposure to gold, or fund managers that select a combination of gold- related companies, or an ETF that followd an index of gold miners around the world, like NYSE Acra Gold Miners Index.

In our view, buying a company that is exposed to gold, through mining or exploring, should really be counted as an investment in your equity portfolio. In fact, the above graph shows that, over time, investing into gold equities as a whole is much worse than just buying physical gold.

While we still suggest that it is prudent for investors to include at least some gold in their portfolio, the level and percentage is  a harder question to answer, and depends on the risk profile of the individual. However, the starting point for buying gold should always be in physical bullion. For anyone that has seen a bar of gold, it is something you could quickly and easily fall in love with.

If you’re looking to buy your very own bar of gold, we would recommend the Perth Mint.  The  Perth  Mint has a range of services, from buying a bar of gold to take it home and store under your bed, to a buying and holding service (for a small fee of course). The Perth Mint provides a government guarantee that all their gold is 99.99% pure.

However, the easiest way for the average investor to gain exposure to the yellow metal is through Exchange Traded Funds (or ETFs). A gold ETF represents a share in a store of physical bullion, often held in a bank vault or other secure location. If the gold price appreciates, your share in the ETF should also appreciate, as the holding becomes more expensive.

 

There are two major options for Australian investors who want to pursue this avenue on the ASX. The ETFS Physical Gold ETF (ASX: GOLD) is the largest gold ETF traded in Australia and represents 358,600 ounces of physical gold held in the London bank vaults of HSBC. It charges a management fee of 0.40% annually for storage and other costs.

Like many international commodities, gold is universally traded in US dollars, which means that for Australians, the price we can buy gold at is affected by the gold spot price as well as the price of our dollar relative to the greenback (we have to buy US dollars in order to buy gold). This adds a layer of complexity and volatility that our American friends don’t need to experience. The BetaShares Gold Bullion ETF – Currency Hedged (ASX: QAU) is another option for those who would like to take the currency risks out of the equation. This ETF also stores physical gold in a London bank vault (owned by JPMorgan), but actively hedges against currency movements between the US and Aussie dollars, to give a “purer exposure” to the gold price. This comes at a cost however, with QAU charging a higher fee of 0.59%.

Gold is an easily understood investment, and a true diversifier. These two ETFs make it easy to buy and sell, and to hedge or unhedge your currency exposure to gold. With the alternative of holding a yield cash deposit more or less disappearing, we encourage investors to consider their exposure to gold, more than ever.

 

Neuberger Berman Global Corporate Income Trust

We have highlighted on many previous occasions, the extraordinarily low interest rates around the world are forcing investors to take on more risk just to sustain (rather than grow) their income each year. Now, this is all well and good if these investors have undertaken due  diligence  and understand what it is they are investing in. Unfortunately, this isn’t always the case.

As independent financial advisers, we are regularly approached by any number of fund managers seeking to distribute their latest  product  to as many people as possible. Listed investment companies have been increasing popular in recent months, with the sector doubling since 2014 due primarily to the fat commissions they offer financial advisers for recommending their products. The obvious  risk  in  this instance is that it is not unlike what occurred with the likes of Timbercorp and Great Southern, that many revenue driven advisers shirk the need for due diligence and focus simply on the commission they will receive. Interestingly, with the move to discretionary managed accounts, the investor may not even know they hold the product until well after the fact.

Of course, we aren’t saying that all listed investment companies are justified solely by their commissions, but that it’s important to understand what it is your investing in.

With this mind, we wanted  to  take a closer look at the very popular Neuberger  Berman Global Corporate Income Trust. Incredibly, despite the fund manager and strategy having no previous exposure to the Australian sharemarket, they were able to raise close to $1bn from investors. The fund was distributed by an extensive list of brokers, joint leader managers and ‘co-managers’ including Evans Dixon, Morgan’s, National Australia Bank, Ord Minnett, Bell Potter, Paterson’s, Shaw and Partners and Wilson’s. The fund was also marketed heavily by Peter Switzer’s media business and conference program.

We have broken our analysis down into a few simple sections:

Who is Neuberger?

Neuberger is a New York based fund manager with expertise  across most sectors of the market including equities, fixed income and alternatives. They were established in 1939 and have over $455bn under management globally with closer to $7bn under management in Australia, primarily with institutions. It’s important that investors do not confuse size with security, as whilst the manager itself is extremely successful and  huge by Australian standards, they do not control the performance of the underlying investments.

What is the fund?

The Corporate  Income  Fund  is  a specialist income focused fund that invests solely into senior bonds issued by global listed companies. This includes secured and unsecured senior debt which are both positioned at the top of the capital structure and first in line in the event that an issuer defaults on their obligations or moved into bankruptcy. The fund targets an annual income of 5.25% delivered monthly through regularly distributions and to complement this through active management and  investment  selection  with   an absolute positive return the secondary aim. The fund is run by one of the largest non-investment grade fixed income teams in the world, with over 50 dedicated staff.

What does it invest in?

The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The underlying portfolio is heavily diversified, which in some instances would be considered as   a way to reduce the risk of yourThe Corporate Income Fund invests into what is commonly referred to as ‘junk bonds’, ‘high yield’ bonds or unrated credit. At present, the portfolio holds less than 1% in what are considered investment grade bonds, with a rating above BBB with the remainder allocated as follows:

The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The underlying portfolio is heavily diversified, which in some instances would be considered as   a way to reduce the risk of your investment. The geographic and sector allocations are as follows:

Thus far, the fund has delivered on its objectives, delivering a  return of 6.63% since inception including an income of 4.74%. The fund  has, however, only been operating since   September   2018, which is an extremely short period of performance to review.

What are the risks?

In our view, the risks of this investment are substantially higher than many of both its investors and the financial planners who recommended it truly understand. The fund invests into fixed rate, senior bonds, issued by institutions that fall many rungs below the likes of the Commonwealth Bank on the credit ratings scale. For instance, the largest current holding is Petrobras bond, lending money to the Government-backed Brazilian gas and oil producer. Being fixed rate securities, the entire portfolio is subject to the risk that prevailing interest rates, primarily in the US, begin to rise once again, whether due to inflation or a stronger economy, resulting in a reducing value of these bonds and potentially a capital loss on the investment.

More importantly, however, investors are exposed to an immensely higher risk of default on the loans made through this fund than through  the likes of a Bond  Fund  issued  by PIMCO or Schroder’s. Yet the managers are extremely clear with this fact in all their publications reporting that essentially none of the underlying investments would pass the investment grade requirement. This represents a substantial  risk  to investors for many reasons, but primarily, the risk of default is substantially higher. The bottom right table shows the probability of default for various bonds rated by market-leader Standard and Poor’s (S&P) over many decades. As you can see, the CCC rated bonds, with makeup  11% of fund today,  have  a 26% probability of defaulting in the first year of their issue, which increased to 50% (yes 50%) after just 8 more years. The trend improves as you move into B rated  bonds that make up 45% of the portfolio, but at 13% after three years, this is substantially higher than the .08% probability of one of Australia’s banks going bankrupt.

Of course, this is all well and good if the investor is aware of the risk and secondly, comfortable with the level of volatility that may be ahead. The managers rely on a substantial amount of diversification to reduce the impact of any one issuer defaulting, however, in many cases this sector of  the  bond  markets  is already highly leveraged. For instance, the largest exposures are to cyclical or struggling sectors including energy, basic industry and media all of which are being disrupted on a daily basis and potentially entering a structural decline. The threat of higher interest rates isn’t limited to the value of the fixed rate bonds, but the viability of the companies issuing them in an increasing competitive environment.

Our View

Be careful what you wish for. To  be honest, we don’t believe an investment of this risk level is suited to the majority of superannuants, pensions and mum and dad investors that make up its share register. The fund was opportunistically listed at a time when Australian investors were seeking alternatives to fully franked dividends under the threat of a Labor Government; to this we say well done. The managers were able to leverage off  this  concern to raise close to $1bn in ‘forever capital’. If you were not aware, the benefit of an LIC or LIT (listed investment trust) for managers is that the capital raised will remain forever, there are no redemptions or purchases, the units are simply traded on the stock exchange. So Neuberger have effectively locked in 0.85% of management fees on $1bn in perpetuity.

We believe this type of strategy may be appropriate for large institutions seeking to complement high quality Government bonds or cash balances with a small allocation to unrated bonds and who have sufficient capital to offset any losses as they occur. We do not, however, believe the strategy is particularly suited to the conditions in which the global economy currently finds itself. An investment in junk bonds is generally best made when interest rates are high and falling, as this provides both earnings and valuation tailwinds. With the launch of this fund in Australia coming towards the obvious end of a 10 year bull market and with US rates increasing, the timing in our view is questionable. The largest issuers in this sector have and will remain companies under pressure, as few others are willing to lend to them. Whilst these may be large companies by Australian terms, the pitch presentation relied upon a comparison of the ‘median’ revenue of these companies being $7.67bn versus the ASX 200  of just $1.41bn, this comparison is irrelevant given Australia represents just 2% of global sharemarkets and it’s the quality of the underlying businesses that matter most.

One of the less considered risks of this LIT is that many of the underlying bonds that form this portfolio, whether in smaller US companies, or emerging markets, are substantially less liquid than traditional bond markets and in many cases are traded over the counter rather than on a listed exchange. We have always been wary of investment strategies offering investors exposure to less liquid investments via highly liquid structures like listed shares.

In conclusion, we believe this strategy has no merit and the 5.25% promised monthly income is not sufficient to offset the substantially higher risks of default.

Market

‘Forecasting is the art of saying what will happen, and then explaining why it didn’t’

We didn’t think the final quarter of the financial year could be explained any better than through this quote. Throughout the period we were provided with  further   evidence as to why both opinion polls and economic forecasters should be given little heed and why it’s important that investors do not adjust their investment approach before an ‘expected’ or ‘guaranteed’ event occurs. The most obvious case in point was the Coalition election victory in May, which polls suggested was unwinnable, but eventually saw sectors ranging from infrastructure to private health insurers, the banks and hospital operators rallying on the back of a status quo government.

In the lead up to the election the noise in the media and throughout the financial industry was immense. Our office seemed to be a revolving door of investment managers selling listed investment companies investing into high yield (and high risk) debt, property development or unrated corporate bonds as alternatives to high yielding shares. As you would have noticed, not one of these ‘unique’ opportunities was of sufficient quality to meet our due diligence process, yet most have seemed to have raised hundreds of millions of dollars without us. We aren’t sure what their investors are thinking now, with many trading at a discount to the value of their portfolio and high yielding Australian equities having delivered the strongest return of all markets around the world for the first half of 2019.

As we outlined in previous issues of UWJ, the additional yield provided by franking credits either in the form of a refund or tax saving, could not easily be replaced without moving further up  the  risk scale. On this basis and given the growing concern throughout the country about this and several other proposed tax policy changes, we did not believe it was prudent for clients to sell down higher yielding (but more importantly high quality) companies solely because they wouldn’t provide the same income as before. The market reaction the day after the election was telling, with most banks up in excess of 5% and now signs that the property sector may be recovering.

The failed predictions continued  in the forecasting of interest rates, with the majority of economist calls made as recently as a few months ago proven wrong as the RBA elected to hold rates in May and then eventually cut in June. This comes just 12 months after most experts were predicting rate hikes to occur amidst a booming global economy. All these events do is solidify the central tenet of our approach to investing your capital, which is to invest for many scenarios, and not assume the expected will happen. In fact, we know that as investors you will need to do with the unexpected occurring regularly.

Worried about growth

There were some concerning signs creeping into the market in the June quarter which suggest to us that there may be a little too much money floating around the ASX. Whilst merger and acquisition levels are not at pre-GFC levels, management and boards appear to be chasing growth at any cost in looking at what appear to be purchases and investments in non-core businesses. There were several cases in point, the first being Wesfarmer’s sudden decision to seek investments in the growing but speculative rare earths and battery industry and secondly, AGL Energy’s decision to lodge a big for Vocus Telecommunications (only to withdraw the bid within    a few weeks). Then there was the continued push into private equity and takeover activity by the industry fund sector who are increasingly concerned about the outlook for growth.

We admit that we fall on the conservative side of investing and find it difficult to justify investments in loss making companies trading at astronomic multiples. It has been these companies that seem to defy gravity and have been leading the broader index higher. Yet Australian companies have a chequered history of pursuing growth through acquisitions, with our largest miners a case study in how to buy assets  at the top of the market. We also have a track record for our ‘growth’ companies to be valued at 2 to 3 times what a more sophisticated market like the US values similar companies. It is at times like this that we stress the importance of sticking to your investment policy and not capitulating to momentum or positive sentiment.

Our approach has and will always be predicated on Bucket allocation, particularly ensuring your portfolio holds sufficient Capital Stable assets to withstand an extended  period of market weakness. Further, we seek to ensure your portfolio is constructed of high-quality assets, trading at reasonable multiples or valuations and which offer exposure to the most important themes occurring around the world. At times our recommendations may seem contrarian, or unwilling to embrace the most popular themes, this is because we are seeking to deliver consistent returns over the long-term rather than chase risky short-term gains.

Markets

The US-China Trade War was the primary driver of volatility during the beginning of the quarter. It was then the Federal Reserve and other global central banks that took the reins and pushed both bond markets and sharemarkets around the world to all-time highs and lows. It is that interesting paradox where the outlook for the global economy is sufficiently weak to warrant cuts to global interest rates and continued stimulus, yet sharemarkets continue to move towards multi-year highs with little concern for corporate profits. Perhaps this is why gold bullion has delivered one of the strongest returns over the last two years.

In the table above we have provided a summary of the major investment indices for the quarter and financial year:

As you can see, the highlights were the Australian and US markets which delivered the strongest financial year returns after continuing to rebound in the final quarter. The European and Chinese markets showed signs of recovery but remain well behind due to the continued political impasse and trickledown impacts of slowing Chinese imports. The table provides an interesting insight into the why the first six months of 2019 have seen the fastest growth in over 20 years, a core reason being the heavy sell- down experienced at the end of 2018 which means financial year results are well below those levels.

Outlook

At this point the global economy and sharemarkets are in unfamiliar territory. One of the most important inputs or factors that must be considered when making investment decisions for today  and for the next 10 years is where you expect interest rates to move throughout this period. It is interest and bond  rates  that  determine the availability of debt to fund investments, the return  required  to warrant further investment in Risk assets like shares and the pain that comes with continuing to hold excess funds in cash. It is this pain that tends to send sharemarkets higher as investors need to do something with their capital.

If you believe interest rates  will  fall further over the next decade,  or at least remain at all-time lows, than an aggressive investment approach targeting higher yielding investments would be warranted. Falling interest rates would suggest assets like property, infrastructure, Government bonds and utilities will increase further in value. Increasing interest rates suggest a more inflationary and higher growth environment, in which case cyclical business-like mining, materials, those facing consumers and even gold bullion will benefit, and the likes of property and utilities will struggle.

Increasing interest rates will lead to lower valuations of most assets and businesses around the world but particularly those whose incomes have already been couponised. Looking short term, however, we believe there remains substantial further downside in rates as some of the world’s overleveraged developed economies, like Australia, come to terms with  a  slowdown in  global  growth.  The  result  is   a portfolio that is positioned for both events to occur  and  a plan to navigate this unfamiliar period whilst keeping your capital intact.