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Deep values - buying on fundamentals rather than following sentiment
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Judith MacKenzie
Partner and Head of Downing Fund Managers
Downing launches new actively managed liquid alternatives fund aiming to deliver 7% to 10%+ per annum and positive returns in most markets. The new MGTS Downing Active Defined Return Assets Fund (‘Active Defined Returns’, the ‘Fund’), is the first fund from its new Liquid Alternatives team.
The Fund is aimed at institutional investors, Discretionary Fund Managers, IFAs and advised sophisticated individual investors, and will primarily consist of UK Government bonds and large-cap equity index options, which provide significant scalability and strong liquidity. It aims to deliver 7% to 10%+ per annum and positive returns in all markets except for a sustained equity market fall (generally more than 35%), over a period of at least six years.
The Fund is the first to be launched by the new Liquid Alternatives Team established by Downing. Collectively, the team has over 125 years of experience and sector knowledge, and includes Tony Stenning, who held senior roles at BlackRock and most recently was CEO of Atlantic House Group; Russell Catley, founder and also a former CEO of Atlantic House Group; Huw Price, a former Executive Director at Santander Asset Management, and Paul Adams, former Head of Cash Equities and Derivatives Sales, Royal Bank of Canada.
The Fund offers investors a compelling building block for multi-asset portfolios, aiming to add consistent and predictable returns, typically secured with a portfolio of UK Government bonds. The unique proposition includes a hybrid approach of using systematic derivative strategies and active management, combining liquid investments with predictable returns, and an equity like risk profile.
Investment strategy: Maximising the probability of delivering predictable defined returns across the economic cycle.
Systematic Liquid Derivatives: Systematic, derivative strategies optimise the equity risk-return profile. The Fund uses rules-based derivative strategies linked to the most liquid, large-cap global equity indices (i.e. FTSE100, S&P500) with the aim of harvesting well-proven consistent returns across a wide corridor of market conditions.
Strong security: The Fund will hold a high-quality portfolio of assets as secure collateral – typically UK Government bonds.
Active benefits: At times, rules-based, passive derivative strategies can underperform when markets move strongly – this is when specialist active management can add incremental gains by monitoring and monetising positions and applying active risk management.
Key benefits
Increased consistency and predictability of returns: Positive returns in all markets except for a sustained equity market fall of more than 35% over at least six years.
Diversification of risk: The Fund’s risk components are diversified across large, liquid equity indices, observation levels and counterparties. Secured with high-quality assets – typically UK Government bonds.
Active management: Our experienced team will actively manage the Fund and its investments to optimise risk and reward for investors.
Russell Catley, Head of Retail, Liquid Alternatives at Downing, said: “Put simply, we focus your investment risk on the probability of receiving the returns you need, not those you don’t. We target the highest probability of delivering 7% to 10%+ per annum with active management adding material incremental gains. We believe that we are building the next evolution of the proven success of Defined Returns funds
The Downing team isseeing strong demand from clients looking for alternatives to large-cap equity funds which are becoming concentrated in technology stocks, or alternatives to UK equity income funds and illiquid alternatives.”
Tony Stenning, Head of Liquid Alternatives at Downing, said: “The launch of our Active Defined Return Assets Fund is a significant milestone in the ambitious build-out of our new Liquid Alternatives strategies. It is a solution-focused fund that should deliver stable high single or low double-digit returns across a wide spectrum of equity market conditions, except for a persistent multi-year bear market. The Fund is designed to enhance balanced portfolios by providing consistent, predictable returns and is suitable for accumulation or drawdown.
“We aim to deliver a unique combination of proven systematic derivative strategies and specialist active management, and we are doing so at a very compelling fee level, below our closest competitors and in line with active ETFs.”
How the Fund is expected to perform in different markets
In bullish markets: UK Government bonds secure the capital, and the equity index options deliver a predictable 7-10%+ return per annum – giving up some less likely upside.
In neutral markets and normal market corrections: UK Government bonds secure the capital, and the index options deliver a predictable 7-10%+ return per annum.
In a sustained sell-off: if markets fall more than the cover to capital loss and do not recover for six years. Then capital is eroded 1:1 in line with the worst performing index.
The average Cover to Capital Loss is targeted at 35%: the average cover to capital loss represents the average level the Global indices within the Fund could fall before capital is at risk.
Fund key risks
Performance: Capital is at risk. Investors may not get back the full amount invested.
Liquidity: Access to capital is always subject to liquidity.
Counterparty risk: Other parties could default on the contractual obligations.
Fund Structure
UK regulated OEIC fund structure, fully UCITS compliant
Daily dealing, at published NAV
Minimum investment: £100,000
SRRI: 6 out of 7
Depositary: Bank of New York
Authorised corporate Director (‘ACD’): Margetts Fund Management Ltd.
I share-class: SEDOL: BM8J604 / ISIN: GB00BM8J6044
F share-class: SEDOL: BM8J615 / ISIN: GB00BM8J6150
Risk warning: Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing; your attention is drawn to the risk, fees and taxation factors contained therein. Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in this fund should be held for the long term.
Important notice: This document is intended for professional investors and has been approved as a financial promotion in line with Section 21 of the FSMA by Downing LLP (“Downing”). This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 10 Lower Thames Street, London EC3R 6AF.
Any personal opinions expressed are the views of the Fund Manager at the time of publication and are subject to change and should not be interpreted as advice or a recommendation.
In the smaller company universe, illiquidity and a lack of natural buyers can lead to heavily depressed prices over a protracted period. This is particularly true in the current environment where markets are being predominantly driven by growth and momentum. In many cases, share prices are motivated by market sentiment rather than the underlying fundamentals or operating performance of individual companies. The resulting pricing inefficiencies can provide long-term investors with attractive entry points and occasional opportunities to average down book cost throughout the holding period.
Adept Telecom, an independent provider of voice and data telecommunications services, is an example of the impact of market sentiment. In August 2017, when the Downing Strategic Micro-Cap Investment Trust first invested in Adept, the business was trading on approximately 25x trailing earnings and around 12x forward earnings. The forward earnings included the contribution from the recent acquisition of Atomwide, a technology services provider within the education sector. We believe this was another transformational deal made at an attractive price that further demonstrates management’s M&A capability. The shares sold off over the fourth quarter of 2017 and into 2018, despite the Atomwide acquisition and the fact it was trading on a relatively low forward earnings multiple. At its lowest point, the share price reached around 260p, pushing Adept to approximately the cheapest forward earnings multiple in its recent history. We determined that the reason for the sell-off was perception and sentiment related rather than fundamentals driven, and bought more shares. Since then, Adept’s performance has exceeded our own expectations. This was reflected in a trading update issued at the beginning of April 2018 which reported both EBITDA and turnover are expected to be ahead of market consensus.
Gama Aviation, a global business aviation services provider, has also been subject to negative market sentiment. In April 2018, Air Partner, another listed business in Gama’s sector, announced accounting issues dating back to 2010/11. Gama and Air Partner’s business models are fundamentally different so we believe that this is an unwarranted overreaction to irrelevant, company specific, news. The shares have since rallied slightly following a positive update from Air Partner but we believe that Gama is still too cheap at these levels, trading on a single digit multiple of earnings with plenty of growth opportunities.
2018 will be a pivotal year for Gama as management embark on several organic and inorganic growth opportunities. We also hope to see operating margins grow further as the model matures internationally. This sets the stage for 2019 and beyond, from which we expect the business to move to a new level of profitability and cash generation as management deploy £48 million of growth capital from a fundraise in February 2018. Once the strategic initiatives are fully implemented, we expect that underlying free cash flow could double in this time.
Redhall, a niche UK engineering business, is a similar story, with an order book and pipeline that is continuing to grow. We estimate that its tangible opportunities in mid-term UK critical infrastructure projects now amount to over £100 million. While some of these projects have become delayed, the gap between what the business is worth to a long-term holder or a trade buyer, and the enterprise value, has continued to widen over our holding period. The shares are more attractively priced than when we first invested and we believe that the market continues to factor in too much risk over the long term.
As value investors, we believe that buying businesses at a significant discount to intrinsic value will outperform over time, unlike growth and momentum styles which are typically transitory. Buying deeply discounted businesses reduces the likelihood of permanent capital erosion - the largest drag on performance through time. These opportunities exist because of the inefficiencies in markets – particularly so at the micro-cap end of the spectrum – yet many investors lack the long-term view and patience to profit from them.
Within the Downing Strategic Micro-cap Investment Trust we overlay various strategic mechanisms to grow and subsequently realise the intrinsic value of portfolio holdings. These mechanisms, alongside capable and well incentivised management teams, are required to be able to deploy meaningful capital in a concentrated portfolio that has the potential to earn good returns with reduced risk.
However, these take time to deploy and typically even longer to mature, therefore our average investment horizon is five to seven years. As portfolios mature and these strategic mechanisms evolve, the investment strategy should deliver returns which are largely uncorrelated, through the cycle and regardless of prevailing market sentiment.
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