23 July 2019
We asked a group of our portfolio managers a series of questions about their respective asset classes. This second video, in a series of three, examines what risks they see and how they go about mitigating them.
Tom Mansley on Mortgage Backed Securities
In the mortgage market there are three primary risks. The first is interest rates, because mortgage-backed securities are bonds. We mitigate that predominantly by buying floating rate securities, which do not need to be hedged, or if we purchase fixed rate securities we use instruments such as treasury futures or swaps in order to eliminate the interest rate risk. The second largest risk is prepayment risk. People can refinance their mortgage in the US at any time with no penalty, so if you purchase a bond priced at 105 and the person refinances, that is a problem because you only get par back. The vast majority of the market we are investing in, however, is currently priced at a discount to par, so if someone refinances and we get par back that actually increases the yield. The third risk is credit. Credit looks very strong right now; the unemployment rate in the US is below 4%, so all the borrowers have the ability to pay. If you are investing in seasoned legacy mortgages, the value of your house is actually higher now than it was when the mortgage was issued and the amount of the mortgage outstanding has gone down as it amortises away, so the loan to value ratio has improved significantly. Therefore you have a very solid asset to secure the loan and the borrower has the ability to pay. The final risk is spread risk. The mortgage market tends to have much more spread stability than other markets such as high yield or emerging markets. That is a risk, however, we do not attempt to mitigate; we are happy to take that on because it is extremely stable.
Gianmarco Mondani on European Non-Directional Equities
The main risk to our approach is when we witness major turning points in economic activity. In such environments, such as in 2016 for example, cyclical stocks tend to perform in the opposite direction to earnings revisions driven by changes in expectations about economic prospects. Over the last few years we have developed a set of tools that are able to identify when such turning points may materialise. We aim to make sure our positioning is not short cyclicals when the economy appears to be turning up, or the opposite when the economy is turning down. With these tools, therefore, we are confident we can manage such short-term situations better and reduce the phases of drawdowns, but at the same time they allow us to continue to focus on the ability of earnings revisions to generate alpha through time.
Swetha Ramachandran on Luxury Equities
Historically the risk has always been that this has been perceived to be a cyclical industry. While that has been true in certain pockets, luxury has actually been very resilient compared to other consumer categories, for instance retail. The luxury consumer tends to be more driven by wealth effects rather than income, and that tends to be fairly stable over time. I think the risks now are much more at brand level. Historically the growth of the luxury industry meant all brands were doing well; a rising tide was lifting all boats. I think there is now a very clear distinction in the minds of consumers between brands that are investing in their product, marketing and communicating with their target audience, and those that are not. That is really where the risk lies, in bottom-up stock selection to make sure we have the right stocks.
Tim Love on Emerging Market Equities
A key risk would be the risk to the valuation argument insofar as global growth is lower. If that is the case it would affect developed worlds as well, so in that sense it is not a unique negative to emerging markets (EM) equity. The specifics across the equity universe would include risks of capital controls, risks of continual lower corruption scorecards, risks of ESG issues and risks of disease, Ebola in particular. These are very specific to the index weightings, with the biggest weightings in EM being China, at 30+%, Taiwan and Korea, North East Asia, then Brazil and to a lesser extent South Africa. I think a lot of these markets have already gone through an extremely difficult patch, especially Russia and Brazil, so they are on the mend. Many of them have rebuilt their reserves, their credit ratings and the rate of change thereof, so they are more resilient than they have been for a long time.
Jian Shi Cortesi on Asia and China Growth Equities
The biggest risks are related to the Chinese and Asian economy seeing a big slowdown if the trade war persists or escalates. But in that scenario the Chinese government will introduce more measures and policies to support the domestic economy. If the trade war does persist, there will be increased pressure domestically, both in the US and China, for the two governments to reach an agreement; such pressure will come from US businesses, US consumers and Chinese exporters and technology companies. Looking at the current situation, the high volatility caused by the trade war is not desirable, but I think two years from now, when we look back at 2019, we may well say it was a good time to buy into Asia and China at bargain prices.
Patrick Smouha on Developed Market Credit
One of the risks we often talk about is credit risk. We invest mainly in investment grade companies, but we are happy to go lower down the capital structure if we feel comfortable with the credit itself. Therefore we feel by going into only strong institutions but then trying to capture the high income by investing in the subordinated debt, from a credit perspective we are mitigating the credit risk. Another risk we have as a fixed income investor is interest rate risk. We invest in different types of bonds: fixed coupon bonds, fixed-to-floaters, which means the coupon is fixed for a number of years but refixes based on where government bonds rates are and therefore your interest rate risk is limited. Floating rate notes refix every three to six months and therefore have very little interest rate risk; indeed they should benefit from interest rates rising as the coupon will also rise.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Reference to a security is not a recommendation to buy or sell that security. Past performance is no indicator for the current or future development.