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We’re all prone to pulling the plug on our portfolios from time to time, but it’s probably not the most productive approach. – Written by Chris Conway | Livewire Markets

There is one only thing you can control in investing. It’s not how an asset class will perform. It’s not what decision a company will make about capital management. It’s not how the terms of trade will affect the Aussie dollar.

It’s the amount of risk you are willing to take at any point in time. That’s it. That’s all you get to decide. Everything else is out of your control.

It’s also why saying, “I’m waiting to see what will happen with (insert random outcome here) before investing” is an inherently flawed investment strategy.

Firstly, you can’t possibly know what will happen and even if you did, you can’t know how markets will react.

Secondly, whilst you might be reducing your risk by doing nothing, you’re also completely eliminating access to any upside.

As such, the better investment strategy is to determine how much risk you are willing to take right now, and then find suitable investments to fulfil that risk profile.

This idea is not lost on Manning Asset Management founder and portfolio manager Josh Manning, who recalls presenting to institutional clients on the macro outlook 10-15 years ago, discussing how markets were ‘climbing the wall of worry’.

“What’s changed?” he asks emphatically.

“I can’t recall a period when I haven’t been worried since then.

The key is despite the noise, some of which is conjured up so that investors don’t move money away from certain parts of the market, is to assess one’s options and act rationally and objectively”.

Manning adds that he rarely hears people discuss what they are waiting for, and “if they can – i.e. for rate rises to finish – there is an element of belief that post that point, the outlook will be more certain or the entry point more attractive”.

In his experience, “there will always be something hanging over markets, and if in a rare Goldilocks scenario, markets would have likely adjusted (rallied) well before that scenario is clear”.

The misconceptions in fixed income and credit

As part of the conversation around staying appropriately invested, Manning is keen to dispel some misconceptions around fixed income and credit, one of which is that if the macroeconomic outlook worsens and loan defaults rise, an investor in a fixed income or credit fund will lose money.

He notes that whilst loans in these funds may come under more pressure, “this high-level belief ignores the structural protections such funds typically have. Arrears during COVID went up around three times, “did we have any losses?” “No”.

What determines losses is the quality of the book and protections in place, not arrears rates”.

Manning adds that when his fund invests in a pool of loans, “we expect a certain proportion to default and thus, we need to satisfy ourselves that even if those defaults increase several fold, our capital will be safe.

That is why we target investments that have a so-called ‘first loss’ buffer, which absorbs losses from loans defaulting and have ‘excess spread’, which means the pool of loans is yielding a higher gross yield than the corresponding financing costs so if a loss does occur, it can be paid for out of the excess income that the pool is generating”.

As for the current market conditions, Manning notes that he and his team are not seeing signs that the outlook is any worse than the modelled stress scenarios employed at the time the investments in the portfolio were made.

Heads I win, tails I win

In conducting scenario analysis, Manning believes that regardless of what happens next, fixed income and credit, if structured correctly, can deliver positive outcomes for investors – particularly when compared to other asset classes.

“If optimistic, then your immediate primary concern is participation in the upside, and in this regard, investing in credit, which is delivering circa 10% per annum, is a very healthy level of return in absolute and relative to other asset classes perspective.

If pessimistic, your immediate concern is around capital preservation with credit offering an ability for investors to go ‘up the capital structure’ rather than their return being determined by how a company’s equity performs after debt repayments, which takes priority over equity dividends. Credit is a more defensible and through-the-cycle investment if appropriately structured and managed”.

Without fear of ruffling a few equity investor feathers, Manning points out that in 2020, the ASX fell over 30% in response to an unknown risk.

“Equity investors saw their capital decrease to 70c on the dollar, while investors in floating rate asset-backed bonds issued by some of those companies saw their dollar modestly rise in value.

Today, the ASX is still only back at its prior early 2020 levels with those investors only enjoying bond-like dividends yet suffering huge swings in their capital balance, highlighting how powerful more capital stable investments can be in such times”.

On a more serious note, whilst Manning is advocating investors adopt fixed income and credit investments, he’s not advocating tipping out equity exposure altogether. Rather, that fixed income and credit can be a valuable ‘through the cycle’ contributor to a well-balanced portfolio.

“Credit assets can add that resilience either to increase defensive characteristics of ones portfolio or park capital until the outlook improves, given the attractive return profile and capital preservation characteristics of the asset class”.

What are the risks?

Whilst Manning asserts that credit assets, particularly those he invests in, are ‘through the cycle’ investments, nothing comes without risk.

He points out that even within the credit space, “we are seeing more cyclical lending propositions have stronger headwinds such as construction finance, non investment grade corporate debt and some sectors of the commercial property market”.

More broadly, the worst thing that could happen would be a major hit to unemployment – and even then, it would have to happen fast and garner no policy response from the government to do serious damage.

“For unemployment to double in a very short period and the Federal Government not implementing the policy tools utilised over the prior 20 years [would be the biggest risk].

While people can find a job, they typically continue consuming and paying their obligations, which supports business and broader economic activity alongside credit performance.

The other risk, of course, is that investors go into fixed income and credit investments, which are not robust to perform through the economic cycle or invest in such a concentrated way that a single idiosyncratic risk impacts their capital.

The importance of process

As noted above, one of the risks to avoid is going into investments that are not robust, but how does one manage this?

Manning has a process that they have developed over an extended period and, first and foremost, it involves turning down the marketing noise on any opportunity and going back to the source information for a true read.

“We assess if an asset will perform through the economic cycle based on our experience and in-house data sets.

If we do not have conviction around this, it doesn’t matter what the terms or broader opportunity are; it simply isn’t eligible for inclusion within the Manning Monthly Income Fund”.

If the asset passes that first test, the next step is sizing the investment in the portfolio, and Manning “have a clear risk appetite statement, the idea being if credit spreads are wide, that’s the market telling you that the outlook is likely less favourable and thus, taking less risk to achieve our return objective is appropriate.

On the other hand, if credit spreads are narrow, that’s saying the market views the outlook as favourable and it could be argued, is more likely to be caught off guard if a negative event occurs. Accordingly, in a low credit spread environment, it is vital to stick to your stated risk appetite and resist the temptation to chase higher yields with riskier counterparties or reduced covenants”.

As always, it seems discipline in executing the process is the key.

A recent example

Fixed income and credit are often hard to wrap our heads around, so I asked Manning for an example of a recent investment.

He shares that the team recently invested in a diversified pool of secured business loans.

“These loans are typically requested by growing businesses looking to replace existing equipment (think cars/utes/vans/light trucks/equipment and alike) or in addition to current assets.

From a business lending perspective outside mortgage-backed lending (which we also do), it is one of the lowest risk areas given such equipment is typically ‘mission critical’ – that is, the business cannot or will struggle to operate without it and via purchasing this asset, the business can typically increase revenues which in turn shall pay down the loan”.

Manning adds that whilst the loans within the investment have a positive selection bias (normally lending to growing businesses) which increases the chances of those borrowers being of better quality, “we also insisted on a range of structural protections that could see, in this case, arrears and loss rates rise circa 10-fold before our capital was at elevated risk”.

This is the critical element for investors to understand. Everything carries risk but there are protections that can be put in place to mitigate said risks, whilst still delivering a suitable return.

A track record of delivering income

Manning Asset Management is a specialist Fixed Income fund manager whose sole focus is the delivery of a strong and regular income stream to its investors through the economic cycle. Learn more by visiting our website or fund profile below.

The Fund delivered +0.77% in October, 9.34% over 12 months and 6.73% annualised since inception (April 2016), continuing to deliver over 5% net return above the RBA cash rate.

We are pleased to report the Fund’s portfolio of assets continues to perform strongly, and we believe, is well-positioned to continue delivering strong income returns with capital stability. Despite the Fund’s higher expected returns, our approach to risk management remains unchanged. Manning has recently completed our quarterly Macroeconomic Assessment, aimed at gauging the influence of present and forecasted economic trends on our portfolio for both the immediate future and the long term. This thorough analysis is part of our commitment to understand the broader economic landscape and its potential effect on portfolio performance, particularly with regard to credit risk.

As we observe the macroeconomic backdrop, including issues around inflation, geopolitical conflict, productivity headwinds, and structural labour force changes, we are assessing what the implications are for Australia’s economy and our investment strategies. As readers will be aware, the bedrock of our investment strategy has always been to find and invest in investments that we believe will perform through the cycle, so moving through the various phases in the economic cycle shouldn’t necessarily require significant changes to our portfolio positioning. Given the RBA’s continued determination to tame inflation and slow the economy, it is key to consider how that contraction might impact the various components of the portfolio, and in turn how that might inform our investment decisions in the immediate future as well as medium term.

In determining credit quality, we assess a transaction via a bottom-up approach rather than top-down via a credit rating. While the assessment is an extensive process, two simplified examples of distinct elements that we consider illustrate how we aim to protect investor capital in times of stress.

Having made a detailed assessment of each of the Lenders we work with, we examine individual assets originated by a Lender by reviewing source information (loan application forms, credit files, and alike) that provides a rich insight into borrower quality. A testament to the value of this approach is looking back at the Global Financial Crisis, which was at least in part caused by loans to poor quality borrowers being bundled up into an often complex and opaque structure, and sold as relatively low risk, until eventually and unsurprisingly, many of those borrowers couldn’t make repayments.

We consider not only if borrowers can make their ongoing payments but also, if their circumstances change, what is the quality and extent of asset security is available to us to protect the portfolio from any credit loss. We believe this approach provides a vital sense of portfolio quality, which, in turn, informs our assessment of overall credit quality.

Another example would be understanding the alignment of incentives. Manning assesses the extent to which a Lender (and the principles behind it) has ‘skin in the game’. Which means what is the risk capital that the Lender itself is prepared to offer to support the performance of the assets they are generating? This is known as the amount of ‘risk retention’ that Manning and other market participants require from the sellers.

Given Australia’s position in the economic cycle and the clear intent of the RBA, management of credit quality remains a key focus. We advocate for investors to either do their own granular due diligence to assess the credit quality of their investments, or alternatively invest with those who have a proven track record in being able to do so.

Is diversification really the only free lunch in investing?

While diversification is often termed ‘the only free lunch in investing’ I am not necessarily a believer. Diversification for diversification sake can mean investors invest in substandard assets that drag portfolio returns lower. We do subscribe to the view that sensible diversification that pays homage to the 80/20 rule (80% of the value from diversification can be achieved by implementing 20% of the possible diversification strategies) can add significant intrinsic value particularly when interwoven into ones asset allocation and asset selection process and, therefore, is a worthwhile pursuit.

How much and by what means diversification is achieved depends on an investor’s goals and highlights the value of good quality advice via an accredited financial advisor, broker or planner. While we have shown the table below since 2016, we cannot emphasise enough observing the asset allocations of some of the most sophisticated investors, such as the Future Fund can assist as a yardstick for investors to assess their own portfolio.

When to diversify

Since establishing the firm 8 years ago, we have spoken with hundreds of investors who, broadly, believe their portfolios require greater diversification. Many confess an overweight position in property and Australian shares, with the former being difficult and expensive to rebalance and, therefore, the latter being of primary interest. So, do investors diversify and if not, why not?

Everyone loves a stock story, with Australia home to many great emerging and emerged companies. On a spectrum, we can broadly think about them from being relatively stable, typically more mature companies that pay strong dividends (so called blue chip) to the more speculative which are targeting growth over profits without a dividend. In conversations with investors who hold an overweight position in these blue chips, we commonly find that while they equally recognise the need for diversification within their portfolio, they feel familiar with these stocks being household names that they have held for many years. Therefore, the thought of selling these shares to move into another asset class to achieve greater diversification is perceived as taking greater risk as it’s a move from the familiar to often something less familiar even though, rationally, the move is designed to lower portfolio risk.

If we consider the other end of the spectrum, the more emerging pre-profit companies have recently been heavily sold off and, in some cases, trading at a fraction of their prior highs. While their current valuation may be supported by the changes to fundamentals (high cash rate and therefore discount rate, in part justifying the lower price), we commonly hear that ‘we think it’s at its lows’ and therefore do not want to sell. In this regard, the fear of missing out on the upside dominates decision-making rather than an unbiased observation of the outlook.

So, when do investors typically diversify? In our experience, when we are in an equity market environment similar to what we are today, characterised by a broadly softening index and overall share prices. We have found that in these times, the rational thought process doesn’t play second fiddle to the fallacy of familiarity nor fear of missing out.

It is unrealistic to believe investor psychology, including fear of missing out or the fallacy of familiarity, does not influence investment decisions. Being aware of such biases and balancing them appropriately alongside objective investor rationale will enhance one’s investment credentials and likely portfolio outcomes.

A deep dive on credit as a diversifier

While we can’t speak to the other asset classes that the Future Fund invests in including Infrastructure, Timberland and broad Alternatives, we can provide a perspective on why more Australians are investing in Credit which in the Future Fund portfolio, occupies a larger share of the portfolio than both Australian Shares and Property, in stark contrast to many other investor portfolios. As outlined above, some are increasing their allocation due to overweight positions in other assets class. Another driver observed is the demographic shift with the so called baby boomers, who in general, are moving from a wealth accumulation to a wealth preservation mindset and thus, are drawn to fixed income/credit investments that prioritise capital preservation, are less influenced by the risk on/risk off cycles of equity markets and can deliver a ‘real’ rate of return, in particular shorter duration strategies where returns typically lift alongside inflation and higher global cash rates. This move towards fixed income and credit has seen an influx in new managers and investment opportunities in this space, we remind investors not all managers are of the same pedigree and for an asset class designed to preserve capital, investing with those that have a track record and the right incentives remains paramount.

Join CIO Adrian Bentley and Head of Investment Solutions Juliet Shirbin, as they discuss the role of macroeconomic analysis in managing a through-the-cycle portfolio. The Manning Monthly Income Fund is designed to perform in all market conditions and maintain its return target of RBA cash rate + 5% net of fees.

Podcast:

https://open.spotify.com/show/3wUHgMkL5dFn9ZNywdLURK

The Fund delivered +0.76% in September, 9.26% over 12 months and 6.70% annualised since inception, continuing to deliver over 5% net return above the RBA cash rate.

We are continuing the theme of explaining a key element of how the fund works in each monthly performance update so clients and advisers can further understand both the investment strategy and attributes of the product.

The Manning Monthly Income fund operates as a fully distributing trust, which means that all income received by the Fund during each period, after deducting fees and expenses, is obligated to be distributed to investors monthly. This structure holds significant advantages for investors seeking both capital stability and a dependable income stream, especially when compared to other asset classes such as equities, where dividends/distributions are often discretionary in terms of the amount and timing of payouts, if any are made at all. Moreover, the monthly frequency of distribution, as opposed to the more typical half-yearly approach, adds an extra layer of consistency for our valued investors.

Manning focuses its investments on assets that yield a monthly income-based return, allowing us to efficiently pass on the returns received by the Fund to our investors in a timely manner. For our investors, this translates into the ability to receive their monthly returns as cash distributions, reducing the need for regular redemptions to meet their income requirements.

Investors will note the distribution rates from fixed income have increased significantly of late due to the higher RBA cash rate. By way of example, the Fund’s annualised current distribution yield is 9.15% versus the ASX 200’s indicative dividend yield (including franking credits) of circa 6.10%.

The Fund delivered +0.75% in August, 9.10% over 12 months and 6.67% annualised since inception, continuing to deliver over 5% net return above the RBA cash rate.

Since May 2022 when the RBA started increasing Australia’s cash rate to slow the economy and its uncomfortably high inflation, there has been little evidence of that higher cash rate’s impact. For example, retail sales remained robust, growing each month throughout 2022. We are now witnessing the lagged impact of that policy, which is reassuring as it indicates the RBA cash rate may be high enough and no more pressure needs to be added to household or corporate balance sheets by way of further cash rate increases. While reassuring, it’s also important to note from a relative perspective, a 4% increase since May 2022 in the RBA cash rate is substantial, and it could even be argued, more impactful given its prior low 0.1% base that it came off.

From a fixed income investor perspective, we are watching for signs of stress both in the economy (i.e. changes in the unemployment rate, corporate insolvencies, house prices and alike) and in fixed income assets. Currently, the most vulnerable assets where we believe stress will be seen first are those with meagre protections, such as business loans not secured by a hard asset such as a property or vehicle or, large loans compared to the size of the borrower. Large loans for a variety of reasons have proven to be more problematic and it is why, bankers globally watch loans size carefully.  Large loans can be even more problematic when they are not supported by a borrower that has regular annuity style income streams to meet regular repayments. For example, a large loan that capitalises interest throughout the term and relies upon a future intended event to pay the loan off. These transactions contain significant ‘event risk’ and make it difficult to detect a deterioration in credit quality before the final repayment is due.

As we assess the outlook for Australian fixed income and credit markets, we are keenly watching lenders who allow large loans, particularly where borrowers have limited regular business revenues to make regular repayments. Such a dynamic is commonplace within construction finance, where you are lending to a developer who often has large net cash outgoings during the construction phase and primarily relies upon the project going according to plan, the apartments or properties selling in a short period and selling at a high enough price to recover the full loan amount. Such an asset has material inherit risk, which is why the Manning Monthly Income Fund has no construction finance assets. It should also be noted, that large loans are also more impactful to an investor. For example, a loan defaulting in a portfolio of 20 loans can have a 10 times larger impact than a portfolio of 200, and so on.

Therefore, assessing the number of loans and the largest loan of one’s portfolio is a good barometer of risk and why Manning Asset Management prioritises avoiding large loans and investing in a diversified fashion.

In the face of an unpredictable economic environment, skilfully managed fixed income investments can provide attractive risk-adjusted returns. Like all asset classes, risks remain that, when poorly managed, can lead to unfavourable outcomes for investors. Join Portfolio Manager Josh Manning, Chief Investment Officer Adrian Bentley, and Investment Committee Member Paul Edwards as they discuss how Manning Asset Management leverages the team’s 100+ years of experience through credit market cycles to create an essential foundation for managing the firms’ portfolios.

The webinar will cover:

• Lessons from 100 years of investing in Australian fixed income
• Asset structuring
• What the investment management team are watching and how we are positioning the portfolio over the quarter

The webinar will be presented by:

Josh Manning – Portfolio Manager and Founder

Adrian Bentley – Chief Investment Officer

Paul Edwards – Investment Committee Member and Executive Director

Juliet Shirbin – Head of Investment Solutions & Investor Relations

Disclaimer:

This video may not be copied without the prior consent of the issuer Manning Asset Management Pty Ltd AFSL 509 561, ACN 608 352 576. This podcast is intended for use only by persons who are ‘wholesale clients’ within the meaning of the Corporations Act. It is intended to provide general information only and has been prepared without taking into account any particular person’s or entity’s objectives or needs. Investors should, before acting on this information, consider the appropriateness of this information having regard to their own situation. While due care has been taken in the preparation of this podcast, no warranty is given as to the accuracy of the information. Except where statutory liability cannot be excluded, no liability will be accepted by Manning Asset Management for any error or omission or for any loss caused to any person or entity acting on the information contained in this webinar. We do not guarantee the performance or success of an investment and you may lose some or all of the capital invested. Past performance is not a reliable indicator of future performance.

The Fund delivered +0.78% in July, 8.97% over 12 months and 6.64% annualised since inception, continuing to deliver over 5% net return above the RBA cash rate.

With the rise of interest in fixed income investments, we have seen an accompanying increase in fixed income fund managers. Investors, therefore, look to understand how our Fund differs from these newer offerings.

In 2015 when establishing Manning Asset Management, we looked at the very best fund managers globally to understand what differentiates a good from a great fund manager, with two themes emerging. First, they do something and do it very well, or in other words, they ‘stick to their knitting’. Secondly and most importantly, they emphasise and ensure alignment of interest in every facet of their business. These two principles have been the foundations of Manning Asset Management.

We demonstrate our close alignment with investors by ensuring all fees, interest, and other related benefits flow to investors. We do not believe the practice of keeping establishment or upfront fees or other such monies paid when investing in a new transaction is fair to investors.  For example, a manager that retains the upfront fees and only passes on the interest payments to investors is incentivised to negotiate higher upfront fees and lower interest rates with borrowers which conflicts with the interests of our clients, who’s capital is ultimately being invested.  A fund manager should be incentivised to invest in transactions that best fit the fund’s risk-return profile, maximising returns and minimising risk. Removing this conflict as we do, removes any bias and allows a clearer perspective on safeguarding investor interests.

We prefer a fee structure that pays an amount for running the strategy and an approximately equal amount if we deliver on our investment objective of achieving the RBA cash rate +5% net of fees (circa 1% per annum in aggregate). This simple fee structure where we are not pocketing other fees along the way has been a vital element in not only ensuring we are best placed to safely manage investor capital through uncertain times but, importantly, has also been a source of additional investor returns and why we have outperformed several peers.

By prioritising specialisation and removing fee conflicts, we have been able to safeguard investor interests and maximise returns. As a result, the Manning Monthly Income Fund has consistently delivered upon its target return of RBA cash rate +5% net of fees since its 2016 inception.

Beneath the yield fixed income investors receive, there are often overlooked avenues of transaction income many investors are missing out on.

The decade high RBA cash rate has been a boon for investors, seeing fixed income expected returns soar. While most investors focus on yield (often termed ‘running yield’), they overlook there are often additional sources of income available from the transaction.

When a new fixed income asset is originated, it should be little surprise that not all investors have the same access or negotiating power. Therefore, terms between investors shall vary. Generally, the larger the investment, the better the economics that can be achieved on a given transaction. As a wholesale capital provider, fund managers like Manning see three important ways to generate returns for their investors.

Firstly and most importantly, fixed income investments typically have a consistent yield paid to the providers of that capital. This rate may be fixed or floating, pegged to the RBA cash rate or bank bill swap rate. In our experience, 80-90% of investor returns come from this source, although the actual percentage can be higher or lower depending on the asset class.

When a new transaction is issued, larger investors can often charge an establishment fee (or upfront fee) of up to 2% (or higher in certain situations), which can be quite material depending on the yield and maturity date of the investment.

Lastly, while uncommon, larger investors may negotiate options or warrants in the issuer themselves in certain circumstances, such as for a newer originator. The rationale being if a manager like Manning can invest a material amount in the new fixed income issuance, that is commercially very attractive to them as opposed to having to court many underlying investors taking time and money, and therefore, there should be some share in the commercial upside. Where this does occur, it is more likely to be in our higher returning strategies (Manning Credit Opportunities Fund) and these can materially boost returns, albeit over a longer timeframe than the above.

How different managers treat these sources of return matters

Across the Australian market, we see a wide range of practices in how these sources of investor returns are shared between fund managers and their investors. In some cases, managers will retain a portion of the yield (e.g. an investment pays 9%, and the manager passes on 8% to the investor, retaining 1% in fees). We also see some managers pass on 100% of the yield and charge a fee for managing the fund overall.

We also see a variety of practices around how the establishment fee is shared with investors. This is a crucial element for investors to consider. The rationale being an issuer of a security is indifferent to paying a 2% establishment fee and 7% yield or a 9% yield assuming a 12 month investment. Therefore, if a manager keeps these establishment fees, that manager is incentivised to trade off investor returns for higher establishment fees in which they keep. This same principle can also be applied to options or warrants when they are not given to the investors whose capital is being used to invest.

Understanding the attribution of your return is key

Investor attraction to fixed income is timely, given the higher expected returns from the elevated RBA cash rate. To maximise investor returns, investors should understand what level of returns are being taken by the manager, and what is being passed on. To do so, an investor needs to understand if the manager is retaining a portion of the running yield, if establishment fees are passed on and if not, how much these fees are and lastly, the treatment of other benefits such as warrants. We believe that providing a manager is transparent and discloses these facts, it’s simply around evaluating how much a manager is paid in total vs the value they deliver to investors and whether the fee structure delivers an alignment of interest that favours investors. If this transparency is not forthcoming, investors should exercise caution, seek further clarification, and consider other investment options if not satisfied.

We urge all investors to understand this equation and ensure the fund manager you are using is genuinely maximising your returns.

(For transparency, I have included how Manning treats such profits

• Percentage reduction in running yield = 0% (i.e. 100% goes to our investors)
• Percentage of establishment fee kept by Manning = 0%
• Percentage of options kept by Manning = 0%
• Manning charges a fee at the Fund level that on average, equates to circa 1% per annum)