News and Insights

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)

The Fund delivered +0.72% in June, 8.88% over 12 months and 6.60% annualised since inception, continuing to deliver over 5% net return above the RBA cash rate.

The Fund delivered 0.72% in June being in line with its monthly return target. Investors will note that returns move monthly as investment maturities occur and new investments come online, impacting cash held by the Fund. During the period, we have identified several opportunities in the late stages of due diligence, although settlement has been delayed seeing the Fund hold additional cash. We are comfortable holding this cash given the attractiveness of the transactions underway.

Throughout the month, we have engaged with multiple advisory and institutional clients who share a common interest in our views on the economic outlook and how we manage risk accordingly. A key pillar of our investment process is picking the right assets to perform through the economic cycle and structuring them correctly.

Structuring refers to the contractual obligations we put in place to control risk, and if those risk limits exceed our tolerance, they give rise to certain rights. By way of a simplified example, Manning will determine what level of arrears we are willing to tolerate when investing in a pool of underlying assets. The counterparty seeking finance must ensure those arrears levels are not exceeded. If these set levels are breached due to counterparty-specific or industry-wide issues, Manning would typically have a right to require that counterparty to repurchase some or all of those assets in arrears, or the facility would need to be closed and paid down. As closing the facility would be detrimental to that counterparty, they are highly incentivised to ensure those limits are not breached initially and, if they are, are quickly resolved before we exercise such contractual rights.

Given this approach, when structuring transactions upfront, we consider how that facility would be paid down should that counterparty not adhere to our pre-agreed risk limits. Importantly, we focus on ‘asset-backed’ transactions in that our financing is secured against assets that are of value and can be recovered to repay some or all of our capital. Therefore, a request to have our facility repaid can either occur through being refinanced or allowing those underlying assets, which are being regularly repaid, to repay our financed amount.

We have had counterparties who have breached our risk limits, and we have had to exercise our rights which has always led to 100% of capital being returned due to the sensible, legally enforceable contractual obligations within our agreement. This approach has ensured the Fund has never had a negative month from credit losses in its 7+ year track record while investing through a variety of market cycles and economic conditions.

We remain vigilant of the outlook and are pleased to say all counterparties are operating within risk limits, and we do not see an elevated risk profile in the portfolio.

The secret to this fund manager’s seven-year track record is to just keep it simple. Written by Hans Lee, Livewire Markets

If there’s one common trait among fund managers that consistently outperform their benchmarks or their competition, it’s that they do one thing and do it well. No distractions, no differences between fund strategies, and little to no divergence from their core mission.

One of those outperforming funds is the Manning Monthly Income Fund. The fund has never had a negative return month from credit in its seven-year existence. When I asked Josh Manning, CEO of Manning Asset Management, how the fund has so consistently outperformed, he points to one thing.

“We’re not doing anything new or different,” Manning said. “Our investment process has been designed to work through all market conditions. We’re simply just repeating that and continuing to deliver the results we have.”

What do you attribute your outperformance to?

Manning: The thing is we’re not doing anything new or different. Our investment process has been designed to work through all market conditions and really what we think we’ve got a very strong investment process and we’re simply repeating that and continuing to deliver the results that we have.

I think in terms of what’s made the strategy so successful, it’s just really about right-sizing our risk limits.

We’ve lost deals because we’ve said we’re not going to take that risk or that’s too big a position but having that discipline to stick to our investment process to have the right risk limits. A lot of managers had a lot of duration on their book and they’ve torn up capital over the last 12 months because of that.

We were very deliberate in terms of how we managed the book around keeping it shorter-dated, particularly through 2020 where there was a lot of market uncertainty.

What investments have detracted from your performance over the past year (if any) and what have you done with them?

Manning: We haven’t had any detractors really over our whole history. We buy assets and some we know will be above investment hurdles, some are below investment hurdle and we just recognise there’s a variety of different reasons why you buy assets.

Firstly, they need to stack up on a risk-adjusted basis. So if something is super low risk then it makes sense to buy it.

The other reason why assets might be slightly below the target is that they have a lot of liquidity in the portfolio. We recognise that’s good from not only an investor perspective but from a flexibility and portfolio perspective.

Have you had to do anything differently this year to deal with the heightened volatility and uncertainty in markets?

Manning: Each quarter, the investment process incorporates a macroeconomic outlook session from the investment committee where we think about what’s happening in the external environment. What’s the context in which we’re making those investments and what are the implications for portfolios.

So there’s already a very robust way in which we think about that external environment and build that into the portfolio construction. Ultimately, the assets that we pick up in the portfolio and how we manage them. It’s a continuing theme, but I think the investment process picks that up and is very well-placed to help navigate that uncertainty.

What are the biggest macro concerns you are monitoring in the portfolio going forward?

Manning: The way I think about it is there are known and unknown risks. So a known risk is the prolific interest rate hiking cycle that we’re going through globally at the moment.

That has implications for unemployment, business investment, business confidence and ultimately, that has implications for the fundamentals of Australian credit markets.

It’s around buying the right assets. So it’s around thinking about these concerns about the macroeconomic environment (and we will always have concerns). We’ll never say we’re not concerned at all. We’ll never go all-in. So we’re about spreading our bets.

But when we make those bets, it’s around stress testing those assets on a very severe basis. So say for an example, an investment had a potential credit loss underneath it of 2%. We knew in a very bad economic environment that could go up three to four times, there will be stress testing at an 8% loss rate.

What kinds of yields are you targeting in the coming year?

Manning: Our main fund is targeting loans that are delivering 9% or higher. While most of our assets deliver yields higher than this, we believe it isn’t a time to be investing based on headline yields. It is the time for being fussy about what deals we participate in, ensuring they fit our risk appetite.

People need to remember, markets are cyclical and when money is flowing into an asset class, it’s easy to get carried along and slowly accept greater and greater risk. We believe in sticking to your risk appetite and looking at investing on a longer term basis that will deliver the best investor outcome.

Is there an area of your market that has huge potential but no one is paying attention to?

Manning: We’ve been quite active in coming in and out of sectors as the fundamentals of those sectors change around. Early on, we had a lot of consumer loans. The fundamentals of those in terms of the risk-adjusted returns came down and we moved our book more into mortgages where we saw a huge opportunity.

More recently, we’ve seen some really strong assets in the business loan space. So we’ve been able to on a relative basis say, well, that’s a better risk-adjusted return, typically a lower risk investment for the return profile.

Speaking of business loans, what kinds of businesses are you wanting to target in this environment of heightened interest rates and risks?

Manning: Business loans is an interesting space, being extremely diverse. Investing in areas such as unsecured lending particularly to plug business cash flow issues is deeply unattractive and not an area we invest in.

Targeting some of the least risky aspects can provide some attractive opportunities. When we invest in this space, we focus on spreading our bets as widely as possible to ensure we do not have large fund concentrations.

We like lending that is naturally suited to businesses when they are growing (e.g. a business buying something to take on an increasing number of orders) and seek opportunities where there are mismatches in business cash flows i.e. they have money due and payable although require funds now for an asset purchase.

Ultimately the cornerstone to our investing is having security over the asset we are lending on. While we are finding good opportunities in this space, we are favouring more traditional non-construction 1st ranking mortgages, given the uncertain outlook placing a limit on our appetite for business loans at present.

This chart appears in the most recent RBA Statement on Monetary Policy and is one way of reflecting the changes in credit conditions in the Australian economy.

How does this chart affect the way you invest?

Manning: I really like macro big picture things. I think they’re really interesting and they tell you a lot about the tide – which way the tide is running and whether you’re swimming with it or against it. Obviously, growth in this multi-trillion dollar credit market, which we’re participating in here in Australia means we are swimming with the tide.

I get excited about capturing that growth in attractive risk-adjusted assets that have the right risk measures around it. But it’s obviously good that the markets are growing and there’s an increasing number of opportunities out there.

Finally – just for fun – who makes a good investor in your fund?

Manning: We actually quite enjoyed thinking about this question because I think my favourite investors are critical thinkers. So people who read widely, make their own opinions on topics using multiple different sources and they don’t just pick up the front page of an article and take that as gospel.

https://www.livewiremarkets.com/wires/how-investors-can-access-9-yields-in-this-asset-class