SPECIALIST CASH AND FIXED INCOME MANAGER
July 2017
In our series of fund manager profiles, we speak to Coolabah Capital Investments which manages Smarter Money Investments funds. Smarter Money Investments provides specialist active management in the in the liquid cash plus & short-term fixed interest asset-classes.
The Coolabah/Smarter Money Investments’ portfolio management team is led by experienced fixed-interest, economics research, and managed investment specialists Christopher Joye and Darren Harvey, who are both Executive Directors and Co-Chief Investment Officers.
Christopher previously worked for Goldman Sachs in London and Sydney, the Reserve Bank of Australia, and was the founder of an award‐winning research and investment group, Rismark International. Darren has previously worked for McIntosh Hamson Hoare Govett, Fay Richwhite, and Deutsche Bank and Bower Capital.
YR: Christopher, the Smarter Money Fund which has an active cash strategy returned 4.6% gross and 3.6% after fees for the 12 months to 30 June. Term deposits have averaged around 2.8% while the RBA rate averages 1.5% over this period. What was the mix of income and capital growth in that return?
SM: We are an active manager that focuses on maximising total returns while minimising risk. Applying up to 12 different quantitative valuation models, we try to find bonds that are cheap—or paying too much interest after adjusting for their various risk factors—and which generate capital gains once the bond’s price normalises back to our proprietary estimate of fair value.
In the Smarter Money Fund the average gross running yield on the cash and bonds we have held over the last year was 3.1%. Given the fund’s gross return of about 4.6% we generated an extra 1.5% in capital gains across our cash and bonds on top of our running yield through active asset-selection.
Since our average portfolio weight to cash was 43.6% and bonds only made up 56.4% of our portfolio, the average total capital gains on the bonds, excluding all cash, was about 3% over the year.
YR: What was your best performing asset over the 12 months? What were the return metrics for this?
SM: Our best performing assets are hard to define because we can produce high returns over short holding periods and lower returns over longer holding periods.
At various times over the last 12 months we have extracted significant alpha out of cheap major bank senior bonds, AAA rated RMBS, AAA rated covered bonds, and some subordinated bonds.
YR: Take us through the different market phases and your portfolio positioning over the last 12 months.
SM: In June 2016 we only had 16.5% of the portfolio in cash given Brexit had unleashed attractive buying opportunities. By November 2016 we had sold down many assets with the cash weight rising to 50.1% and it has mostly stayed in the 40%-50% range ever since given our view that credit was approaching our estimate of fair value.
More recently there have been some interesting new issues that we have capitalised on, which has lowered our cash weight to around 35%. Our long-time base-case for 2017 has been that spreads would slowly compress (ie, prices rise) as the negative real cash/interest rates imposed by the RBA, and very low cash rates globally, continue to encourage a search for yield.
We have thought this would be amplified by a sell-off in duration, or a rise in long-term interest rate expectations, which should force many institutional investors to move away from fixed-rate bonds to floating-rate products, the latter of which comprise 100% of our portfolio.
YR: The funds gross return over the last 5 years has been 5.2%. Have there been any negative quarterly returns during this period?
SM: Pleasingly, we have never had a negative quarter over the last 5.4 years since the Smarter Money Fund’s inception in February 2012.
YR: What was the highest and lowest rolling 12 month return over the period and what impacted those return outcomes (both positive and negative)?
SM: Our best rolling 12 month periods have tended to result in us beating the RBA cash rate by between 3% and 4% after all fund fees (our target is 1%-2%) while in our worst rolling 12 month period we delivered a return after fees that was comparable to the cash rate.
As a value-based manager we are constantly hunting out cheap assets. When those bonds converge back to fair value we provide large excess returns as we are crystallising capital gains through selling our holdings. Conversely, when bonds are cheapening we are generally buying. We cannot, however, perfectly predict the future, and so there can be occasions when bonds continue getting cheaper and this drags on performance until values normalise again.
Since inception we have been through many of these cycles with spreads widening sharply in mid-2012 and then crunching tighter by the end of that year, widening again in June 2013 only to compress to post-GFC tights in August 2014. Then came a massive sequence of credit shocks over 2015 and early 2016 that drove some financial spreads close to their GFC wides, and finally a tightening phase again during late 2016 and 2017 notwithstanding Brexit and Trump.
YR: Your FUM has grown by over 100% over the last 12 months to $644m. What do the profiles of your investors look like?
SM: Around 75% of our $1.5 billion plus in FUM comes from institutional investors. The remainder is contributed by savvy financial advisers, family offices, and individuals.
YR: Has the growth and size of the fund impacted your investment universe or the way that you trade or execute your positions?
SM: We have found that size is a big advantage in fixed-income. You get better access to market-makers, issuers, deals and resources by reinvesting your own revenue in people and technology. That means superior liquidity, allocations, asset pricing ability, and the optionality to negotiate terms of bond issues (e.g. the interest rate and tenor).
YR: Have you made any additions to your investment team as a result of this growth?
SM: We have significantly expanded our investment team over time from the original two portfolio managers and two part-time analysts in 2012 to four full-time portfolio managers today. Two of our portfolio managers also serve as quant analysts while we have another three full-time analysts (two credit and one quant). Our team is augmented with the skills and experience of our chair, Melda Donnelly, the former CEO of QIC and deputy chair of VFMC, and independent director, Bob Henricks, who was chair of Energy Super for 20 years.
YR: Looking forward over the next 12 months, what’s your view on official cash rates, term deposit rates and credit margins on floating rate notes and what will be the key things to look out for?
SM: We believe that it is very difficult to forecast accurately future interest rate changes, which is why taking any interest rate duration risk in portfolios is so incredibly dangerous for defensive investors. We run our portfolios such that they all basically have near-zero interest rate duration.
Our only source of excess returns is capital gains secured through identifying mis-pricings or valuation alpha.
Having said that, our central case is that the RBA increases its cash rate by 2 to 4 standard moves over the next year. We believe that credit spreads will tighten over the next 6 months, or for the remainder of 2017, as negative short-term real cash rates incent the drive for yield.
From an investment point of view we focus on the horizon where our predictive capabilities are greatest, which is between zero and six months.
YR: In terms of your strategy, can you briefly describe your investment strategy?
SM: The Smarter Money Fund has what we call an “active cash” strategy whereby we have historically held 45% of the portfolio in cash and 55% in floating-rate notes. These numbers are deceptive, though, because we dynamically move between cash and FRNs with our cash weight rising beyond 60% on six occasions since 2012 and below 20% twice.
We focus on producing superior risk-adjusted returns not by increasing interest rate duration risk, credit risk or illiquidity risk, which are the common approaches in the active fixed-income world. Instead we use our large team to look for mispriced assets that are trading below fair value (i.e. cheap prices or wide spreads) after adjusting for each bond’s risk factors.
We have found that in more than 1,000 bond sales over the last 6 years we have been able to generate capital gains on top of the interest we earn on a bond about 85% of the time.
YR: Does the Smarter Money Fund invest in ASX listed bank hybrids or notes?
SM: This fund does not invest in any ASX hybrids. We have a sister strategy, called Smarter Money Higher Income, which can invest up to 15% of its portfolio in hybrids, although it has never been above 7%. Smarter Money Higher Income has produced consistently larger returns than the Smarter Money Fund with slightly higher volatility of 0.8 per cent annually (versus about 0.6 per cent for Smarter Money).
YR: Approximately 2/3rds of the portfolio is invested in floating rate notes which are traded on an over the counter market which is available only to professional investors. Many investors and advisers are not familiar with this market.
SM: The over-the-counter bond market is widely misunderstood. Across commonwealth government bonds, state government bonds, RMBS, ABS, and corporate and financial bonds there are about $1.5 trillion of securities, which is roughly the same size as the ASX equities market.
Liquidity is however much better than equities. The secondary turnover ratios for commonwealth and state government bonds are about four times higher than the equities market. Some people think secondary “credit” is illiquid, yet the secondary turnover ratio for corporate and financial bonds, which are worth about $500 billion in outstanding stock terms, is around 50%, which is on par with equities.
Within the corporate and financial bond markets you also have specific classes of securities, particularly anything that is eligible to be sold to the RBA for its liquidity facilities, which can be immensely liquid.
And then if we look at the annual volume of new bond issues in the primary market, this is about 4x to 6x bigger than the value of new IPOs on the ASX. In contrast to the ASX where the IPO market often shuts when conditions sour, companies with debt always need to issue to refinance or repay their existing obligations otherwise they will be insolvent. So you find the primary bond market will be trading actively when the primary equity market is closed.
We actively participate in both primary and secondary trades.
YR: What changes do you think would be needed to the way the market operates in order for all investors to access this market more easily and get better market transparency?
SM: While being very large and liquid, the OTC bond market is perversely opaque and dark with very little information disclosure on actual prices and volumes. We have been arguing for years with ASIC and the ASX to require Austraclear to regularly disclose all the prices and volumes of trades to enhance the market’s efficiency and transparency, which will only feed back into better access and liquidity.
YR: Equities managers are under pressure with the active vs passive debate and whether active managers add value. Your fund targets a return equivalent to the RBA official target cash rate + 1%-2% pa after fees over rolling 12 month periods. Your track record demonstrates consistent outperformance. What are the key ingredients to this success?
SM: We believe the keys to success are combining a very hard-working, aligned (i.e. equity owning), and talented team of investors with a market that is intrinsically very inefficient. You would be hard pressed to find a more inefficient market than what you see in Australian bonds, which is one of the few fixed-income markets in the world where there is zero mandated price and volume reporting post-trade.
To properly motivate active managers you need to have the right incentive structures or fees. The incredibly silly idea advocated by many researchers that active bond managers should be paid passive fees with no success incentives is undoubtedly why most of our peers have underperformed for so long.
We took the relatively bold step to over-turn this approach, and we have success fees on all our funds and have had no difficulty convincing smart investors that this provides for a stronger alignment of interests with our stakeholders.