Diversified Thinking Through the Cycle
DIVERSIFIED RETURN FUND
RWC Diversified Return Fund
Introduction
The RWC Diversified Return Fund’s objective is to conservatively grow investors’ capital through the cycle, while providing genuine diversification to their portfolios from traditional equity and bond holdings. The mandate goes beyond simply reducing volatility in investors’ asset allocations to generating positive returns when they need it most. The recent period of turmoil in financial markets exemplifies one of those times. As seen in the graph below, the fund performed well just as equity markets collapsed and, just as significantly, as government bonds failed to play their diversification role
at a critical juncture.
Contrarian thinking
Positioning a fund to take gains at cycle extremes from reversals in market sentiment – which is what genuine diversification entails – often requires contrarian thinking and the ability to generate returns by means other than common asset allocation. Moving away from the herd can be difficult and requires a strong philosophy and process to guide investment decisions. Generating returns beyond basic asset allocation requires alternative exposures and more sophisticated portfolio construction.
The key two parts of our investment process to achieve our objectives are:
John Malloy and James Johnstone co-manage the RWC emerging and frontier markets team. The team is composed of a further 17 analysts, economists and strategists based in Miami, London and Singapore, many of whom have worked together for over twenty years. The team joined RWC Partners in 2015 and now manages c. $9bn for its clients. Emerging and frontier markets represent the fastest growing countries in the world. The RWC team believes the continued growth in these markets represents opportunities across a range of industries.The highly experienced and dedicated team takes an index-agnostic, opportunistic approach which allows it to explore investment opportunities that are often off the beaten track.
‘Generating returns beyond basic asset allocation requires alternative exposures and more sophisticated portfolio construction’
This forms the foundation for our decision-making process and
guides how much and what kinds of risk to take in the portfolio.
The credit-cycle framework often leads to contrarian thinking and investment exposures. It is an investment tool designed to identify risks either increasing or dissipating in areas of the financial system and positioning accordingly.
1. The Credit-Cycle Framework
The team
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Phases of credit cycle
Figure 1: Reported Covid-19 cases
A contrarian perspective will be critical going forwards
Mar 2020
Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 27th March 2020
A liquid, low-cost, transparent way for investors to gain true diversification from traditional equity and bond holdings
The fund prioritises portfolio construction and seeks to harness alternative-return streams. This combination means extending beyond basic asset allocation techniques in order to provide genuine diversification. Different strategies are deployed according to the position in the cycle, ensuring they are in sync. Achieving balance in the fund through thoughtful portfolio construction helps ensure that contrarian thinking mitigates losses.
This combination of contrarian positioning because of the credit-cycle framework, sophisticated portfolio construction, and alternative return streams helped produced the fund’s outcomes. Not only did the fund perform well during the market sell-off but the returns also have been positively skewed. Meanwhile, the pattern for equities and even bonds have been fat-tailed and negatively skewed. Traditional correlations, upon which basic asset allocators rely, have broken down, meaning their means of diversification have let them down when they need them most.
2. Portfolio Construction and Alternative Return Streams
Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. “Strategy” is defined as the investment guidelines utilized by Clark Fenton in managing the Agilis Master ICAV adjusted by the estimated ongoing charge of the Protea Fund- Agilis UCITS Class A (0.85%) for the period 01 June 2017 – 25 June 2018, the gross return in USD of the Protea Fund-Agilis UCITS adjusted by the estimated ongoing charge of the Protea Fund-Agilis UCITS Fund Class A (0.85%) between 25 June 2018 and 10 October 2018 and the net return of the Protea Fund-Agilis UCITS Fund Class A USD from 10 October 2018 through 25 October 2019 and the net return of the RWC Diversified Return Fund Class B USD after 25 October 2019. The Agilis Master ICAV was launched on 1 June 2017 and was managed with similar investment guidelines, using the same investment process as the Protea Fund- Agilis UCITS. The performance history of the Agilis Master ICAV is estimated using the ongoing charge of the Protea Fund- Agilis UCITS Class (0.85%) ongoing charge. The actual performance of the Agilis Master ICAV may have differed significantly from the results shown based. The results show are for illustrative purposed only. They are based on the historical returns of the investments of the fund but adjusted to reflect the ongoing charge of the Protea Fund-Agilis UCITS fund. The results do not represent, and are not necessarily indicative of, the results that may be achieved in the future. There can be no assurance that an investor’s performance would have been the same. 1,2 Index performance data is measured in USD and sourced from Bloomberg. All statistics are measured using weekly performance data.
The following section describes the phases of the credit cycle the fund has encountered thus far, highlighting how it was positioned and performed in each.
In Q4 2018 the fund transitioned to a more defensive stance, judging that the Overextended phase had begun. This conclusion was based on the continued increase in leverage, particularly in corporate credit, while earnings and cash flows were declining. Furthermore, financial conditions were tightening as central banks attempted to normalise monetary policy. The fund moderated its net exposure to risky assets, especially equities, increased convexity positions, and prioritised liquidity. The strong absolute and relative performance in Q4 2018 was function of this defensive transition.
In 2019, the fund maintained its defensive outlook and exposure as earnings and credit quality continued to decline while leverage did not. This posture proved contrarian as market participants were fixated on easier financial conditions, even suggesting that monetary largesse might have done away with credit, business and investment cycles for good. The fund sustained moderate losses as a result of this contrarian stance. The losses were mitigated by the fund’s portfolio construction and use of limited-loss strategies to achieve convexity.
By definition, preparing for a downturn must happen in advance. The fund was well positioned for the onset of the Deleveraging phase, which began mid-February 2020. With moderate net exposure, convexity strategies and ample liquidity, the fund has performed well. The fund’s short exposures have been significant contributors to performance. Basic asset allocation would not have accomplished the same results as traditional fixed-income to equity correlations have been unstable.
Full-cycle perspective and contrarian thinking mean we are preparing for the next phase of the credit cycle: Balance-sheet Repair. This will entail investing from the long side, taking risk as many are capitulating to the bear market. The nature of our investments will change from convex to more carry orientated strategies, and net exposure to risky assets will increase significantly. To signal the shift from Deleveraging to Balance-sheet Repair, we will be looking for a diminution of debt levels and a trough in earnings. At the same time, valuations will be low and risk premia high. Normally, the expected rate of defaults exceeds the likely reality at this point because negative sentiment overshoots the actual repair of financial health. As an aside, the nature of this cycle’s balance-sheet repair may entail inflationary pressures, which will necessitate a different approach. As such, a contrarian perspective will be critical.
Overextended
Deleveraging
Balance-sheet Repair
1. The Credit-Cycle Framework
2. Portfolio Construction and Alternative Return Streams
From Q3 2017 through Q3 2018, the fund was managed for the latter stages for the Re-leveraging phase of the credit cycle. While debt levels in the financial system had grown significantly, so had earnings and cash flows to service the debt. Consequently, the leverage build-up was not yet flashing warning signs, notwithstanding more stretched valuation levels and greater investor complacency. The fund was positioned with moderate net exposure, few hedges and participated in risk assets’ rally.
Releveraging
Q3 2017 - Q3 2018
Q4 2018
From Q3 2017 through Q3 2018, the fund was managed for the latter stages for the Re-leveraging phase of the credit cycle. While debt levels in the financial system had grown significantly, so had earnings and cash flows to service the debt. Consequently, the leverage build-up was not yet flashing warning signs, notwithstanding more stretched valuation levels and greater investor complacency. The fund was positioned with moderate net exposure, few hedges and participated in risk assets’ rally.
Releveraging
In Q4 2018 the fund transitioned to a more defensive stance, judging that the Overextended phase had begun. This conclusion was based on the continued increase in leverage, particularly in corporate credit, while earnings and cash flows were declining. Furthermore, financial conditions were tightening as central banks attempted to normalise monetary policy. The fund moderated its net exposure to risky assets, especially equities, increased convexity positions, and prioritised liquidity. The strong
absolute and relative performance in Q4 2018 was function of this defensive transition. In 2019, the fund maintained its defensive outlook and exposure as earnings and credit quality continued to decline while leverage did not. This posture proved contrarian as market participants were fixated on easier financial conditions, even suggesting that monetary largesse might have done away with credit, business and investment cycles for good. The fund sustained moderate losses as a result of this contrarian stance. The losses were mitigated by the fund’s portfolio construction and use of limited-loss strategies to achieve convexity.
Overextended
Q4 2018
Q3 2017 - Q3 2018
Feb 2020
By definition, preparing for a downturn must happen in advance. The fund was well positioned for the onset of the Deleveraging phase, which began mid-February 2020. With moderate net exposure, convexity strategies and ample liquidity, the fund has performed well. The fund’s short exposures have been significant contributors to performance. Basic asset allocation would not have accomplished the same results as traditional fixed-income to equity correlations have been unstable.
Deleveraging
Feb 2020
Mar 2020 onwards
Q4 2018
Full-cycle perspective and contrarian thinking mean we are preparing for the next phase of the credit cycle: Balance-sheet Repair. This will entail investing from the long side, taking risk as many are capitulating to the bear market. The nature of our investments will change from convex to more carry orientated strategies, and net exposure to risky assets will increase significantly.
To signal the shift from Deleveraging to Balance-sheet Repair, we will be looking for a diminution of debt levels and a trough in earnings. At the same time, valuations will be low and risk premia high. Normally, the expected rate of defaults exceeds the likely reality at this point because negative sentiment overshoots the actual repair of financial health. As an aside, the nature of this cycle’s balance-sheet repair may entail inflationary pressures, which will necessitate a different approach. As such, a contrarian perspective will be critical.
Balance-sheet Repair
Mar 2020 onwards
Q4 2018
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Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. “Strategy” is defined as the investment guidelines utilized by Clark Fenton in managing the Agilis Master ICAV adjusted by the estimated ongoing charge of the Protea Fund- Agilis UCITS Class A (0.85%) for the period 01 June 2017 – 25 June 2018, the gross return in USD of the Protea Fund-Agilis UCITS adjusted by the estimated ongoing charge of the Protea Fund-Agilis UCITS Fund Class A (0.85%) between 25 June 2018 and 10 October 2018 and the net return of the Protea Fund-Agilis UCITS Fund Class A USD from 10 October 2018 through 25 October 2019 and the net return of the RWC Diversified Return Fund Class B USD after 25 October 2019. The Agilis Master ICAV was launched on 1 June 2017 and was managed with similar investment guidelines, using the same investment process as the Protea Fund- Agilis UCITS. The performance history of the Agilis Master ICAV is estimated using the ongoing charge of the Protea Fund- Agilis UCITS Class (0.85%) ongoing charge. The actual performance of the Agilis Master ICAV may have differed significantly from the results shown based. The results show are for illustrative purposed only. They are based on the historical returns of the investments of the fund but adjusted to reflect the ongoing charge of the Protea Fund-Agilis UCITS fund. The results do not represent, and are not necessarily indicative of, the results that may be achieved in the future. There can be no assurance that an investor’s performance would have been the same. 1,2 Index performance data is measured in USD and sourced from Bloomberg. All statistics are measured using weekly performance data.
The RWC Diversified Return Fund’s objective is to conservatively grow investors’ capital through the cycle, while providing genuine diversification to their portfolios from traditional equity and bond holdings. The mandate goes beyond simply reducing volatility in investors’ asset allocations to generating positive returns when they need it most. The recent period of turmoil in financial markets exemplifies one of those times. As seen in the graph below, the fund performed well just as equity markets collapsed and, just as significantly, as government bonds failed to play their diversification role
at a critical juncture.
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