Global Outlook - September

Global Outlook

Tactical Asset Allocation (TAA)

The Multi-Asset team’s view on bonds, equities, commercial property and other assets will affect asset allocation over the coming months. When making these asset-allocation decisions, we first consider the outlook for each asset class (e.g. government bonds), followed by views within that market (e.g. the US versus Europe, or European core economies against peripheral countries). The views of individual asset class teams may differ to this multi-asset view.

TAA Model Allocation - as at September 2019



Ken Dickson, FX Strategy

During the summer, markets have reassessed the risk of weaker economic growth together with further disinflationary forces. President Trump’s decision to renew his threat of tariffs on consumer goods imported from China triggered much of the change in market sentiment. Equity markets slipped lower, as did bond yields and yield curves flattened sufficiently to warn of a more generalised recession risk.

Whilst Global PMI surveys suggest that the manufacturing sector is already enduring a mild recession, the larger services sector has been more resilient - albeit still trending downwards. Nevertheless, there has been a significant easing in global Monetary Policy and there is increasing talk of Fiscal stimulus – which could support activity in the medium term. In the meantime, just as the global trade backdrop looks set to deteriorate, analysts are poring over key indicators for retail sales specifically, and the service sector more generally, to gauge the risk of a more serious downturn.

In light of this combination of political, economic and market activity the September edition of Global Outlook is concerned with the impact of these issues on various asset classes, and what could be done to help weather the storm. Collective decision making, diversifying risks and following robust processes are all key themes.

Challenging market conditions are exactly the types of problems investors face when allocating investments across asset classes and regions. How does an investor respond to the current market conditions and make sensible investment decisions? In our Spotlight article this month, ‘Back to basics’, Ken Adams, Head of Tactical Asset Allocation (TAA) delves into the workings of the TAA process to show how to best manage some of these issues. It is a fascinating report detailing the range of hard and soft skills required for the successful navigation of this global environment.

This month we also feature the private debt market where we analyse the key differences between bond investments in this sphere and debt investments within the public domain. Marianne Zangerl, Investment Director, sets out the advantages and adds caution with respect to liquidity issues. With mitigation of these challenges, we conclude that this asset class has some additional value for investors, both in terms of risk profile and diversification benefits.

Amanda Young, Global Head of Responsible Investment, in her article ‘From process to product’ dispels some of the confusion between Economic, Social and Governance (ESG) factors and Socially Responsible Investment (SRI) funds.

Taking this ESG investment process one step further can lead to the development of SRI based products. Importantly, she sets out clear advantages for asset returns, capital allocation and society as a whole when ESG is at the forefront of investment decision-making and portfolio construction.

And what impact have the current market conditions had on quantitative investment strategies (QIS)? David Clancy, Head of QIS Portfolio Construction, comments on the first six months of 2019 global equity returns using a detailed style breakdown – featuring phases of tough and exuberant market conditions – in order to set out the key drivers of factor investing.

And finally, whilst we note the current macroeconomic conditions are worrying investors, for some sectors of the market a ‘bottom up’ longer-term approach has been very successful over many years. Harry Nimmo, Head of Smaller Companies, writes of the value in picking stocks with a long-term outlook rather than taking a top-down approach. Interestingly, this still requires analysis of investment factors like quality, growth and momentum, as in the QIS article, but using research and judgement rather than a systematic quantitative approach.


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Ken Dickson


Back to basics

Chapter 1


Ken Adams, Head of Tactical Asset Allocation

Tactical asset allocation can successfully navigate a changing investment landscape by remaining faithful to a well thought out investment process.

Active investing

On a monthly basis ASI publishes its multi-asset TAA investment views at the front of this publication. In this article we discuss the process behind defining our asset class views.

Studies suggest that a group is smartest when each person thinks and acts independently.

Tactical asset allocation (TAA) is an active investment approach, which focuses on asset class and currency allocation across four key groups (stocks, bonds, real estate and cash) within a multi-asset portfolio. It typically operates over a rolling one-year time horizon. The aim is to take advantage of excessive reaction by investors to economic, corporate and geopolitical events in different countries by expressing overweight and underweight investment positions relative to clients’ long-term strategic benchmark allocations.

There are times when this challenge appears to be a relatively straightforward task: the world makes sense, fundamentals play out as expected and market behaviour appears consistent. There are other occasions when the opposite is true and uncertainty reigns: it can be difficult to make sense of a changing world. An obvious example would be the recent ‘weaponisation’ of trade policy by the United States, at a time when the global economic cycle is relatively long in the tooth – making it increasingly difficult to make confident predictions about key drivers of economic, corporate and therefore market performance. In the absence of a ‘true north’, individual market participants struggle to hold views with conviction, investment time horizons shorten and emotion begins to cloud judgement.

How does ASI’s TAA team navigate a changing investment landscape? The answer is by remaining faithful to a long-standing and well-thought out investment process. This is no easy task: fund managers are human beings, and human beings are far from perfect. We all have biases and we all make mistakes. Our job is made harder by the sheer volume of information at our disposal to digest and analyse. Some critics would argue that the task is more complicated when investment decisions are made by a committee rather than an individual! However, there is a greater likelihood of success if the task is approached in a structured way.

James Surowiecki’s book Wisdom, of the Crowds, is essential reading for anyone involved in group decision making. Supported by numerous academic studies, the case is convincingly made that “the many are smarter than the few” - but only when certain conditions are met. For the crowd to be smart there must be diversity of cognitive thought and opinion, independence of belief, decentralisation and a mechanism to aggregate judgements into a collective decision. We examine each of these important issues in turn.


A successful team should comprise individuals with different skills, career paths, specialisation, length of experience, and analytical preferences, to list the most obvious examples of cognitive diversity (not to mention other manifestations of diversity such as gender, nationality and culture). In other words, a new member of a team should preferable bring new skills to bear. A diverse team benefits from broader perspective, is better at keeping or retaining its knowledge, learning from experience and is more likely to make decisions based on facts rather than authority or influence. Such an environment encourages individuals to share what they really think. An additional result is a greater level of disagreement amongst team members than might otherwise be the case, but this is exactly what is necessary to guard against ‘groupthink’. Psychology Today explains that ‘groupthink’ occurs “when a group of well-intentioned people make irrational or non-optimal decision that are spurred by the urge to conform or the discouragement of dissent”.


Studies suggest that such a group is (paradoxically) smartest when each person thinks and acts as independently as possible. In other words an individual’s opinion should not be determined by the opinions of others. Independence makes the group smarter because it is more likely to uncover new information and reduce the risk of a collective error. In theory individual errors should cancel out, although this may be a controversial assumption! However, such an outcome is hard to achieve because humans are sociable and it is common practice to learn from or even imitate others. If a colleague is undecided, there is social pressure to follow the majority view. That might be a sensible outcome but not at the expense of doing the necessary homework. Unquestioning imitation will make the team less wise. The responsibility of each team member, therefore, continuously to develop their own ‘private’ library of information (i.e. data, research, interpretation, analysis, intuition) cannot be understated. If at the end of the day a colleague is still consciously unwilling to express a view in favour or against a market that is quite satisfactory. On many occasions a market position could justifiably be neutral.


Providing team members the autonomy to focus their interest and energy on certain markets and/or analytical approaches encourages specialisation, which in turn fosters decentralisation. This makes individuals more effective (productive and efficient) and increases the breadth and diversity of information available to the team. For example at ASI the TAA team conducts its own markets research, and also collaborates with asset class (equity, fixed interest, and real estate) plus economic and political experts, both internal and from external sources to find insights. A risk is that information uncovered by one colleague or team need not be shared or understood by others. The solution is the development of a ‘common language’ to help facilitate the aggregation of the team’s insights. In our case we organise our thoughts and deliberate around four factors: macro-profits, monetary, valuation and behavioural drivers, with a ‘focus on change’ approach.


While all three of the previous conditions may be present, without a way to turn individuals’ private information into a collective decision, a group’s efforts may be wasted or fall short of potential. Aggregation requires a straightforward process. In our case, individual team members numerically score each market driver, as well as provide an overall consolidated score. Importantly it is a secret ballot which goes a long way towards eliminating some of the pitfalls of collective decision making. The reasons behind any individual’s views on the market factor scores can easily be identified for further discussion. The next part of the process ranks the scores to work out which markets are most liked and disliked, to show which assets have been upgraded or downgraded and to identify areas and indeed the extent of the group’s agreement or disagreement. This approach also provides an effective learning loop: good and bad views can be analysed both at the individual and team level, with the aim of making better decisions in the future. It also helps guard against the risk of team ‘polarisation’, where in certain circumstances discussion produces a more extreme view.

There is of course the important question of how much discussion should take place before an investment decision is made, as well as what should be discussed, who should speak and for how long? These are valuable process questions because in any group individuals inevitably exert direct and immediate influence on others. The danger is that judgements become more volatile and extreme. In order to avoid sub-optimal outcomes, we follow a number of vital processes:

  • meetings must have a set agenda giving everyone the opportunity to speak;
  • evidence is examined before reaching a conclusion, especially information that runs contrary to a perceived view;
  • the team is not obliged to reach a consensus. A minority view makes decision making more rigorous, even if the minority view in question turns out to be wrong.

Current Asset Class preferences

What is the outcome of these deliberations, in terms of asset class preferences, in past few months? Table 1 presents the team’s average market factor and consolidated scores expressed on a scale of -3 to +3. It should be noted that the consolidated score is not a simple average of the driver scores. Also shown are the percentages of the positive/negative votes, as well as the net position in favour of each asset class.

  • Equities are preferred with a positive score, a large majority in favour and no dissenting minority view. A positive monetary and macro-profit driver mainly explains this. Put another way, easier central bank policy making offsets recession risks.
  • Credit is next most attractive, followed by real estate and government bonds. The valuation factor clearly drives the dislike of government debt, although the behavioural driver (very overweight investor positions) is also a negative.

Table 1: Consolidated market factor scores

Table 1 Source: Aberdeen Standard Investments (as of August 2019)

Given the volatile equity market performance, our outlook for this asset class is worth exploring further. With respect to the macro-profits driver, leading indicators of economic activity point to a modest recovery in industrial production over the next 12 months, which in turn, suggest modest single digit corporate profit growth in most regional blocs. This is best illustrated by the stabilisation and modest recovery of our macro-momentum indicator, albeit still low by historic standards (chart 1). Based on past experience, equity market returns are on average mildly negative and volatility above average when macro-momentum sits below 45%. However, our monetary conditions indicators suggest a further improvement in macro-momentum over the next 6-12 months. At the same time the future path of the US-China trade war remains open to debate with little visibility and its impact is also hard to quantify with precision – as a result the level of conviction attached to leading indicators is somewhat muted. Nonetheless, macro-economic news has consistently, and negatively, surprised investors. Ironically, this means that the sensitivity of the stock market to good news could be greater given the weaker investors’ growth expectation.

TAA Chart 1: Losing negative momentum

Source: Aberdeen Standard Investments (as of July 2019)

Major central banks have acknowledged that monetary policy must be used to support economic growth, triggering a reassessment of the path of interest rates by government bond market participants. This expectation has so far calmed investors and reduced, but not eliminated, its sensitivity to bad news. We do not currently consider equities to be expensive on the condition that the global economy avoids a recession, but markets are unlikely to re-rate significantly. Bond yields have already fallen substantially and the risks around profit growth are to the downside in the short term.

What is clear is that the exuberance towards equities apparent 18 months ago has melted away and been replaced by an air of considerable caution. Whilst we cannot be measure investors’ fear and greed directly, there are ways to do so indirectly: looking at a combination of financial market sentiment measures, as well as surveys of investor sentiment and positioning. Nowhere is this better illustrated than by our equity market short-term timing indicator, which has fallen considerably and currently sits well inside the ‘buy’ zone (chart 2).

TAA Chart 2: The right time to buy equities?

Source: Aberdeen Standard Investments, Refinitiv Datastream (as of 23 August 2019)

Cautious Optimism: moderately overweight risk with diversification

Going back to our four drivers of group decision making (diversity, independence, decentralisation and aggregation) the current collective view is one of cautious optimism towards equities, and so is consistent with a moderate overweight towards the asset class, within a multi-asset portfolio. We note that as geopolitical news may lead to sharp swings in sentiment, flows and prices, these may well provide opportunities to add incremental positions in portfolios by tactically adjusting equity market exposure sequentially higher and lower. At the same time, given the risks of a policy error, it is important that a portfolio holds some diversifying investments if the central case is proven wrong. In our TAA portfolios we do so via an overweight position in the Japanese Yen against the Euro but a variety of other approaches (Swiss Francs, Gold, derivatives) could be adopted depending on the appropriateness for each client’s portfolio.

Studies suggest that a group is smartest when each person thinks and acts independently.

Widening investment horizons
through private market debt

Chapter 2


Marianne Zangerl, Investment Director Fixed Income

We explore the problems and the advantages of private market debt as a valuable addition to investing in traditional bond markets.

In today’s environment of low interest rates, and investors ‘hunt for yield’, investment in private debt instruments continues to grow. Asset classes such as commercial real estate debt, infrastructure debt and corporate debt appear increasingly attractive, and not just because of the enhanced yield that they provide. That being said private debt is often able to provide higher returns than sovereign debt, corporate bonds and high yield securities.

Despite seeming like a relatively new asset class, private credit is perhaps the longest standing asset class there is.

Despite seeming like a relatively new asset class, private credit is perhaps the longest standing asset class there is as, at its core, money is being lent directly to a borrower. To be able to make these loans, a very well developed sourcing network is required, to identify those in need of borrowing.

Borrowers often prefer to work with private lenders, rather than banks, as we have the potential to have a much more tailored approach and make decisions more quickly. There are numerous reasons why not all companies choose to issue debt in the public markets. Considerations such as minimum issuance size, costs associated with issuing, requirement to provide public market updates can push issuers away from the public bond markets.

Private debt tends to have a different risk profile to public debt and also offer positive diversification benefits, as it tends to be uncorrelated to other asset classes and the economic cycle. This article will highlight some of the attractive features of private debt investments while also considering the risks and what might be lost in the shift in asset allocation from public to private debt. Lastly we can assess some areas of private debt compares to public bond markets.

Access to unique drivers

When considering optimal portfolio asset allocation, an investor will only be able to access the full spectrum of the investment universe if they are able to invest across both public and private markets, including a range of private debt options. Private infrastructure debt, for example, can provide access to areas such as renewable energy. Governments often subsidise renewable energy (for example in the UK the Renewable Obligation Scheme or the Contract for Difference schemes provide renewable energy owners with a degree of revenue certainty that stimulates investment). These government subsidies provide stability of cashflows for debt investors and either partially or fully (depending on the subsidy) remove a project’s exposure to electricity prices.

Whilst investors can gain exposure to utility companies, some of whom own renewable energy generators via the public bond market, their businesses are so broad that you are also gaining exposure to a number of market drivers including electricity prices, retail pricing etc. By expanding the investment universe to include private financing of renewables projects, diversification within a portfolio increases via access to drivers that are more idiosyncratic in nature and less exposed to general economic cycles. A renewables project with no exposure to electricity prices creates exposure to changes in environmental factors and project specific technology risks. Chart 1 below shows average recovery rates for Infrastructure debt, which are substantially independent of the economic cycle, both when a project defaults and when it emerges from default.

Chart 1: Infrastructure’s cyclical indifference

Source: Moody’s (as of 2016)

Access to different types of issuers

For some privately owned companies, the transparency required on the public markets and the issue of information on a publicly available information sharing site is not always something they wish to do. By issuing privately, these companies can share information only with investors and maintain the private nature of their companies from competitor scrutiny.

Finding issuers who wish to procure private financing requires a wide network of origination contacts. In the public market, brokers and clearing systems govern access to transactions so the ability to invest is open to all market participants. In the private market, whilst brokers can play a role, origination tends to rely on bilateral relationships with borrowers and advisors. The greater the network of contacts, the more transactions are reviewed and the more disciplined an investor can be with deal selection.

For this reason, selecting an asset manager who has this depth of market contacts is essential.

Commercial real estate debt in the private market can give access to smaller issuers as they tend to focus on one or perhaps a small portfolio of assets across different geographies. When thinking about exposure to commercial real estate debt, the underlying market drivers vary depending on the sector and the location. A prime office in a city centre has a very different set of economic drivers than an out of town industrial park. Commercial real estate debt allows an investor to access smaller or rare issuers who may have unique or trophy assets that do not typically seek bond market funding. However it should be noted that trophy assets, by their nature, can sometimes have less attractive terms and limit you to a smaller universe of opportunities in major cities.

Debt structures & recovery values

The majority of issuance in the public bond markets is unsecured, for example in the ICE BofAML 10+ Year BBB Sterling Corporate Excluding Subordinated Financials index, around 5% of this index consists of secured bond issuances. In private debt markets, and with the exception of some corporate debt private placements which can come to market on an unsecured basis, the majority of the private market issues on a secured basis. Therefore the amount of risk being taken is often lower than with public bonds, as there is often physical security – real bricks and mortar – standing behind each investment. But, it’s important to recognise that investors take on liquidity risk and should expect to hold these assets until their maturity.

The combination of security and a structure designed to protect the interests of debtholders means that, as shown in Chart 2, in the event of a default, recovery values for private assets tend to be much higher than those on the public market. For example, a private corporate debt instrument has a recovery value of around 80 cents in the dollar versus an unsecured public corporate bond, which has a recovery value of around 50 cents in the dollar. Given where we are in the current market cycle, it is a timely point in which to consider recovery values.

Chart 2: Recovering in private

Source: Aberdeen Standard Investments. The recovery rate for “public corporate bonds” is based on BBB unsecured corporate debt and the recovery rate for “private corporate bonds is based on BBB senior secured loans. Both are sourced from Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2016. Recovery rates for “structured credit” is proxied by CLOs and sourced from “CLOs: Impairment and Loss Rates of U.S. and European CLOs 1993-2016.” with reference to the BB tranche. The recovery rate for “infrastructure loans” is sourced from Moody’s Default and Recovery Rates for Project Finance Bank Loans 1983-2015. The recovery rate for “commercial real estate loans” is sourced from Cyclicality in Losses on Bank Loans by Bart Keiisery, Bart Diris and Erik Kole. The recovery rate for “corporate loans (direct & syndicated)” is sourced from S&P Credit Analytics: Credit Pro Loss Stats database, 1987-2016. Statistics based on ultimate recovery rates.

Scope for bilateral negotiation

Investors in private debt can have much more influence over the negotiation and structuring of the debt instrument. Private debt instruments are bespoke and more tailored to suit the specific needs of the asset or the financing company. Private debt instruments always have some form of financial covenants e.g. an Asset Cover or Leverage test as well as the ability to step-in to operate the asset or company prior to the company defaulting. These covenants act as a warning for investors, alerting them to underperformance. The covenants will also trigger certain events such as trapping cash to repay debt in the event that something goes wrong. Private deals attract significantly fewer investors. Whereas a bond issuance can be sold to numerous market participants, private deals tend to be bilateral (one investor and the borrower) or club deals (typically 2-4 investors but can range up to as many as ten in the case of much larger transactions). This allows for considerable scope in negotiation and helps ensure that a transaction can meet both the borrower and the investor’s needs. An investor may have a liability gap they want to match in 20 years or a desire for inflation linked debt with a cap and collar or a longer maturity or a significant amount of money they wish to deploy in one issuer, then the borrower can often work with these parameters. This Cash-flow Driven Investing is increasingly popular in private markets with investors contacting issuers on a reverse enquiry basis with a set of terms in mind.


One or more of Fitch, Standard & Poors or Moody’s will publicly rate the vast majority of the public bond universe whereas the majority of private deals tend not to come with any public rating. This places a high level of importance on the ability of the investor or their appointed asset manager to undertake rigorous ratings analysis as part of the credit assessment. However, it also reduces the number of investors that can participate in the debt. This results in a less competitively bid debt investment and a more prudent approach to risk management. It mitigates against the risk of over reliance on public ratings that the public bond market exhibits.

Illiquidity – Pricing & Spread pickup

Given the high level of active trading and the role of market makers in the public market, there are typically readily available market prices for public bond instruments. Private assets do not tend to trade on a regular basis and therefore there are not readily observable market pricing data for these assets. Private assets must either be valued at amortised cost or have a fair value methodology applied to them. Whilst amortised cost is a simple accounting concept, fair value methodologies involve marking the investment to market based on some observable public market data. This illiquidity in private markets gives rise to the concept of an “illiquidity premium”, compensating investors by a pickup in spread relative to public corporate bonds in exchange for being unable to sell out of a position. Graph 3 below shows the range of illiquidity premiums that are achievable by investing privately versus corporate bond spreads for BBB rated assets. Note, the illiquidity premium on offer tends to differ across the rating spectrum, with the pick-up achievable on AAA credit typically smaller in basis points terms than what would be achieved in BBB rated debt instruments.

Chart 3: Reaping the illiquidity premium

Source: Aberdeen Standard Investments (as of July 2019)

Generating illiquidity premia is only one benefit of private debt investing. When considering whether a private debt instrument looks attractive an investor should also consider if it adds diversification to the portfolio i.e. through an issuer that may not be available on the public market. Another is the benefit in terms of recovery value e.g. if a private debt instrument is secured and a comparable public bond is not, consideration must be given to the value that this represents. However, an investor should also make sure that they receive the appropriate compensation for taking this illiquidity risk. Asset managers, who already invest across both the public and private space, can best make this assessment regarding relative value.


Given our current stage in the cycle, private debt investing has some key advantages – better recovery values via security, structuring and step-in rights and access to economic drivers that are more idiosyncratic in nature. Moreover, private debt correlates less with public bond markets and adds diversification via access to smaller issuers or those who choose not to issue publicly.

What is exciting about this asset class is investing in an area that is growing and evolving all the time, which brings with it many new opportunities with attractive characteristics. Today, private credit includes all sorts of weird and wonderful opportunities such as trade finance, receivables finance, aircraft finance, litigation finance, royalty finance and, of course, so-called peer-to-peer or marketplace lending.

However, the lack of a readily tradeable market for these investments reduces an investor’s ability to shift their positions quickly, along with the risk of operating in a less regulated environment. Focus on selective investing in well-structured transactions with sound credit fundamentals is the key determinant of success for investing in private sector debt. As will all investment decisions the risk and benefits should be careful weighed.

Despite seeming like a relatively new asset class, private credit is perhaps the longest standing asset class there is.

ESG: From process to product

Chapter 3


Amanda Young, Global Head of Responsible Investment

ESG Investment is on the increase but many are often confused by what ESG Investment means in practice.

World problems creating risk for investment

The world is facing an increasing number of environmental and social challenges. As a consequence, the nature of what makes a good investment has changed. These evolving challenges create a myriad of risks for investors but they also open up the possibility for thinking differently about capital allocation.

ESG integration means thinking about ESG issues in relation to how they would affect a company’s ability to generate sustainable returns.

There are three major environmental and social forces challenging the investment landscape; climate change, the growth in inequalities and unsustainable consumption patterns.

Climates are changing: We are constantly exposed to rapid changes in weather patterns.

San Francisco, British Columbia and Delhi all reported all-time high record temperatures this year. Other unusual weather occurrences including storms, flooding and giant hailstones across Europe and Asia and typhoons and hurricanes across the Far East and America’s have been prevalent in the media this year. As the cause is associated with the rise in carbon dioxide in our atmosphere from industrial activities, this poses a risk for any company exposed to heavy carbon industries.

The inequality gap is widening: The gap between the “haves” and the “have nots” is growing and is driving social pressures and trends. The pressure on companies to ensure they are not exacerbating this gap, as well as the pressure to demonstrate a “purpose” and deliver more than just a financial return, needs to be factored into investment considerations.

Consumption is unsustainable: We also continue to consume at unprecedented rates. This year, earth overshoot day (the day we have used more from nature than we can replenish in a year) occurred on 29th July, two days earlier than in 2018. All companies consume natural resources and they need to manage how they do so, as natural resources become scarcer and harder to access.

Companies cannot operate in isolation. What they do, what they make, the services they provide and how they treat their stakeholders and communities all affect their ability to continue to operate freely, and influence their ability to return cash to shareholders.

ESG Integration is a process

This is where ESG integration plays an important role in investment. ESG integration is not making a moral judgement about an investment but rather thinking about ESG issues in relation to how they would affect a company’s ability to generate sustainable returns. ESG matters should form a holistic part of understanding the risk processes, governance mechanisms and operational standards of any company. Corporate scandals from the past demonstrate how material poor risk management, operational control, culture and governance structures can be. Examples include BP’s Macondo oil spill, Enron’s business ethics, Nike’s accusations of child slavery in factories, Volkswagen emissions scandal and Facebook’s data privacy issues.

The rise in legislation relating to single-use plastic, a growing move away from fossil fuel use and providing access to basic services are all examples of ESG trends. Investors need to understand how these themes affect different sectors as well as individual companies. Assurance needs to be sought that investments have well established governance frameworks, strong board composition, risks assessments, policies, audit mechanisms and target setting relating to key ESG factors.

Beyond integration

While ESG integration is about making better informed decisions, there is another aspect about ESG Investment worth exploring. Beyond risk management, there is a growing desire to think about capital allocation strategies that support sustainability objectives. While the world faces significant challenges, it is worth remembering that problems often drive innovation, opportunity and encourage the belief that you can make money and make a difference.

More recently, the UN Sustainable Development Goals (SDGs) have been established which identify key problems that the UN wants to address before 2030. These goals can be used to establish investment strategies, and SRI funds, focused on driving investments into those companies that are helping to provide tangible solutions and develop business activities in a way that support the goals.

Over the past 30 years, we have seen a spectrum of capital developing that incorporates environmental and social aspects into investment strategies driven from a set of values and sustainability beliefs. This ranges from the integration of these factors into mainstream investment analysis, through to using ESG factors to develop sustainable investment strategies that focus more on how investments benefit society and contribute to the solutions the world needs, to solve the issues and problems we face today. The Impact Management Project developed a spectrum of capital that considers how investments can fall into three areas: avoid harm (reduce risk), benefit stakeholders and contribute to solutions. The chart below provides examples of how this spectrum can be applied if you were to invest in a specific sector.

Table 1: ESG Investment: A Spectrum of Capital

Table 1: ESG Investment: A Spectrum of Capital Source: Aberdeen Standard Investments, as of August 2019

Two methods to gain from developments in ESG

The awareness of environmental, social and governance issues has risen yet investors can be confused with the terminology and its application. We use ESG factors in one of two ways – the first is within the investment process; to ensure a better understanding of the ESG issues that impact investments and so to drive change for a better financial return. The second is to create a ‘socially responsible’ outcome or product where the investment strategy embeds greater considerations of sustainability factors. In conclusion, we see sustainable investment influencing ways that we allocate capital as well as how we create sustainable returns.

ESG integration means thinking about ESG issues in relation to how they would affect a company’s ability to generate sustainable returns.

The ups and downs of
‘style’ performance

Chapter 4


David Clancy, Head of QIS Portfolio Construction

Investment styles or “risk premia” factors such as Value, Quality, Momentum, Size and Low Volatility can be important drivers of market and fund performance.

This year has continued to be a difficult one for systematic investors with traditional Quantitative factors such as Value, Momentum and Small Size posting negative or largely flat returns. Some Quant strategies additionally target lower beta stocks, also known as ‘Betting against Beta’. This strategy struggled too as Beta rallied strongly for much of the year, with an exception in May.

Early in the year Beta, Value and Small Cap all outperformed in what was a classic example of the ‘January effect’.

In this article we review equity markets in the first half of 2019 in order to analyse the performance of investment styles in both very positive and difficult market conditions and draw some implications for the longer-term future of factor investing.

Winners and Losers in different market conditions

Global markets saw strong performance in 2019 to the end of June, with the S&P 500 recording its best 6 months performance since 1997. This continued an upward trend from late 2018 following the market sell off in Q4 2018. The MSCI All Country World Index (ACWI) was up 20% by June, in USD terms, since its low point in late December. The first 4 months of 2019 saw markets rally sharply before a brief, but notable, set-back in May when global markets retreated, before continuing their ascent in June.

Early in the year Beta, Value and Small Cap all outperformed in what was a classic example of the ‘January effect’. This is where investors sell losers at the end of one year to harvest tax losses, before buying them back in the new-year. These out of favour styles rallied strongly for the first month of 2019.

However, the rally changed somewhat in the following months. Whereas higher Beta stocks continued to outperform or at least keep pace in most regions until May, Value fell away, as it had for much of 2018. Small Size was also down in most regions for the remainder of the year to date.

Beta suffered a large reversal across all regions in May as markets sold off amid trade war concerns and a strong risk-off environment. Low Volatility, as you would expect, had a strong May as investors swung towards lower risk assets generally. Interestingly, for 2 styles that tend to be negatively correlated, in some regions both Beta and Low Volatility show positive returns for the first 6 months of 2019.

Quality (average of Return on Equity (ROE), low Earnings Variability and low Debt / Equity) and ROE were up in all regions except North America (NAM) to the end of June. After initially struggling in January and February these styles recovered to be up almost everywhere and were particularly strong in May as investors sought out lower risk and higher quality assets in a sharp sell-off.

Momentum struggles without consistent market trends

Price Momentum continued to have mixed fortunes throughout the year partly as the profile of Momentum changed to be quite defensive towards the end of 2018. This meant that it struggled in the early months of 2019 as higher beta (less defensive) stocks outperformed. In most regions, Price Momentum had positive returns in March before declining again in early April. Mid-April was the low point for the strategy with the style recovering after this and it was particularly strong in May as markets sold off but by the end of June the style saw negative returns in many regions. An inconsistent environment with changing market direction is generally unhelpful for Price Momentum, which does better in trending, consistent markets. On the flip side, Reversals (a strategy which buys last month’s losers and sells its winners), outperformed in the first half of 2019 finishing as the best performing style in most regions.

The Value style has persisted as a poor performer

Value continued to struggle in 2019 and after an initial rally in January returned to its long-term and much publicised downward trend. The macro environment has not been supportive of this investment strategy, with low rates, inflation and weak growth being significant headwinds. The Fed’s dovish pivot at the end of January precipitated another period of underperformance despite Value being very cheap relative to history. It follows disappointing returns in the previous two years.

Longer term studies provide support evidence for systematic investors

The style environment has continued to be a difficult one for systematic investors in 2019. Surprisingly diversification has not come to the rescue of Factor investors either. Typically Value and Momentum are negatively correlated, while cyclical Value (Book Yield, Forward Earnings Yield) and low Beta also tend to move in opposition. Quant strategies aim to take advantage of these longer term relationships by targeting exposure to all of these factors and gaining diversification through their somewhat offsetting returns. In 2019 however these relationships also broke down, meaning there was little to provide relief from the poor performance.

There have been many articles discussing the difficult environment for Quantitative investors this year. Axioma, the risk model provider, commented about the headwinds facing systematic managers back in April, highlighting that most popular Quant factors posted negative returns in Q1. Interestingly in a follow up paper their analysis showed that a systematic multi-factor approach, with constraints on sector and non-targeted style factors (an approach generally thought to be best practise over the long term in terms of diversification and risk management), performed worst of all strategies they follow through April 2019.

Given all this it is no surprise that many Quant firms have continued to underperform in 2019. However, MSCI recently released their review of factor performance for Q2 2019. While highlighting the difficult recent period for factor investing, they also pointed out that over longer periods the data still supports investing in a well-diversified set of academically proven factors, providing hope at least for long-term systematic factor investors.

Quant Chart: No value, high quality and plenty of momentum

Source: Aberdeen Standard Investment, FactSet, as of August 2019
Early in the year Beta, Value and Small Cap all outperformed in what was a classic example of the ‘January effect’.

A focus on stock picking

Chapter 5


Harry Nimmo, Head of Smaller Companies

Amidst considerable economic and political volatility, a focus on stock picking can pay dividends.

Guiding principles

Different equity investors use different styles to choose stocks and construct portfolios. Some focus on the macro-economic trends, for example the relationship between the shape of the yield curve and the outlook for banking sector profits. Instead, our guiding principle is that we are ‘bottom up’ investors of small cap stocks. We concentrate on picking the best stocks with a long term outlook, rather than using ‘top down’ global forecasts and scenario analysis. Our view is that by focusing on a ‘Matrix’ driven process and finding companies with the best attributes of quality, growth and momentum we can construct portfolios which can navigate difficult times.

Macro-economic conditions can be volatile meaning that a resilient investment process is required.

Defining Quality, Growth & Momentum

It is important to define investment factors, as similar names can hide different attributes. In simple terms ‘Quality Companies’ are measured according to their balance sheet strength, demonstrate a high return on equity, exhibit management stability and show robust corporate governance. Such firms are generally more robust and hence valued more highly in times of stress. In terms of ‘Growth Companies’ we are looking for businesses which can display stronger than average market growth and can continue to expand even during a recession. Lastly, ‘Business Momentum’ reflects those companies where business conditions in their particular niches are improving and earnings visibility is strong. Our investment process over the past twenty years has involved choosing stocks by using our proprietary backtested quantitative screening tool which we call ‘The Matrix’ and which tracks a range of these Quality, Growth & Momentum factors.

A focus on stock selection

Predicting global macro conditions is not only fraught with danger in an environment where Presidential tweets can cause sharp market moves, but can also lead many investors to focus on the same stories and chase the same assets. Our current positions include an overweight to such factors as balance sheet strength, growth and medium term momentum, as well as being overweight the larger firms in our universe of small cap stocks. Our equity risk tool has also shown that our UK portfolios have an underweight exposure to exchange rate sensitivity. The portfolios favour companies which derive their earnings from subsidiaries based outside the UK. There are only three holdings that are physical exporters of goods from the UK, namely Games Workshop, Fevertree and Abcam. The portfolios are very underweight in UK orientated cyclical sectors and sector such as real estate, construction and engineering. All this positioning reflects a combination of bottom up Matrix led stock selection.

Looking at relative performance of small vs large

Smaller companies tend to out-perform larger companies over most time periods. However it is worth examining the recent performance of small-cap stocks and put it into perspective.

Although smaller companies have under-performed big cap stocks significantly in recent months, in our view the main driver of such market movements has been the slowdown in economic growth worldwide, exacerbated by trade tensions between the US, China and Europe, with Brexit uncertainty as a third factor. In detail, the index of smaller global companies has under-performed its larger companies counterpart over the past fifteen months, and in the UK since May 2017. This is typical in the second half of an economic cycle as smallcap heavy economically sensitive stocks consistently come under pressure. Our experience is that markets tend to anticipate economic recovery very early, indeed at the point of greatest pain. Smaller Company markets actually turned upwards in December 2008 arguably at the height of the Banking Crisis, while Large Cap stocks followed in March 2009.

Chart 1 shows smaller company performance relative to larger companies over the past 20 years for the UK, Europe and globally. It demonstrates how small caps can under-perform in bear markets which occur in the lead up to major economic downturns. The period after these turning points typically display very strong periods of absolute returns for smaller vs larger companies. We always recommend that investors should take a strategic view towards investing in small company stocks, preferably with a time horizon of at least six years.

Chart 5: Small cap, long time performance

Source: Refinitiv Datastream, Aberdeen Standard Investments (as of 30 August 2019)



Macro-economic conditions can be volatile meaning that a resilient investment process is required.