Your questions, our answers
2018 was not an easy year. What lessons have you learned from this?
Clearly, 2018 was a year where, within the bond universe, diversification only had a limited effect on the annual performance of a fund. In the last two months of the year in particular, true to Murphy’s Law everything that could go wrong, did go wrong and both equities and credit headed south. Due to the scenario outlined above, in early 2018 the Ethna-DEFENSIV took all the necessary steps to limit potential losses. Not only did we shorten the maturities of our holdings, we also increased the credit quality substantially. Why did we do this? Because the higher the rating and the shorter the maturity, the lower the adverse impact on the fund’s performance in a negative environment. In hindsight, the move to liquidate the long USD-denominated bonds and to purchase shorter and higher-quality Euro bonds was the correct one. This limited the fund’s losses by at least another 3 percent.
The notion of liquidity risk has moved from academia to the real world. As long as yield levels stay at the rather low points that we are currently observing in the Euro space, one has to take liquidity or, even more to the point, liquidation risk quite seriously. The room for error, which is typically given via the coupon accruals, is extremely small. It therefore requires very anticipatory behaviour by the fund management, more so than in the past.
At times, 2018 was characterised by extreme market movements in both directions. Contrary to the real-world expectations, the first month of trading saw the good economic environment continue for a very long time, and prices rose considerably, whereas in December all risk values were sold as if a recession were imminent. In retrospect, it is obvious that, not only during these two months but also over the remainder of the year, the reality lay somewhere between these extremes. However, avoiding the prevailing sentiment at that moment is not easy and therefore represents the greatest challenge in portfolio management. Although the majority of our decisions based on our macroeconomic scenario were correct, we were unable to convert them into returns for the portfolio consistently enough. Therefore, even more so than in 2018, the focus for 2019 will be on the key elements of our fundamental analyses and their implementation, as this will bring the most significant added value to the portfolio. Furthermore, we can only warn again about illiquidity in some areas of the bond market. During the improvement in the quality of our bond portfolio last year, we were particularly aware of the dramatic deterioration in tradability compared with previous years. In potential crisis scenarios, the current composition of the portfolio now gives us the ability to retain the bonds in which we are currently invested and not have to trade at horrendous discounts.
In 2018, investors were once again reminded that, in the case of doubt regarding the capital markets, it is less a question of absolute levels than of direction. Although we continue to see a relatively solid growth environment worldwide, for some time the adjustments in expectations have been moving downwards. A global growth forecast of 3.5% for 2019 is a sound basis. However, for the development of the markets whether the previous expectations were 3.2% or 3.8% makes a significant difference. Accordingly, many parts of the markets were severely punished, above all cyclical equities.
A further lesson can be taken from this: a low valuation offers less protection against potential price setbacks than high-quality business models. Like our first observation, this is not really a new insight for us. However, the combination of both factors hit us particularly hard in 2018 and pushed the selection result in the Ethna-DYNAMISCH into negative territory for the first time in years.
For our last, and perhaps most important, experience of the past year, we would like to highlight the benefits of diversification. In a year in which almost every asset class performed negatively, a lack of diversification is often and quickly pointed out as the offender. Secure government bonds and gold, for example, have fully lived up to their promise in exactly those moments when diversifying and risk-minimizing properties in the portfolio were needed. In combination with a flexible weighting of the different asset classes, active asset managers such as ETHENEA are well equipped for the future with attractive and effective instruments. This is an important prerequisite for being able to operate successfully in a wide variety of market situations.
The economy is showing signs of a slowdown. Should we be getting worried about a stock market crash?
It always makes sense to keep an eye on the risk side. With regard to the current situation, the market is currently in a state of tension. On the one hand, there is the fear of possible recession scenarios; on the other hand, there is the possibility that the worst is already behind us. As we don’t know which path the economy will take, it is important to position oneself as robustly as possible for various scenarios and always take into account what has already been discounted or "priced in" by the market in current prices. After the recovery rally of many risky asset classes since the beginning of 2019, the situation has not become any easier. If the signs of a prolonged downturn or even a recession intensify, there are certainly further significant downside risks for equities. Although the term "crash" is often used, we are rather cautious with this choice of words. Many of today's market participants are still affected by the stock market crashes of 2000 to 2003 and 2008/09. Both were notable for their magnitude and clearly eclipsed "normal" bearish phases on the stock markets. We currently see little to no signs that point to comparably strong stock market crashes in the near future. In summary, we can answer the question as follows: caution is advisable, panic is inappropriate.
How do you position a fixed income portfolio in an economic downturn and from where do you expect performance to come?
As markets price in the economic reality as it unfolds, yield levels typically already reflect the status quo. If things start to worsen, bond yields generally tend to move lower. This would then lead to capital appreciation of the bonds, a handy source of performance. Were we to see the opposite movement, where credit spreads widen, this could more than offset the general decrease in yields, as this drop typically only applies to so-called “safe haven” assets like Bunds or Treasuries. It is therefore essential to balance the fund in such a fashion that, if the economic situation does not worsen but instead improves – and we see higher government yields and tightening spreads – the fund is still in a position to deliver positive returns. By having the right balance between safe haven and credit assets, it is possible to generate positive performance in market environments that reflect the fund management’s base case, while being prepared should the opposite situation unfold.
Why do you maintain a relatively low equity quota in the Ethna-AKTIV?
There is both a fundamental and a technical reason for the current relatively low equity ratio of around 15 percent. Fundamentally, we are aware that the predominant valuation multiples have moved some distance from historical highs. Against the backdrop of increased uncertainty about global economic growth, we believe this decline is justified. As long as no growth and/or valuation impetus is provided by either fiscal or monetary policy measures or the end of economic policy disputes, we will continue to keep the equity ratio rather low. In addition - and this is the purely technical reason - the use of index options, for taking optimised long exposure, is responsible for an even lower ratio.
In the Ethna-AKTIV, part of your equity portfolio consists of options. What is the reasoning behind this?
In the Ethna-AKTIV, the focus is on asset allocation. The fund is invested in various asset classes in accordance with our macro scenario. The ongoing review and adjustment of this allocation represents the fund’s added value. The risk ratio is actively managed over time, in particular for the equity asset class. To do this, we primarily use liquid derivatives, i.e. futures and options, on the main equity indices. The change in equity exposure is influenced on one hand by our interpretation of the fundamental data of the various regions and on the other hand by the framework provided by our risk management. The long-term goal is attractive participation in global equity markets. For this purpose, we select an asymmetric profile, with which you gain more in rising markets than you lose in falling markets of equal strength. We achieve this asymmetry through the use of options and futures. For us, the use of these instruments is particularly attractive and convincing, despite the costs associated with them, because we can profit effectively from rising prices while at the same time limiting losses. In order to manage the fund's equity exposure as efficiently as possible, and to protect the fund from both the negative effects of possible price jumps (so-called gaps) and too frequent trading, it is advisable to make balanced use of both instruments.
Please contact us at any time if you have questions or suggestions.
ETHENEA Independent Investors S.A.
16, rue Gabriel Lippmann · 5365 Munsbach
Phone +352 276 921-0 · Fax +352 276 921-1099
email@example.com · ethenea.com
Legal notices: An investment in investment funds, as with all securities and comparable financial assets, carries the risk of capital or currency losses. Consequently, the unit price and the yield are variable and cannot be guaranteed. The costs of a fund investment have an effect on the actual profit. No guarantee can be given that the investment objectives will be achieved. The statutory sales documents (Key Investor Information Document, sales prospectuses and reports) provide detailed information on potential risks and form the sole legal basis for a purchase of units. These documents can be obtained free of charge from the management company, ETHENEA Independent Investors S.A., the custodian bank, as well as the relevant national paying and information agents. All information published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information, or an offer to buy or sell securities. The contents have been carefully researched, compiled and checked. No guarantee can be given for correctness, completeness or accuracy. The information includes past data which are no indicator of future performance. The management fee, custodian bank fee and all other additional costs are taken into account in the calculation of the unit price as stated in the provisions of the contract. Performance is calculated using the BVI method (German federal association for investment and asset management), which means that the calculations do not include an issuing charge, transaction costs (such as order fees and brokerage fees), custodian bank fees, or other management fees. Including the issuing surcharge would reduce performance. The performance shown is not a reliable indicator of future performance. 21/02/2019