Meet the game changers


Thankfully 2020 is now officially behind us, but it certainly won’t be  forgotten. Our day-to-day lives here in Australia remain relatively unaffected while the impact of the pandemic still rages in many countries. More virulent strains have abetted the virus to reach new highs in cases and concerningly hospitals are again hitting capacity, especially in the US and UK. Vaccine headlines tend to focus on the slower worldwide rollout; however, the reality is that the most vulnerable groups are being inoculated enabling governments to be more effective in managing the virus than headlines suggest. Globally, in excess of 100 million doses have now been administered and inoculations are due to start in Australia following the approval of the first vaccine (Pfizer) for use, with another 6 continuing their domestic clinical trials.

January also saw the culmination of the US elections with the two run-off Senate races in the state of Georgia being won by Democrat candidates. This results in both parties holding 50 seats in the Senate, however the balance of power shifts to the Democrats as a tiebreaker vote is possessed by Kamala Harris, as Vice President. This results places President Biden’s fiscal stimulus front and center , but potentially in less size than some of the loftier estimates as he cannot afford to alienate any of the more conservative Senators from his party due to his ‘tiebreaker’ majority.

Positive returns amid the challenges

Despite the challenges and negative returns from most major asset classes in January the fund delivered a positive return of +0.5%. This was a pleasing result and shows the benefit of  the adjustments we have been implementing over the past 6 to 9 months; replacing securities offering very low yields (sovereign issuers) with assets offering a better return, albeit with a moderate increase in risk. Despite the negative return for major US and global equity indices, our equity exposures delivered positive contributions in January. Our defensive assets also added to performance aided by  interest rate hedging positions in US treasuries which added to returns as US yields rose over the month. The diversifiers bucket was also additive with insurance-linked securities and relative value strategies performing well, while the emerging market debt allocation partially offset some of the performance.

The challenge of high equity multiples still confronts us today, therefore post the results of the US Senate runoff election we took advantage of the subsequent rally to reduce our equity weights by 3%. At the same time the Democratic sweep meant the policy outlook became more certain and the proverbial fiscal accelerator would remain flat to the floor. Similar to our strategy over the US Presidential election, we capitalised on the higher implied option volatility in the equity market to sell out-of-the-money S&P 500 puts, generating additional income for the portfolio. At the same time the clarity of US policy resulting from a Democrat ‘Blue Sweep’ was stabilising for markets, it was also negative for US treasuries as large-scale spending will increase bond issuance to the market. To reduce the impact of this potentially negative development on interest rates, we reduced the duration of the portfolio by 0.5 years;  we also reduced our near-term equity put protection as we expected the equity market to take a more positive view of the fiscal plans. This resulted in larger cash balances which we invested 1% into Australian higher yielding corporates offering a c. 2-2.5% yield which remains relatively attractive, especially considering the RBA’s additional $100bn QE package.

The GameStop story: Goliath, meet David

No January 2021 summary would be complete without mentioning  the fun and games experienced in US equities towards the end of the month. The poster child of what I will simply refer to as the entertaining David and Goliath story;  Gamestop[1]. The company is a bricks and mortar physical video game store company in a sector where online sales dominate and the revenue from the biggest video game releases dwarf their Hollywood blockbuster cousins. Gamestop’s massively disrupted business model was reeling  before COVID-19 and was then in critical condition due to the pandemic. It became a prime target of short sellers. A group of retail investors, communicating via an investment forum on the social network Reddit, discovered that the number of shares shorted in Gamestop was greater than 100% of outstanding issuance. They subsequently started buying shares and call options which triggered a battle against some well-known and highly capitalised hedge funds who subsequently publicly mocked those buying. As the share price rose, the battle played out in real-time on front pages of global financial media with mania escalating the situation as Gamestop’s shares subsequently rose 1,600%. As the dust settled it was clear that hedge funds had lost this battle with one fund losing billions, down over 50% in January alone and requiring recapitalisation.

Stories such as this whilst entertaining serve as a reminder that investing remains a challenge and even shorting a company that has a high likelihood of going down a similar path of Blockbuster Video isn’t a sure thing. That is why we will stick with our diversified approach and ensure that any alternative strategies added to our portfolios are done in smaller size and under a strictly risk controlled approach.

Our portfolio position

A short squeeze in GameStop and other companies including AMC Entertainment and Blackberry, driven by retail investors from Reddit, saw a spike in market volatility (as measured by the VIX) and concerns about the broader market, which pushed equity markets lower towards the end of the month. Global equities returned -0.8% in local currency terms during January, while the Australian market outperformed producing a return of 0.3% for the month. Emerging markets continued to be the strongest performer by region, returning 3.1% in USD terms through January, with Asian markets doing particularly well.

With valuations remaining stretched, and our expected returns remaining low across most equity markets, we reduced our equity weight by 3% in January, down to 25%. This was implemented through a blend of Australian and US equity futures. We have maintained our tilt towards emerging markets (EM) as we believe EM will outperform through the recovery phase but decided to take profit on our US small cap position. We also continued to combine the equity sale with selling additional out-of-the money put options to earn a premium. The portfolio continues to hold put option protection strategies to buffer the fund from small to medium sized market corrections.

Fixed income

Global bond markets sold off in January, particularly for longer dated maturities in the US and Australian markets. This was driven by the prospect of significant fiscal stimulus in the US, which combined with both the US Federal Reserve’s and the RBA’s continued support of QE, has resulted in higher inflationary expectations, which has ultimately pushed longer dated bond yields higher. 10-year yields in Australian and the US jumped to 1.13% and 1.07% respectively at month end. In credit, global investment grade and high yield spreads were relatively flat over the month.

During January, we reduced our overall portfolio duration by 0.5yrs down to 0.75yrs, through selling US treasury futures. This represents an overall duration reduction of 1.0 yr over the last two months. With US 10-year yields slightly above 1%, there is limited room for treasuries to rally. Inflation expectations continue to rise and are estimated at 2%. With a real yield of around -1%, US treasuries are becoming increasingly unattractive. While we believe central banks will ultimately implement a version of yield curve control, the risk remains for yields to gradually rise. The US Federal Reserve has highlighted their intention to let inflation run above their target, so for now we have continued to reduce our exposure to duration. We also allocated a small amount to Australian higher yielding corporates, which still offers a yield of over 2%.

Currencies

The US Dollar (USD) rebounded moderately in January, after selling off through the second half of 2020. While our medium to longer term view is for the US dollar to weaken, this view is commonly held as evidenced by short positioning in the US dollar at record highs. In light of this positioning, and together with our view that the efficacy of duration as a risk hedge has diminished, we added 2% to our long USD position through January, taking the overall FX exposure in the portfolio to 22%.

[1] We held no direct exposure to the company in portfolios, however it rose to be the second largest name in the Russell 2000, an exposure we do hold via index futures.

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