4 places to shop in a pricey market

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In a previous wire, Lucerne’s Anthony Murphy and Michael Houghton warned that rising inflation and a reversal of excessive valuations could take the steam out of risk assets.

But with bond yields delivering negative real returns, and sky-high property and equity prices, where do investors go from here? Fortunately, Murphy and Houghton believe opportunities to generate impressive returns still exist for those willing to think outside the box.

In this wire, the two portfolio managers discuss four areas they’re putting their clients’ money into right now. One is private debt, where they’ve been generating reliable returns of about 8%  with little volatility. Another is buying insurance via options to profit from market volatility.

“You can take a 2-3% position and if volatility spikes, you’re making multiples on your investment but you’re also providing that underlying protection," Murphy says. "And when things calm down and the circus leaves town, you can remove that position from the portfolio.”

Watch the video or read on as Murphy and Houghton delve deep into their best ideas on where to invest amid pricey markets.

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Edited transcript

Anthony Murphy:

So given our unfortunate view on the market, which is not as optimistic as probably some viewers out there would like to hear, within Lucerne, let's talk about how we're actually positioning portfolios at the moment.

The types of things we actually are investing in, because investors are going to be saying, "Well Lucerne, if the market outlook's not rosy, well, how are you actually going to continue to make money over the next three to five years, if it's not going to be by buying your traditional household asset class portfolios, such as equity, bonds and property?"

So, how are we going to do it, Michael?

Michael Houghton:

Well, I think the important thing is we're always paying attention to what the market's doing. Our view of the market may not be rosy in the eyes of people who are traditional long-only portfolio investors (equities, bonds) but it's realistic.

I think that's the important piece – you've got to be realistic about what you expect asset classes to do, what you want your investments to do, and the types of returns that you're prepared to accept for the risk that you're willing to take.

With all that in mind, Lucerne Alternative Investments Fund (LAIF) plus Lucerne, and the portfolios for our private wealth clients, were always informed by those particular characteristics, being risk and return. And we use the phrase "risk-adjusted return" a lot when discussing these investments.

The key for us is being able to position portfolios so that they're somewhat agnostic to what market behaviours do. Obviously we're in the market, but they're not driven by people's reactions or market's reactions.

Some of the things that we continue to look at are impact investing. It's one of the toughest areas to find quality investments in. It's something that we have probably been looking at for 12-18 months and probably only found one that we've been willing to put some money towards, and that wasn't a true impact investing, but it had enough characteristics to satisfy us.

And we've now, we think, come across another one that we're going to make some allocations to, that will actually fulfil a lot of the impact characteristics that we want to see.

And by that, I mean, an impact or an ESG (environmental, social, governance) fund isn't one that calls itself that because it invests in things that sign up to the UN convention. You've actually got to see something meaningful take place.


We've looked at a number of these ESG funds around the world, some of the larger ones, and Microsoft appears in the top three investments in their portfolios. And I mean, give me a break, from an impact investing perspective, Microsoft fits that bill.

And I think historically also one of the questions that investors were always asking us about five years ago was about this ESG and impact investing theme.

And I think it's fair to say now the market's probably caught up to that and absolutely the echo in Nick Griffin from Munro's comments recently, this new wave of the world waking up to environmental change, the climate footprint that companies are going to be beholden to, is now a real thing.

And we've got to spend the time and the work now figuring out and deciphering who is real in this space and who is actually delivering on these mandates, versus the majority of managers in this space that are not.

And just because you don't invest in tobacco, porn or firearms doesn't make you an ESG fund, whereas historically, that was the filtration process that fund people would go through.


And also a lot of the big investment companies. I had a conversation with one of the largest super funds in Australia's investment analysts about this particular topic and just posed, "Well, how does Woolworths fit into your 'no more bad investments' if you like, using an ESG screen?"

And they've always got reasons why. Well, that can stay, that one can stay, that one can stay. And that's because without those companies in their portfolio, they're missing out on a large chunk of what the ASX top 10, top 20 stocks do, which is where the performance comes from.


They've got to be beholden to the market. That's what the mandates require.


So, to that end we've, as I said, come across a fund that we think, on a global basis, has really put to the test some of those characteristics that we've found challenging.

They've come up with some screens that we think test for a lot of what we want to see adopted, and impact investing still gets informed by the E, the S and the G in ES and G, but it actually makes a difference.

And what we liked about them is the fact that they are looking for more than 80% of the revenues from any of their investments actually making a meaningful contribution to something to do with the environment.

And finally, that's the breath of fresh air that we've been looking for, and we're going to start allocating to that from next week, and we'll probably start showing it to client portfolios as well.


Exactly. And we'll talk about the specifics of that fund and name them shortly, but talk about some other themes in the portfolio that are working well for us.

And this is something that you've really led at Lucerne, and that's starting to allocate capital to the private debt space. I mean, from a portfolio perspective, you're using what's happened over the last 12 years – the S&P 500 has annualised 16.5% per annum since the GFC.

And to put that in perspective, over 100 years, it's done 8%. So it's doubled the average annualised return every year for the last 12 years. Again, is that sustainable?

But if we use that long term return of 8% per annum, I think many investors out there, for the risk, they're actually willing to take – not what they think they're prepared to take, but actually willing to take – that net annualised return of 8% is sensible.

What we've been able to identify in the private debt and mortgage space is a portfolio for investors that allows us to deliver a return of net 7.5% with monthly income. So an equity-like return with full security over an asset.

And so we've obviously started to point a lot of capital to the private debt market and been very selective in how we do that, and obviously launched something ourselves recently.

But just talk about maybe that private debt space for our viewers as a whole and the types of returns and those risk-adjusted returns we can deliver.


Yeah. Well, private debt's been around forever and it's something that all of a sudden has got a lot of traction because a lot of players are participating.


And cash and bonds are on the floor.




So, what is that again, TINA (there is no alternative) – we've got to bring it back into the conversation. But what is that alternative? And private debt's now come to the fore for us.


Exactly. And that's one of the things that you look for when you're wanting to make an allocation of a client's capital, is what sort of return can they generate? Again, I'm repeating myself because it's so important: for the risk that you have to take.

By private debt, I'm talking about first mortgages, essentially – investing in property, lending money to borrowers and getting the returns paid to investors.

And we've identified monthly is a key factor because a lot of investors are struggling now to find income, and to generate income, to sustain their lifestyles. And you don't want to be always selling assets to fund lifestyle.


You want to sell assets when you want to sell assets, not when you're forced to. And I think just for investors out there to understand this, you can find a physical asset, like a quality tier-one asset that we're about to fund in Church Street, down the road here in Richmond, that's right next to the Melbourne CBD.

We're able to take a first charge over that asset at a 65% LTV (loan to value) or LVR (loan to value ratio). And to put that in perspective, banks historically will lend against a house in this country at 80%.

The purchase of that property shows up with 20% equity. The bank's there for 80; we're showing up with 65% and expecting 35% to be there from an equity perspective. Over a 12 month period, we're generating that net return into our investors' accounts of 7-7.5%.

And it's a really interesting space where we can be quite opportunistic here because our top four banks and the other banks in Australia at the moment, they much prefer to lend to the residential property market because it's just far more profitable to them and more efficient, and it's easier and they can grow their loan book that way.

So they're actually providing a space for us and our investors to move into and support well with a partnership that's 50 years old in Victoria.

And that's something that we think deserves a meaningful allocation in portfolios at the moment, particularly the current market environment we're in.


Yeah, definitely. And that's the key, and you've identified the major banks have retreated from that market considerably over the last 18 months.

Part of it is because it's much cheaper for them to fund housing, the way that the capital adequacy structures are in place for large financial institutions. But in addition to that, the investor capital.

So if you're an investor and you're putting your money in the bank, you're getting half a percent on a good day for a 12 month term deposit. And the bank's taking that half a percent term deposit and funding home loans at 80-85%, and getting back their 1.5-2%.

We're saying that investors have the opportunity to fund a return that gets them 7, 7.5%  for a similar risk that you're taking with a bank.

Obviously it doesn't have the bank guarantee, but likewise, you're making a quality decision on risk for the return that you're prepared to take.


But, you're also getting offered a personal and company guarantee behind that as well, in addition to the mortgage title.


You get all of that, and transparency. And with the portfolios, you can see the security that's held in the portfolio. You can get your car; you can drive past it.


You can walk down the street and see the asset right here. It's a 400 metre walk away. So yeah, no, it's a quality point.

And I think another theme that we've been spending a lot of time for an investment committee level, in the last 3-4 months, and we're getting prepared to, again, allocate to, is volatility.

We've spent a lot of time working at the moment and scouring the globe for a volatility allocation in client portfolios, and of course inside LAIF.

And so where our mindset at the moment is that if we do see that car-crash event eventuate again, or if we do start to see a market correction, for our viewers to understand this – that volatility tends to spike the most when markets come off. 

You know that old saying, "Bulls go up staircases; bears come down elevators." So when markets sell off, they tend to sell off in an extreme period. It took four years to get to the GFC. And then we saw all those returns were eroded within an 18 month period.

So at the moment, why we're looking at a volatility allocation, particularly within LAIF, is that you can take that 2-3% position and if volatility spikes from where it is at the moment from 20 to 40 or 50, again, from an index perspective, you're making a multiple return within the portfolio, but you're providing that underlying hedge and protection.

And then when things calm down and the circus leaves town again, you can actually remove that volatility position from the portfolio. So when we think about portfolio construction, yes, we've always got some long term themes sitting there within LAIF.

A number of our managers that are doing LAIF today have been there from day one, and have performed well at different parts of the cycle. But then you need to overlay that with medium and short term themes in the market as well.

And one of those short to medium term themes we're looking at at the moment is volatility, and we think the best way to go about that is actually to potentially just go and purchase the VIX or the Volatility Index in the US.

And that's obviously something we're looking to bring into portfolios over the next two weeks as well, in alignment with our impact fund.


Yep. That's our insurance policy, if you like.


Exactly right. Exactly right.


Yep. So one of the things that we talk about often with our investors is the attraction that we have to start-up funds or managers. So maybe expand a bit more on why we're interested in start-up funds and managers, and the couple that we've been allocating to recently.


Yeah, sure. Emerging managers as a whole is a bias that we've had in LAIF over time. Look, in investing, being early pays, and it pays well.

And if you look at some key stocks that everybody knows in the market, CSL struggled to get that float away in the mid 90s. And those that were fortunate enough to participate then have obviously made multiples and multiples on their money.

Afterpay is a great example. Everybody knows about it at the moment. Some of our funds that we own in LAIF saw that story very early on and believed in it before the rest of the market even knew what buy now, pay later actually was.

Those that purchased Afterpay at $3-$5 did very differently than those that purchased at $80, $90, $100, when the rest of the world knew about it.

You can actually apply the same approach to fund managers. When we look at start-up managers, I'd like to focus on the fact that we're actually looking at managers that have generally cut their teeth at a much larger institution.

So they understand the craft of investing and funds management. But then they're looking to set up their own business by themselves, just like with professions around the world.

If you're a good lawyer within a law firm, you might go and set up your own practice. If you're at a good accountant, you might go and set up on your own. Same for a doctor. You might specialise in a particular field, so you go and set up your own practice, say being a heart surgeon.

We apply the same approach when you're looking at funds management.

There is so much material out there and research that shows that many emerging managers or start-up managers actually deliver their best performance in the first few years.

Why is that the case? Because they're running a finite pool of capital. So if you think about funds management as a whole, it's an interesting space because in the industry as a whole, the larger you get, the more inflexible you become. And that just comes down to liquidity.

If you look at behemoths in this world, like say your Platinums, your Magellans, I take my hat off to them, they're great institutions, and they've performed well over time. But the larger they get, the smaller universe is of companies they can actually invest in for liquidity reasons.

If you're running $100 billion and you want to take a 1% position in your portfolio, you're buying $1 billion of a company. Even trading $1 billion of CSL or Commonwealth Bank is not easy when the market capital of those companies is circa $120 billion.

If you're a fund manager that's starting off with $10-$20 million, I mean, you're like a jet ski compared to the QE2 with a turning circle. So you have the ability to move in and out of markets very easily.

You also have the ability to be very flexible with your capital. So you can take large cash positions. You can move in and out of different market sectors and you're never really getting stuck in companies if liquidity does dry up, so you can move. So that's important to us.

Also, when a fund manager is starting off, they're not on everybody's radar. And as a result of that, given the extensive network we've now built up, particularly via LAIF, we're now seeing these managers actually coming to us with concepts and ideas that we might want to support.

And we saw that last year in resources when we felt that the resources thematic was going to play out at the start of the year.

And so we looked to Perennial, who we were already a partner with and had client capital invested with, and we backed Sam Berridge and his team to set up the Global Resources Trust.

We were the only investor in that trust on 1 April, when he launched. We were the only investor for the first three to four months, of course, alongside Sam's personal capital.

Within those first three months, that fund delivered a return of 40%. Then everybody saw the 40% return and said, "Right, I'm now going to get on board with it." Now, that's where your herd mentality comes from.

But probably two of the biggest themes that we're looking for in LAIF at the moment, one's not from a start-up manager and that's the TT Global Environmental Impact Fund that I'll let you talk to in a second.

But the other one is PURE Asset Management. PURE Asset Management launched a fund about three years ago now called their Income and Growth Fund.

They recently saw an opportunity in the market, in the resources space, where they could actually come to resources companies with their mandate, and their mandate is to provide debt to businesses with an attaching equity optionality.

And what I mean by that, it's either a warrant or a call option to eventually own that equity in that company, if it delivers.

This is a really important, powerful point, particularly for the resources space as a whole, that it's a thematic that's playing out, but it's a thematic that carries a lot of volatility.

We're trying to reduce investor volatility in returns as a whole – that whole underlying theme of risk-adjusted returns.

You think resources, you think highly volatile and you think also questionable outcomes in the space. So how do we still want to own that theme yet reduce the volatility?

And we can do that via PURE Asset Management, where they're going to these businesses, they're providing them debt of say $5-$20 million and they're profitable resource companies already. And they're doing that with a coupon attached to that of 8-12%.

So you're already realising that 8-12% annualised return in debt. Now, if these businesses do perform and deliver, and those equity prices go up by multiples, they're then converting that debt into equity at a significant premium to that warrant or call option strike price. And that's when that portfolio can generate significant returns.

So their mandated return is annualised 15% per annum for investors over time, and they've delivered 25% per annum because they're not only picking the right companies, and to date, the fund has never lost on an investment.

If it had owned the equity in these investments, it would've lost on some of those investments over time.

So it's a really disciplined approach. And so we like how they've adopted that approach now to the resources space. And so we've added that fund when it was established on 1 May this year and has come into LAIF and maybe you'd like to talk to us about the TT Global Impact Fund.


Yep. And I'll be brief on this because I did speak about it a bit earlier without naming it. But it is a global impact fund.

Impact investing, as we've already said, is a theme that we've been studying and looking into for quite a while now. But trying to find the right fund has been the difficulty for us.

We think we've done that with this fund and yes, they're a new fund, but they're part of a long-established global fund manager.

But they've also just identified that the opportunity exists to have this as a stand-alone investment. And in the scheme of what size they are and the amount of money they invest, the fund isn't particularly big now. We'll be again, relatively early.


But that's a theme that we want, right?


Exactly. Early into the fund. Won't be first, but we'll be early. But what, as I said earlier, we really like about it is that there is a lot of discipline about how they're going to deploy that capital. They're aligned as well.

Each of the managers has all their investible capital in the fund. Another thing that we look for when it comes to investing with people, it's also alongside them.

And in addition, this way that they want to see that any company that over 80%, that's a fair, large target of their revenue, is actually making a meaningful contribution or difference to the environment, hence the impact terminology.


And also it's the first we've seen from a manager where 20-30% of their actual management fee for the fund is actually going to charitable organisations that actually benefit the environment.

So, from an impact perspective, as well, they're true to their words and their actions in terms of actually what they're doing, even with their remuneration, putting back into the community, which I think's excellent.

Where we're trying to be different in this global impact space, and I'm happy to go out there and say, this is where maybe Lucerne's been a little bit different and contrary, is I think when most investors think about the drive to be carbon neutral in 2050, the whole focus is on actually developed nations around the world and your more westernised markets.

Where if you actually think about where probably the most ESG issues actually lie, it's in emerging markets. Out of the top 50 cities in this world that have the most pollution, the majority of them sit in China and India.

TT Global have been operating in emerging markets for the last 30 years as investors in equity space. They've already got deep roots in networks within China, within India, within Southeast Asia.

And so a large portion of their portfolio is actually biased towards impacting investing in emerging markets.

We are ultimately going to get a much greater outcome for the planet than obviously funding businesses that are in more established markets that are probably more ahead of the game already in the ESG space.

This ultimately then should lead to greater investment performance for investors, because you're identifying themes that are probably more under priced in the impact space versus ones that are already more established.


Yeah. Well, imperfectly priced, and we've spoken a lot about emerging markets and the opportunity that exists there as well, and this is just another one of those that combines both our emerging markets opportunities and the impact investing.


You're getting the best of both worlds. You get the impact theme and you get emerging market economies. And for our investors out there just to understand this, over the last 10 years, emerging markets have significantly underperformed developed markets.

And that's a theme that often actually doesn't last in markets. So, if you're a betting person at the moment, you'd probably argue there's a much greater chance of upside in emerging markets on a go-forward basis than there is developed economies.

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