The average Trustee board may have some interesting investment decisions at the current time. Their equity portfolio has likely performed extremely well, which may mean funds are available to invest in ‘less risky’ asset classes. Alternatively, in the past, you may have swapped the equity portfolio with a Diversified Growth Fund (DGF), depending on the manager, you may be looking at underperformance (relative to expectations), and the potential need to find something else for volatility managed returns.


There is a real drive towards credit at the moment, to diversify the portfolio, to de-risk, and/or as an alternative to flagging DGF’s. These are described, often confusingly interchangeably, as Diversified Lending, Absolute Return Bonds, Multi Asset Credit, Semi Liquid Credit and likely many more. The premise is normally the same; you are looking to invest into a mixture of credit opportunities which are diversified to provide a smooth return and contractual income (if you want it). However, when you look at the previous descriptions (and actually the funds themselves), the underlying investments can be very different in the risk spectrum. I have a few key points to assist in understanding your investments, which I summarise below.

Apples and Apples

The first key for Trustees is to ensure they are comparing like with like. The credit world can be just as risky as equities if managed in the wrong way. You must understand where your investments sit in the debt pyramid. If you think mezzanine only refers to the mid level of a theatre, you may need to do more homework. You need to understand your exposure to different countries, in particular in the emerging market. You must understand the credit ratings underlying your ‘contractual income’. You need to understand the derivative exposure, if any. Then you need to balance this up and understand the underlying risk and how diversified you actually are. When comparing funds, you must compare these side by side. The better returns almost inevitably mean greater risk. We are living in a low default environment and past returns are not always the best measure of future performance. I have seen example shortlists with funds I wouldn’t have in the same universe, let alone as comparable managers in a selection process.

Hitting supply to meet demand

For any of you who have seen the Big Short, you will be all too aware of what happens when you wrap up a lot of bad credit. There is currently a real push in the credit market at the moment, which does worry me. You must ask yourself the question (or better the manager), how will they cope managing £1 billion, rather than £500 million? How does their quality process operate, and how will they ensure they don’t lower the bar to meet the demand? The willingness of people to jump into the credit market does not create a mass of great credit opportunities overnight. Remember that. We are already seeing some of these funds struggle due to low yields and a shortage of opportunities.

There is no such thing as a free lunch

The majority of DGF investors are probably asking if “equity lkie returns, with lower volatility” was the right description. In two market cycles, it may be proved right but the jury is firmly out, and may be coming in shortly to pass judgement if things don’t improve. The same may be said of these credit opportunities in five years time. You must understand the fund and what it is going to do for you. The investment modelling should be separate to this. A good consultant once said to me “the only certainty with modelling is that it will be wrong”.

Summary

The drive for better funding has meant a number of schemes are funded at a Technical Provisions basis or above. They have clear de-risking plans, which create the opportunity for new investment opportunities down the risk spectrum. My caution to all is understand the investments, understand the risk, and don’t lose your improved position. We are in a complex world at the moment and you need a diverse portfolio with the right balance of risks if you are to get through this positively.

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