M&G’s Andrew on positioning the £725m Episode Income fund for rising rates

Steven Andrews joined M&G in 2005 and launched the £723m Episode Income fund in 2010

M&G fund manager Steven Andrew remains bullish on US banks having taken advantage of the unwinding of the ‘Trump bump’, which saw banks stocks soar following the election on promises of corporate tax cuts and a reduction in regulation that have failed to materialise.

Currently US banks make up 8.96 per cent of the Episode Income fund, representing the largest portion of the equity exposure. Andrew has increased the weighting from 3 per cent six months ago on the view US banks are an ideal diversifier for a multi asset fund.

He says: “I bought a basket of what appeared to be attractively valued banks, when their share prices fell sharply in August 2015 and again in January 2016, well before Trump’s election.

“Then I reduced exposure to US banks after their prices rallied and used subsequent price weakness to rebuild positions. I still feel that US bank equities are likely to benefit from higher growth in the US economy, as well as potential further interest rates increases in 2017, hence I retain meaningful holdings.”

Among the banks were Bank of America, American Express and JP Morgan.

On valuations, Andrews justifies his choice saying while at an index level US equities are expensive that is not the case for US bank equities.

He says: “Looking at valuations is the most effective way to manage volatility but it comes second to risk management.

“Banks’ balance sheets have also improved and banks are well resourced to grow that balance sheet. They are also a good investment for the prospect of rising rates.”

In a rising rates environment, Andrews says he is not keen on US bonds.

He adds: “At a time when US treasuries had a 5 per cent loss the US equity market earned 30 per cent.”

The fund manager points out the general discontent among investors over the past few years, especially around the fixed income market with bond yields touching very low levels.

Andrew says: “The most important evolution [in the market] has been moving from being overly pessimistic to a more optimistic tone.”

The multi-asset manager, who has been with M&G since 2005 and has been the architect of the £723m Episode Income fund, aspires to a 4 per cent yield, a “doable” target to achieve over the long term, he says.

However, he reckons the potential of good returns for income seekers has changed since November 2010 when the fund was launched.

Andrew says: “Back in 2009 we looked at what was a doable [yield] and at that time the yield could be achieved at 5 per cent. What we knew about the future at that time was that society was ageing.

“You’ve never had a circumstance like this in the history of the human being with such an ageing society.”

In a growing ageing population, the fund manager continues to work out the best possible asset selection to guarantee a growing and consistent income to his clients but also a growth of the underlying assets of the fund.

He says: “We launched the fund with the sole aim of sustainable income delivery over the medium to long term. We are mindful of the attitude to risk but also the need to keep generating income for many years. We think a global multi asset mandate is the only way we could sustain this income.”

Andrew says: “The most important evolution [in the market] has been moving from being overly pessimistic to a more optimistic tone.”
The Episode Income fund has consistently outperformed its sector over the past five years. It returned 55 per cent versus the 42 per cent of the IA Mixed Investment 20-60% Shares sector over the period. Over three years, the fund returned 27.3 per cent against the sector’s 21 per cent, according to FE data.

The fund is able to hold 50 per cent in equities and Andrew says while he has always preferred holding a large amount in equities he has gradually been increasing the exposure over the years.

He says: “I have always bought more equities. Since the launch of the fund I have been above 30 per cent in equities. Now 44 per cent of the fund is in equities. But [to balance the fund] we also needed to allocate pretty aggressively to bonds and now 25 per cent of the fund is in US and UK government debt.”

The manager has been “very active” on the European periphery, he says, in particular in the debt space. But while the Episode Income fund used to hold 10 per cent in Portuguese government bonds, Andrew reduced the exposure from 10 to 4 per cent because of the critical political climate in the region a year ago.

He feared Portugal could have been “the next political accident” following the Greek debt crisis of 2015.

Andrew says: “Thinking about the driving forces in Europe last year, the region was stumbling from one event to another.

“But over the past 12 months there has been an improvement in the economic data in Europe. If you look at the industrial production it has outstripped that of the UK and the US over the past two years.” For this reason he is happy to hold on Portuguese bonds.

The fund manager is also looking to increase the fund’s exposure to the Asian region. Currently the fund invests 7.8 per cent in Asia, excluding Japan but Andrew plans to introduce a position in Japanese equities.

Andrew says: “Asian global trades are pretty robust. The evolution of Japan is also interesting. It has been a frequent overpromiser but an underdeliverer. However, since Shinzo Abe came in things have improved, but we’re not out of the woods yet. The additional point in favour of Japan is corporate governance and transparency and the rise of shareholders to have the dominant say to run the business.”

On UK equities, which make up 7 per cent of the fund, Andrew is also positive and he has bought into those sectors that were highly discounted after the Brexit vote a year ago.

However, Andrew says UK equities are still seen as a risky asset.

He says: “In the UK we have a diverse basket of domestic exposure including media, financials, retail and industrials. This includes some of those trades that sold off and were massively discounted right after the Brexit vote but that are now improving.

“People seem to be pessimistic and lazy on the UK. Unemployment data is at a 40-year low. It still seems to me the economy is robust although not growing. We are positive on sterling and negative on rates [rising]. But there are still some UK stocks yet to pay dividends and so UK equities remain a risky asset.”