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Tapping into economic recovery through the UK's booming smaller companies
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Judith MacKenzie
Partner and Head of Downing Fund Managers
Downing launches new actively managed liquid alternatives fund aiming to deliver 7% to 10%+ per annum and positive returns in most markets. The new MGTS Downing Active Defined Return Assets Fund (‘Active Defined Returns’, the ‘Fund’), is the first fund from its new Liquid Alternatives team.
The Fund is aimed at institutional investors, Discretionary Fund Managers, IFAs and advised sophisticated individual investors, and will primarily consist of UK Government bonds and large-cap equity index options, which provide significant scalability and strong liquidity. It aims to deliver 7% to 10%+ per annum and positive returns in all markets except for a sustained equity market fall (generally more than 35%), over a period of at least six years.
The Fund is the first to be launched by the new Liquid Alternatives Team established by Downing. Collectively, the team has over 125 years of experience and sector knowledge, and includes Tony Stenning, who held senior roles at BlackRock and most recently was CEO of Atlantic House Group; Russell Catley, founder and also a former CEO of Atlantic House Group; Huw Price, a former Executive Director at Santander Asset Management, and Paul Adams, former Head of Cash Equities and Derivatives Sales, Royal Bank of Canada.
The Fund offers investors a compelling building block for multi-asset portfolios, aiming to add consistent and predictable returns, typically secured with a portfolio of UK Government bonds. The unique proposition includes a hybrid approach of using systematic derivative strategies and active management, combining liquid investments with predictable returns, and an equity like risk profile.
Investment strategy: Maximising the probability of delivering predictable defined returns across the economic cycle.
Systematic Liquid Derivatives: Systematic, derivative strategies optimise the equity risk-return profile. The Fund uses rules-based derivative strategies linked to the most liquid, large-cap global equity indices (i.e. FTSE100, S&P500) with the aim of harvesting well-proven consistent returns across a wide corridor of market conditions.
Strong security: The Fund will hold a high-quality portfolio of assets as secure collateral – typically UK Government bonds.
Active benefits: At times, rules-based, passive derivative strategies can underperform when markets move strongly – this is when specialist active management can add incremental gains by monitoring and monetising positions and applying active risk management.
Key benefits
Increased consistency and predictability of returns: Positive returns in all markets except for a sustained equity market fall of more than 35% over at least six years.
Diversification of risk: The Fund’s risk components are diversified across large, liquid equity indices, observation levels and counterparties. Secured with high-quality assets – typically UK Government bonds.
Active management: Our experienced team will actively manage the Fund and its investments to optimise risk and reward for investors.
Russell Catley, Head of Retail, Liquid Alternatives at Downing, said: “Put simply, we focus your investment risk on the probability of receiving the returns you need, not those you don’t. We target the highest probability of delivering 7% to 10%+ per annum with active management adding material incremental gains. We believe that we are building the next evolution of the proven success of Defined Returns funds
The Downing team isseeing strong demand from clients looking for alternatives to large-cap equity funds which are becoming concentrated in technology stocks, or alternatives to UK equity income funds and illiquid alternatives.”
Tony Stenning, Head of Liquid Alternatives at Downing, said: “The launch of our Active Defined Return Assets Fund is a significant milestone in the ambitious build-out of our new Liquid Alternatives strategies. It is a solution-focused fund that should deliver stable high single or low double-digit returns across a wide spectrum of equity market conditions, except for a persistent multi-year bear market. The Fund is designed to enhance balanced portfolios by providing consistent, predictable returns and is suitable for accumulation or drawdown.
“We aim to deliver a unique combination of proven systematic derivative strategies and specialist active management, and we are doing so at a very compelling fee level, below our closest competitors and in line with active ETFs.”
How the Fund is expected to perform in different markets
In bullish markets: UK Government bonds secure the capital, and the equity index options deliver a predictable 7-10%+ return per annum – giving up some less likely upside.
In neutral markets and normal market corrections: UK Government bonds secure the capital, and the index options deliver a predictable 7-10%+ return per annum.
In a sustained sell-off: if markets fall more than the cover to capital loss and do not recover for six years. Then capital is eroded 1:1 in line with the worst performing index.
The average Cover to Capital Loss is targeted at 35%: the average cover to capital loss represents the average level the Global indices within the Fund could fall before capital is at risk.
Fund key risks
Performance: Capital is at risk. Investors may not get back the full amount invested.
Liquidity: Access to capital is always subject to liquidity.
Counterparty risk: Other parties could default on the contractual obligations.
Fund Structure
UK regulated OEIC fund structure, fully UCITS compliant
Daily dealing, at published NAV
Minimum investment: £100,000
SRRI: 6 out of 7
Depositary: Bank of New York
Authorised corporate Director (‘ACD’): Margetts Fund Management Ltd.
I share-class: SEDOL: BM8J604 / ISIN: GB00BM8J6044
F share-class: SEDOL: BM8J615 / ISIN: GB00BM8J6150
Risk warning: Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing; your attention is drawn to the risk, fees and taxation factors contained therein. Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in this fund should be held for the long term.
Important notice: This document is intended for professional investors and has been approved as a financial promotion in line with Section 21 of the FSMA by Downing LLP (“Downing”). This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 10 Lower Thames Street, London EC3R 6AF.
UK is emerging as one of the most attractive markets for investment
After years in the wilderness following the vote to leave the EU, the UK is now emerging as one of the most attractive markets for investment across the globe. This revival in fortunes is due in part to the success of the UK’s rapid vaccine rollout, and the potential for a strong economic recovery as the country has emerged from lockdown over the summer.
With almost all Covid-19 restrictions now removed and as people embrace the ‘new normal’, where should investors look for the best opportunities for tapping into the recovery?
Small is beautiful
As UK small/micro-cap investors with a strong value bias, we believe that this part of the market is currently very attractive. In the first half of 2021, UK smaller companies represented the top performing IA sector, generating a total return of c.20%1. Despite this impressive performance, it is an area of the market that is often overlooked. This is fundamentally due to inefficiencies and a lack of analyst cover both on the buy and sell side, meaning UK micro-caps continue to look undervalued.
Compared to larger peers, and those in other geographies, UK small caps look cheap, with a forward median PE of 16.1x compared to the S&P on 22.5x2. It is therefore no wonder that the level of corporate activity and inward buyers to the UK small cap market is so buoyant. This has begun to reach the micro-cap sector and we expect to see more activity as earnings improve to pre-pandemic levels.
A further positive for the asset class is the potential for superior investment performance - it has long been understood that smaller companies outperform their larger cap peers over the long term. They can afford to be more agile in the face of evolving demand and often fulfil very specific needs and operate in niche markets. Many small businesses have survived Covid-19 and emerged stronger and with more operationally efficient business models.
However, the very smallest UK companies, with the greatest potential for growth, tend to be under researched and are not well covered by analysts. The introduction of MiFID II has exacerbated this, and we believe that there is only 0.6 of an analyst per company covering companies in the sub £150 million market cap space. However, less cover and poorer quality research creates opportunities to find those businesses that are not priced correctly, relative to their intrinsic value and growth potential.
How do you access this opportunity?
There are a number of ways of investing in small and micro-cap companies, but we believe that investment trusts are an attractive option, given that they are ideally suited to investing in less liquid assets. This is because investment trusts have the advantage of their closed-end structure, which allow managers the freedom to buy and sell holdings as and when they want rather than have their decisions dictated by fund flows. This is in contrast to the equivalent open-ended funds which run the risk of trading suspensions and the forced selling of assets to meet redemptions.
Regardless of sometimes challenging economic conditions, investment trusts continue to be traded on the stock market as we witnessed through the pandemic. Typically, their discounts – when the share price is less than the NAV per share - will widen, and it may not be a good time, but shares may still be sold. This discount also offers an attractive entry point for investors to take advantage of market sentiment.
Importantly, the manager of an investment trust does not have to sell underlying assets in order to fund redemptions because those investors wishing to sell their shares do so on the open market, to other investors. The closed-ended structure allows investors to harness the long-term benefits of investing in less liquid assets without the managers being forced sellers, or buyers, on bad days in the market.
Bargain trusts – trading at a discount
There are several excellent investment trusts focusing on UK small and micro-cap companies – many of which are considered cheap because they are currently trading at a discount. There is considerable variation in the investment strategies adopted by managers such as the number of holdings, market cap bands, their levels of borrowing or ‘gearing’, the types of instruments they invest in, and the size of the positions they take in individual holdings.
The Managers actively engage with the underlying companies
The Downing Strategic Micro-Cap Investment Trust (DSM) is almost unique in the space as it is a concentrated portfolio of between 12-18 positions in companies under £150 million market cap at initial investment. The Trust is strategic in that we take influential positions of between 3-25% of the underlying equity in businesses that we believe are undervalued and could benefit from strategic and operational initiatives to drive performance and unlock shareholder value.
A significant equity holding allows the managers to be strategic, to engage closely with aligned management teams and put catalysts in place to drive returns. Following extensive due diligence, the managers develop plans where they have tangible levers to help generate better performance. In turn, that better performance will ultimately lead to better earnings and cash flow, ultimately leading to an improved share price too. When these catalysts play out, the aim is to close that gap between the value of the company today and what they believe it's actually worth.
It can take time for these strategic catalysts to play out and DSM has a long-term investment horizon, with a rough lifecycle for this type of investment of between three and seven years. DSM is currently trading on a c.14% discount to NAV3, which the managers feel is unjustified given the quality of the portfolio.
Tapping into the rebound
Investment trusts can offer reliable streams of income, the opportunity for strong long-term growth, and access to less liquid assets in a stable, closed-ended structure. For investors looking to take advantage of the recovery in markets and positive outlook for the domestic economy, UK small and micro-cap investment trusts make a compelling opportunity for attractive returns in the short, medium, and longer term.
1 Shore Capital, Capital Markets, Downing Strategic Micro-Cap Investment Trust - “Portfolio recovery – moving up the J-curve" Research Note 26 July 2021
2 Factset S&P 500 and FTSE Small Cap report, 27 September 2021
Downing Fund Managers (DFM) is part of Downing LLP, a company with over 30 years’ experience and more than £1.4 billion AUM. DFM was founded in 2010 as a boutique investment house with a value-based style that favours a private equity approach to investing in public markets. The range of mandates covered by DFM now consists of five funds – all different from, and complementary to, each other. DFM are also committed to the Principles of Responsible Investment, which can make investments more rewarding by being profitable for our investors.
Risk warning:Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Please note target returns are not guaranteed. Investments in this fund should be held for the long term and are higher risk compared to investments solely in larger, more established companies. Values may be affected by fluctuations in currency exchange rates and may cause the value of your investment to go up and down. Diversification may not be achieved and investments may be in the same sector. Opinions expressed represent the views of the Fund Manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing; your attention is drawn to the risk, fees and taxation factors contained therein.
Important notice: This document is intended for retail investors and their advisers is for information purposes only. It does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments.
Downing LLP is authorised and regulated by the Financial Conduct Authority (FRN: 545025). Registered in England and Wales (No. OC341575). Registered Office: 6th Floor, St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
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