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6/12/2024
10
min read

The Power of Incentives

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 is seeing 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

Learn more about the Fund here.


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.

Fund Manager Rosemary Banyard uses an insight from the late Charlie Munger to emphasise the importance of well-aligned incentives in driving shareholder value. She highlights the benefits of directors having significant shareholdings and well-structured remuneration packages focused on long-term goals, and warns of the pitfalls of conventional remuneration targets. An analysis of the VT Downing Unique Opportunities Fund shows that companies with well-aligned incentives tend to perform better, highlighting the need for rigorous economic criteria and cautious acquisitive strategies.

The late Charlie Munger, with his customary penetrating insight, once observed: “Show me the incentive and I will show you the outcome”. In the UK-listed company arena, one size does not fit all, but there are certain incentives which seem to us more likely to generate better shareholder value than others. Two which we favour are skin in the game, and remuneration packages which include any or all of: a long-term focus, the risk of personal loss, or the incentivisation of superior capital allocation.

Skin in the game

We define ‘skin in the game’ as directors (and occasionally founders who have left the board) who own more than 3% of a company. The larger a company is, the harder this hurdle is to achieve, and we recognise that a smaller stake in a big company could still be monetarily significant to the individual concerned. Furthermore, new management may simply not have had enough time to build up a significant holding. Nevertheless, we believe that significant director shareholdings represent greater alignment with our interests than any other remuneration package. We refer to it as ‘the owner’s eye’, and believe it brings the right blend of prudence and decisiveness, coupled with a long-term mindset.

It is noteworthy that in our fund, the VT Downing Unique Opportunities Fund (DUO), there are both high levels of skin in the game and management longevity within the underlying investee companies:

Source: Downing Fund Managers and underlying DUO investee company public reports as at 30 September 2024.

Overall, the weighted average holding of directors in DUO companies is 9.8%, and the average tenure is eight years as CEO.

We recognise that some of our investee companies are run by executives who may not meet the 3% ownership hurdle for whatever reason, but still have an owner’s eye and a longevity which signals superior commitment. These include Nigel Newton at Bloomsbury Publishing or Kevin Lyons-Tarr at 4Imprint who have clocked up 37 and 33 years respectively inside their companies.

Remuneration packages are a complex topic, and circumstances vary enormously. However, one element we regard very favourably, in bonuses or longer-term plans, is a target or underpin requiring a minimum level of return on invested capital or return on capital employed. This is particularly important where the company in question is acquisitive, as it incentivises capital allocation which delivers an economic profit, while penalising expensive or ill-conceived acquisitions, or poor integrations. The following companies held in DUO include such a target:

We also favour incentives that encourage long-term thinking and share ownership since this aligns with our own attitude to investment. Occasionally too, especially in instances where a turnaround is needed, there can be a case for an element of remuneration linked to an absolute (high) share price, which at least has the merit that it focusses the mind.

We set out three companies in DUO which exemplify some of these approaches below:

Source: Downing Fund Managers and latest individual companies reports correct as at 30 September 2024. *LSE as at 13 November 2024

More conventional approaches to remuneration tend to involve targets for adjusted earnings per share, which leave shareholders open to all manner of “adjustments”, potentially including write-offs for previous errors made by the same management team! Worse still are targets linked to adjusted EBITDA, a measure for which Charlie Munger reserved a well-known and well-deserved but unprintable description. The difficulty with earnings per share is that it does not tell the investor a great deal about the capital that generates it, which we consider a crucial element to assessing the quality of a business.

We have performed an analysis of all the companies owned by DUO since launch in March 2020 to see whether there is a correlation between incentives and returns. We placed the companies into three buckets: A where management or founders own >3%; B where there are incentives that align with our objectives, such as ROCE targets, long-term holding periods or absolute returns; and C: the rest. We assumed for the purpose of this analysis that all companies were owned throughout the period at our average weighting.

The contribution of the three buckets to total return is shown below

Source: Downing Fund Managers, FactSet and individual company public reports as at 30 September 2024. Average total return of all underlying DUO investee companies from fund launch (25 March 2020) to 31 October 2024 including positions since exited from the fund.
Please note that past performance is not a reliable indicator of future returns.

The results made us sit up! In bucket A (skin in the game) average total returns were 63.6%. There were 19 companies, of which only three produced a negative return, and only two of these were into double-digit declines. In bucket B (well-crafted and aligned incentives), average total returns were 78.1%. There were only six companies, two of which were stand out contributors, namely Games Workshop and Diploma. In bucket C, total returns were only 12.5%. Here, there were the largest number of holdings at 23, of which five were insignificant (e.g. nil paid shares, in specie distributions). Of the 18 others, eight of them exhibited negative returns, seven in double-digits.

Key learning points from the data

How should we react to this data? Firstly, it’s important to say that correlation doesn’t always indicate causation! High barriers to entry and attractive financial characteristics may well be the strongest contributing factors to good performance. Moreover, the starting point for this data (and our fund) is 24 March 2020 in the depths of the Covid downturn in stock markets, so there will have been uneven experiences in and levels of recovery from the pandemic effects. Secondly, there is a concentrated number of stellar performers, although we believe it is quite common for many funds to have a few outsized winners over time. Thirdly, you might reasonably ask why we have held the most investments in bucket C! Of the 23 investments, as already stated, five were insignificant. Four of these and nine larger holdings have been sold, two in connection with takeover bids.  Some companies in bucket C clearly possess very good business models, have significant economic moats and excellent returns on capital, notably Auto Trader and Rightmove. However, many of those which performed the worst, and were at some point sold, had in common that they had made poor acquisitions and had taken on significant debt. The suspicion raised is that these management teams, possessing neither significant skin in the game nor properly aligned incentives, took undue risks with shareholders’ money with unfortunate results.

Key learning points for us from this exercise are that we must remain rigorous in our demands for superior economic characteristics, and even more wary of acquisitive strategies, particularly if we are investing in companies where management does not have significant skin in the game or incentives to deliver economic returns on our capital. We also think it important that any investment philosophy and process is dynamic, not static, involving self-reflection in the quest for constant improvement. So, at the time of writing, we have 15 companies in bucket A, 6 in bucket B, and 10 in bucket C.

This article is written by:
Manager of the VT Downing Unique Opportunities Fund

Explore additional details about the VT Downing Unique Opportunities Fund.


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. Important notice: this document has been prepared for professional investors and has been approved as a financial promotion in line with Section 21 of the FSMA by Downing LLP (“Downing”). Capital is at risk and investors should note that their investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a reliable indicator of future performance. Any subscription to the fund should be made on the basis of the relevant product literature available from Downing or from the ACD, Valu-Trac; and your attention is drawn to the charges and risk factors contained therein. 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.

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