Income Investing Roundtable

1 Income Investing Roundtable

Diversifying assets in the pursuit of income

April 2018

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Articles

15 AEW UK Investment Management LLP

19 M&G Investments

22 Old Mutual Global Investors

This marketing document has been prepared by CAMRADATA Analytical Services Limited (‘CAMRADATA’), a company registered in England & Wales with registration number 06651543. This document has been prepared for marketing purposes only. It contains expressions of opinion which cannot be taken as fact. CAMRADATA is not authorised by the Financial Conduct Authority under the Financial Services and Markets Act 2000.CAMRADATA Analytical Services and its logo are proprietary trademarks of CAMRADATA and are registered in the United Kingdom. Unauthorized copying of this document is prohibited. Introduction 3

A sustained era of ultra-low interest rates, against a backdrop of low government bond yields has led to investors stepping up the hunt for yield.

This hunt has increased the array of asset classes being considered and in tandem has caused those asset classes that historically have offered a reliable income, to become more expensive due to increased demand.

Some investors have looked to take on more risk to lock into a healthy income and so yet again we see that investors who are seeking to generate a healthy income in 2018 will once again have a challenge on their hands.

Although many income funds state they provide yields of 4-5%, the question is whether these funds are able to maintain and can continue to deliver this level of return, and whether there are actually other types of income investing asset classes that investors should be considering as well.

CAMRADATA’s Roundtable focussed on the opportunities offered by income investing and investigated what the future holds for this and alternative asset classes, both in the current macroeconomic climate and going forwards.

AEW Company Profile

AEW UK Investment Management LLP is a 50:50 joint venture between the Management Team and AEW Europe. The AEW UK team has been providing solutions for institutional investors for 20 years and has developed a range of funds and segregated accounts to meet their differing needs, from value add strategies to traditional core style total return and latterly a real return strategy. The management team average 20 years working together and are 50% equity owners in the business, this ownership over investment process and decision-making, helps deliver a consistent approach through different cycles.

AEW is one of the world’s largest real estate asset managers, with €58.5bn of assets under management as at 31 December 2017. AEW has over 600 employees, with its main offices located in Boston, London, Paris and Hong Kong and offers a wide range of real estate investment strategies. AEW represents the real estate asset management platform of Natixis Investment Managers, one of the largest investment managers in the world. The AEW Group focuses exclusively on providing real estate investment and asset management services to institutional investors globally, offering investors a wide range of investment solutions including separate accounts and commingled funds across core to opportunistic strategies in both direct real estate and listed REITs.

At the start of 2016 the AEW UK Real Return Fund was launched largely as a solution for the increasing number of defined benefit schemes needing higher yielding real returns to match their cash flow liabilities and help scheme sponsors plug any deficit in funding that may exist. The Real Return Fund is positioned as a strong alternative to traditional core and long income funds. The strategy targets a 4% total real return (net), a 5% gross portfolio yield and inflation- linked income growth, together with capital preservation, in real terms, by building a portfolio based on the strong property fundamentals of this real asset class.

Ian Mason Director and Portfolio Manager of Real Return Fund

Ian Mason can rightly be called a veteran of the property fund management industry, having started at Mercury Asset Management in 1985, he joined their direct property team. It was here he began his drive to understand the needs of investors and to find ways to use property to meet their objectives. After a series of mergers, some 20 years later it emerged as Blackrock and he left, having seen their UK property fund grow from £35m to over £2.5bn, to take over running the Schroders Property Unit Trust in 2008. The global financial crisis was now in full swing and the fund performance was suffering.

Having repositioned the portfolio to get income to be the key driver of returns, and the fund had delivered five years’ outperformance, it was time to move onto the next challenge. Having noticed that the needs of his UK client base were undergoing fundamental change; DB schemes were closing, liabilities were being sold to annuity linked insurance providers, in other sectors relative return benchmarks were being replaced with cash plus or inflation plus objectives and investors were selling core growth style strategies and investing in cash flow, Mason joined AEW UK to launch the AEW UK Real Return Fund.

He is a past Chairman of AREF (Association of Real Estate Funds) and Chair of the Regulation Committee. He is a passionate advocate of listed and unlisted funds. Roundtable 5 Sponsor

M&G Investments Company Profile

M&G Investments is the European asset management arm of Prudential plc, operating in the UK, Europe and Asia. As a trusted partner, our clients’ individual needs are at the heart of our business. We align our interests with those of our clients and develop value-based strategies to generate strong and consistent returns. Our goal is to help our clients meet their long-term liabilities regardless of the market environment.

With £281 billion* of assets under management (including £132 billion* on behalf of our parent company) across fixed income, equities, multi-asset strategies and real estate and over 400* investment professionals (including what we believe to be one of Europe’s largest credit research teams), we have the scale and expertise to offer tailored investment solutions across a wide range of risk and return requirements.

*As at 30 June 2017

Stuart Rhodes Portfolio Manager

Stuart Rhodes has been the manager of the M&G Global Dividend strategy since its launch in July 2008. He was appointed deputy manager of the M&G North American Dividend strategy in April 2015.

Stuart joined M&G in 2004 as a global equity analyst after graduating from Bath University with a degree in business administration. He is a CFA charterholder 6 6 Roundtable Sponsor

Old Mutual Global Investors Company Profile

Old Mutual Global Investors (OMGI) is a leading asset management firm, offering a distinctive blend of investment prowess and a deep commitment to customer service and transparency.

Our aim is to deliver strong investment performance and customer-focused investment solutions that result in positive outcomes for our clients. In pursuit of this aim, we seek to offer customers and their advisers real choice, from fully-packaged solutions for those who want to outsource some of the biggest decisions, to the highest-quality investment building blocks for those who wish to retain greater control and flexibility.

Lloyd Harris Co-Manager

Lloyd joined Old Mutual in 2012 as a senior credit analyst focusing on the financial sector, before being appointed lead manager of the Old Mutual Corporate Bond Fund in 2015.

Prior to joining Old Mutual Lloyd was at Cutwater Asset Management, initially as an asset-backed CP/MTN trader, then as a European financials credit analyst. Before this, Lloyd worked in structured capital markets at Deutsche Bank. Lloyd graduated from the University of Bristol with a BA (hons) in electronics and telecommunications engineering. Roundtable 7 77 Participants

Sam Roberts Head of Investment Consulting

Sam heads the investment consulting team at Cartwright, with overall responsibility for the quality of the investment advice provided by the team, the fund manager research and the smooth implementation of Trustees’ investment decisions.

Sam is also the lead investment consultant for his own portfolio of clients, covering all aspects of investment strategy and investment-related consulting.

Sam believes that investment strategies can be relatively sophisticated without being over-complicated or expensive, and that every pension scheme is unique. He enjoys helping clients to prioritise those areas that will have the most beneficial impact, to better understand and manage their investment risks, and to implement practical cost-effective scheme-specific solutions to help to achieve their (and their members’) objectives.

Sam is a qualified actuary and worked for over 10 years as a pensions actuary before switching to investment consulting. He believes that this helps him to better understand both sides of a pension schemes’ balance sheet (i.e. both the assets and the liabilities). This is particularly important when considering DB liability-related assets such as LDI and bulk annuities, the interaction between the different measures of DB liabilities, and the potential risks faced by DC members when planning for retirement.

Alistair Sutherland Consulting Director, Investment Services Team

Alistair Sutherland is a Consulting Director within Deloitte’s Investment Services Team, providing investment advice to public and private sector clients covering investment strategy, manager structure and selection, ongoing monitoring and governance reviews. In addition, Alistair is responsible for leading the manager research undertaken by the Investment Services Team.

Prior to joining Deloitte in 2007, Alistair was responsible for running Mercer’s Investment Consulting business in Scotland.

Alistair has over 30 years of investment experience encompassing investment management, stock broking and consultancy. 8 Roundtable

Participants

Nicola Ralston Director

Nicola Ralston has forty years’ investment experience as an analyst, portfolio manager, investment consultant, board member and investment adviser. She is a director and co-founder of PiRho Investment Consulting, which offers bespoke investment advice to institutional investors. She is a director of the Centrica Combined Common Investment Fund; other current roles include Chairmanship of Henderson EuroTrust and of the British Heart Foundation Investment Committee.

Previously, Nicola spent 22 years at Schroders, where she became Head of Investment, and was subsequently Head of Global Investment Consulting at Hewitt (now Aon Hewitt). She is former Governor of CFA Institute and a former Chair of CFAUK.

Daniel Banks Director, Solutions

Daniel joined P-Solve in 2010 from Punter Southall where he worked from 2008. He currently works as an Investment Consultant for clients between £100m and £5bn, advising on areas including Manager Selection and Strategic Asset Allocation with a particular focus on matching assets and liabilities in a consistent manner.

Daniel currently sits on P-Solve’s Insurance Investment Committee, Investment Strategy Committee, DC Management Committee and Group Investment Committee. He splits his time between consulting with clients including both pension schemes and insurers alongside a focus on P-Solve’s modelling and technical capabilities. He has been quoted in a number of publications such as Engaged Investor and Financial News whilst regularly giving industry talks such as at the Institute of Actuaries GIRO conference. Roundtable 9 9 Participants

Reza Mahmud Senior Investment Consultant

Reza represents PwC’s Pensions Investment Consulting business, which focuses on Trustee and Corporate advice. He helped establish and is a member of PwC’s multi-disciplinary Investment Committee (pensions, insurance, sovereign wealth funds, private wealth). Prior to PwC he was a multi-asset investment manager at Aviva Life and Pensions,and before that he served with Brunei’s sovereign wealth fund as a portfolio manager and asset allocation analyst.

Reza has an LLB law degree from Exeter University and an Investment Management MSc from Cass Business School (City University). He has also studied behavioural finance and investments at Harvard University, University of Chicago Graduate School of Business, and London Business School, and studied Psychology and Cognitive Science at Johns Hopkins University. w

Aruran Morgan Senior Analyst

Aruran Morgan has been working as a Senior Analyst in the Manager Research team at SEI Investments since October 2016. He is responsible for the selection and monitoring of non-US fixed income strategies. Prior to this he worked for 6 years in a similar capacity at Buck Consultants.

He attended Imperial College London where he studied Mathematics.

10 Income Investing Roundtable Diversifying assets in the pursuit of income

In March 2018 CAMRADATA held its annual investing for income roundtable. The panel of asset managers and consultants were looking at how pension funds, insurers and charities can diversify their sources of income. Key conclusions were that many investments have a capital and income component: the two must be considered together. Valuations at the time were stretched Some asset classes such as property and equities have waned in popularity because enough because they are considered solely as growth investments. To reverse this decline, their income component has been exaggerated. Consultants at investors had decided the roundtable warned against such exaggeration, which panders to asset these sorts of ‘quality’ owners’ craving for certainty. companies, many in the consumer staples and Instead, asset owners should have a clear understanding of the nature of pharma sectors, had underlying investments. They could be surprised to learn that property returns such reliable streams mostly derive from income; or that CoCo bonds are easier to trade than investment grade debt; or what dividend growth tells us about the strength of of revenue that they publicly-quoted companies. could be considered bond proxies In July 2016 the price-earnings ratio for Colgate-Palmolive reached an eye-watering 48, the kind of level usually reserved for technology start-ups, not toothpaste manufacturers. Valuations at the time were stretched because enough investors had decided these sorts of ‘quality’ companies, many in the consumer staples and pharma sectors, had such reliable streams of revenue that they could be considered bond proxies. Phrases such as ‘dividend aristocrats’ and ‘dividend kings’ came into circulation. Presentations talked of ‘harvesting income’.

“It was astonishing,” recalls Stuart Rhodes, manager of M&G’s Global Dividend Fund. “Even when Colgate-Palmolive was issuing updates on falling sales, investors seemed to ignore reality. Share prices were going up even while revenues were falling.”

It might seem glaringly obvious that bond coupons and share dividends are not the same thing but the search for income has warped many investors’ sense of difference. Trustees of DB pension plans closed to new accruals no longer have regular income from contributions. Baby boomers at the start of their retirement and charities starved of funding in an era of austerity need cashflow. 11

Their predicaments might explain the recasting by some asset managers of equities as securities for income. But just like Rhodes, consultants are wary of the simplistic sell: “We have had equity managers saying: “Look at the dividend yield of 6% on this stock! It’s so much better than an investment grade bond yield of 3.5%”,” says Daniel Banks, investment consultant at PSolve. “But this is comparing apples with oranges. The dividend yield is an income yield whilst the bond yield is based on a yield to maturity which includes the fact the bond is currently trading above par. If you look at the income yield on the bond, it may be very similar to the equity. Who is to say the value of the equity will not fall as the bond will?” Many savers – retail and institutional - Indeed, many ‘quality’ consumer staples, including Kraft Heinz and Campbell Soup, did see their share price tumble last year. Even Colgate-Palmolive has fallen back to a PE were in a situation ratio of 30. where they needed capital appreciation The failure to hold in mind both components of total value – income and capital – for decades of informed a key theme of the CAMRADATA 2018 roundtable on Income Investing. Nicola retirement plus Ralston, co-founder of investment consultancy PiRho, criticised those asset managers income on an and media which have fostered a blinkered obsession with income. She pointed out that many savers – retail and institutional - were in a situation where they needed capital ongoing basis appreciation for decades of retirement plus income on an ongoing basis. She was worried that the myopic focus on income did not meet these investors’ dual needs. The consultants at the roundtable were then asked what combination of asset classes and strategies could meet the dual needs of income and capital appreciation.

Reza Mahmud, investment consultant at PwC, noted that many asset classes looked expensive these days. He said PwC’s clients were looking at a range of alternative fixed income but there was the entry price to consider, not just the asset or strategy characteristics.

Sam Roberts, head of investing at pension fund consultancy, Cartwright, gave an example of a £10m defined benefit plan that he advises. “The covenant with the sponsor is ok but not the strongest. The plan is looking ultimately to reach buyout. To reach that goal, we have an active equity fund to generate returns. Then there is a complementary Absolute Return Bond strategy to provide income and generate some returns,” he said. 12

Aruran Morgan, fixed income analyst at fiduciary manager, SEI, gave a similar example: “A fiduciary client of ours re-evaluated its equity book in 2004 and replaced all market- index-relative mandates with new briefs based on current yield and expected growth. The asset allocation is now between equities and government bonds, with the fiduciary being able to allocate between the two to handle capital calls and income protection.” Morgan added that the managers had been asked to prioritise income yield since 2004 and had generally underestimated and overdelivered income to the fund.

Ralston pointed out that liability modelling and strategic asset allocation are first-order matters for investors. What role then for the asset managers at the roundtable? M&G, offering a Global Dividend Fund; AEW, promoting a real return UK property fund; and Old Mutual Global Investors, with a specialism in CoCos, publicly issued debt which bolsters banks’ capital for a handsome fee?

Global issuance None would claim to be a panacea for every investor’s need. Yet all three were adamant of CoCos is that they did not fall into the trap of promising income without due attention to capital growing, which value too. means current yields are in the Lloyd Harris, co-manager of Old Mutual Global Investor’s Financials Contingent Capitals (CoCos) Fund, buys a unique type of debt, issued almost exclusively by banks to region of 7% beef up their regulatory capital reserves. Global issuance of CoCos is growing, which means current yields are in the region of 7%. Harris challenged the roundtable to find comparable yields on debt issued by single ‘A’ rated institutions.

Morgan raised the story of Banco Popular, a Spanish bank that was put under the resolution process in 2017. Morgan’s concern was that the regulatory response to ailing banks was unclear, which made it harder to value CoCos.

Harris replied that Banco Espirito, like Spain’s Banco Popular after it, was one of a number of troubled banks too weak to be considered by his fund. “Ninety per cent of European banks are in good shape but you have to do your credit work. Banco Popular was trading at a spread of 30%. We don’t need to touch the weaker banks or those kind of yields.” 13

This is one means of protecting capital and eschewing the lure of higher yields from riskier issuers. Ralston asked, however, if the failure of banks that had issued CoCos proved that they were a mere figleaf, not actually fulfilling a protective function.

Harris agreed in part. He explained that in general, by the time capital ratios start falling, the trading of a bank shares starts to seize up and the end is near. CoCos don’t change that. Their purpose, then, is not cure but prevention, ie CoCos help by improving capital ratios up front, not by saving a bank in terminal decline. And Harris sticks to blue-chip names like BNP Paribas, with an equity buffer on Tier 1 Capital of 13%, to keep clients’ capital secure.

The consultants at the table expressed interest in Old Mutual’s CoCos offering. Banks said PSolve had already looked at CoCos already, as has SEI’s Morgan. Yet most consultants expected exposure to CoCos by pension funds and charities to come via a multi fixed income strategy or as an off-benchmark allocation within a credit mandate. Core property’s This was the opinion of Roberts and Mahmud. Harris’s colleague, Craig Stevenson, place as the original head of institutional at Old Mutual Global Investors, understood their perspective. “Multi- diversifier for long- strategy funds make up a proportion of our existing customers,” he said. term investors has Real estate offers real income come under pressure as the volatility from Ian Mason is portfolio manager for AEW’s UK Real Return Fund. He started his pitch total return relative by admitting he had spent the last thirty years apologising for being in an illiquid asset benchmarking has class. Yet today, in 2018, the ‘illiquidity premium’ has become highly fashionable. Yet become increasingly core property’s place as the original diversifier for long-term investors has come under pressure as the volatility from total return relative benchmarking has become increasingly unattractive to unattractive to matching strategies. matching strategies

Mason’s new Fund, however, seeks to earn the majority of its return from income rather than capital gains. This is true of UK property in general on a long-term basis, a fact that many investors obsessed with house prices overlook. The illiquidity characteristic does not help because some asset owners confuse slow-to-sell with little cash generation. This may be true of private equity holdings; it is not true of most real estate.

AEW makes this point explicit by including “Real Return” in the Fund’s name. Not only does 70-80% of property’s return come from income but it is indirectly inflation-linked. Mason gives the example of a care home in Ascot that his Fund owns. Purpose-built care homes are needed in an ageing society like Britain’s and will be for the foreseeable future. 14

The initial revenue is over 6% and is set to grow as it is linked to inflation because the leasee, ie the care home operator, will likely raise its fees, whether to local authorities or private individuals, in line with the cost of living.

While purpose-built care homes offer the best design [unlike conversions of Victorian residences], there should be the ultimate option of reconfiguring the building if needs be. Mason notes this option is feasible, if unlikely, because the cost per m2 of the care home is so far below the cost of residential flats in Ascot. With a portfolio of similar properties, the Fund is distributing over 5% and investor capital is protected by focusing on the property fundamentals of this real asset class. Explicitly named Long Lease funds As ever with investing, price matters and Mason is adamant that AEW has to understand have been all the its sector before it makes a purchase. There have been a few recent high-profile failures rage among UK by care home operators. These would be the equivalent of Old Mutual’s CoCo fund purchasing a BBB-rated bank (but without the security of the underlying property). pension funds. Mason has to ensure that the leasee’s business is viable – or at worst easily replaceable Rather like dividend – because whilst the AEW fund has a weighted average lease length of 17 years, its core ‘aristocrat’ equities, aim is sustainable, repeatable income, secured and collateralised by the underlying real long leases have estate, from not just care homes but also car dealerships, pub tenancies and supported been championed living. as a source of good Explicitly named Long Lease funds have been all the rage among UK pension funds. income in a world Rather like dividend ‘aristocrat’ equities, long leases have been championed as a source starved of yield of good income in a world starved of yield. Alistair Sutherland, pension fund investment consultant at Deloitte, noted, however, that demand for Long Lease funds now outweighs supply. Mason added that Long Lease funds are restricted by their own terms from opportunities involving shorter contracts. His fund, on the other hand, recently purchased a car showroom even though the dealership’s contract expires in a few years’ time. By understanding the dynamics of the operator market, gleaned through years of experience, Mason is confident that the manufacturer will require the dealer to take a new, longer (and more valuable) lease. Such flexibility gives his fund higher returns than the Long Lease fund average.

M&G’s Global Dividend Fund produces wealth from both capital appreciation and income in the form of dividends. Rhodes made the point that when he started the £7bn fund nine years ago, he resisted marketing pressure to label it an income fund. Like the CoCos and Property Funds, it holds approximately 40 stocks. Many of these are global brands, such as Microsoft, JP Morgan and Cisco. 15

Rhodes’ philosophy is that quality companies who grow their dividend are the best sort of equity to own. He points out that M&G used the term quality back in 2009, long before it was classified as a factor by quantitative investors. Like AEW’s Mason, however, flexibility is also needed and the M&G fund approaches quality dividend growth from two moderately different angles (It also has the discipline to sell at the right price).

The other angles are assets – which tend to include more cyclical lower returners such as Siemens – and rapid growth, which are companies such as Visa and pan-Asian insurer, There is a lot of AIA, currently putting on extraordinary spurts. capital at risk from rising bond yields Companies such as Silicon Valley giants Amazon, Facebook and Google are characteristically not dividend-payers. They don’t appear in Rhodes’ portfolio, which even on long lease caused underperformance last year, although not enough to dent his overall record with strategies despite M&G. the fact that they offer a relative yield Looking to the future, Rhodes sees winners and losers from the corporate tax breaks advantage announced under the Trump regime. He told the CAMRADATA panel that benefits would accrue most to those enterprises without intense competition. As an example, he gave railroad haulier, Union Pacific. “There are only seven rail franchises in the US and a couple of operators on each one. New competitors are not going to invade this sector, which means Union Pacific and its shareholders should benefit from lower taxes,” he said. In contrast, Rhodes expected fiscal breaks for retail banks in the US to be competed away on cheaper deals for customers in a harshly competitive sector.

The other managers were asked what rising rates could mean for their portfolios. Harris replied that CoCos reset every five years over the 5-year mid-swap rate. And because there is a spread of maturities in the portfolio, this hedging benefit has an ongoing effect. Having said this, Harris said he expected running yields to fall to 5% over the next three years as rates rise and CoCos issuance slows - but emphasised that this still represented a very attractive spread to other types of corporate debt, whose issuance and yield is likely to follow similar patterns.

Mason made the point that it is only natural to expect that bonds should suffer from the rising rate environment, and the same should be expected of property strategies which are used as bond proxies. This means that there is a lot of capital at risk from rising bond yields even on long lease strategies despite the fact that they offer a relative yield advantage. 16

If we are entering a growth phase of the economy then income strategies that play to the strengths of property as a real asset should win the day.

Sutherland asked about CoCos’ liquidity. Harris pointed out that with names like HSBC having issued a total of £18bn in CoCos, this market was much more liquid than some investment grade markets. The Old Mutual fund itself has daily pricing. Sutherland himself noted that while corporate debt is claimed to be a liquid asset class, the transaction costs are not insignificant. One of the biggest sterling investment-grade funds currently has a bid-offer spread in excess of 100 basis points.

The consultants on the panel made numerous other insights on the complications of accessing alternative sources of income. Mahmud pointed out that infrastructure, real estate and private equity managers are sitting on lots of uninvested cash. He said that on the one hand this showed a potentially more disciplined and longer-term approach to a ‘hot’ market but at the same time questioned what signal it gave to prospective investors about the current investable capacity in some markets.

PSolve’s Banks concluded that the problems around income as a matter of misinterpretation. “People are mistaking income for certainty,” he said. Investing For Income 17

The changing role of real estate in cashflow matching strategies

At a time when interest rates are starting to rise but the hunt for yield goes on, pension funds seeking cash flow matching strategies could do a lot worse than consider real estate income, says Ian Mason, a veteran of the property fund management industry.

This may seem surprising to many who traditionally regard property as a total return asset sitting in the growth allocation of a pension portfolio alongside equities, but with 32 years’ experience at Mercury Asset Management/Blackrock and Schroders, Mason noticed that The issue for the needs of UK pension funds were undergoing fundamental change and he joined AEW traditional core UK to launch their Real Return Fund. “growth” strategies is that they tend to The property fund market has responded well to the changing needs of institutional investors, developing different matching strategies. These include long leases, real estate focus on relative debt and ground lease funds. However, as these have found the greatest support in the peer group total actuarially-driven world of closed defined benefit schemes, they are shaped more as returns that produce bond-proxies rather than strategies aimed at delivering a real total return and preserving cyclical volatility that capital, as well as providing a high level of income. Hence the conviction that there was a is increasingly seen need for something different. an unacceptable risk in cash flow Chart 1. The property sector has responded well to the needs of investors and matching strategies developed a range of new strategies; although these are mainly used as bond proxies:

EXPECTEDPERCEIVEDRISKRISK

GROWTH (TOTAL RETURN FOCUSED STRATEGIES) Opportunistic

Value add

Core funds • Listed core REITS* • Retail core funds* • Institutional core funds* MATCHING (BOND PROXIES) AEW UK Real Return Fund • Open-ended • Alternative real estate • Net 4% total real return target • Gross long term income 5% p.a. Long lease funds

Real estate debt funds

Ground lease funds

Income ‘strips’

EXPECTED RETURN

Source: AEW * All typically seeking to outperform the MSCI peer group total return benchmark

The new AEW strategy focuses on the fact that whether saving for a pension via a corporate defined benefit (DB) scheme, a defined contribution (DC) scheme or a private pension such as a SIPP, most lifetime savers’ underlying liabilities are linked to inflation. Real assets are therefore an excellent match for the cash flows which investors require. The issue for traditional core “growth” strategies is that they tend to focus on relative peer group total returns that produce cyclical volatility that is increasingly seen as unacceptable risk in cash flow matching strategies. 18

Chart 2. The volatility of property’s total return disguises the fact that stable income has driven 70-80% of property’s performance:

40.0

30.0

20.0

10.0

0.0 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

(10.0)

(20.0)

(30.0)

Income Return Capital Growth Total Return RPI Income Return Capital Growth Total Return RPI Source: MSCI

As a real asset however, property has delivered annualised returns of over 5% pa above inflation since 1980. In fact, nominal income returns alone have been more than 6% pa over the same period - ideal for cash flow matching and for inflation-linked liabilities.

So what seemed to make sense to the team at AEW was that if 70-80% of property’s performance came from stable, sustainable income, then the Fund should have a core property strategy that simply focused on cash flow and income growth and avoided the traditional risks like development and leverage. After all, property is a very simple asset class; if you focus on property fundamentals and buy good quality buildings in areas of strong occupier demand, then if the market rent goes up, the value goes up. So unless you have paid a premium for the bond-proxy duration of a long lease, you get the capital growth for free.

Why is this relevant now? Well, in the current economic environment the new dynamic which has come into the equation is the prospect of rising interest rates as monetary tightening in the USA is starting to influence policies in Europe.The prospect of higher inflation driven by growth (rather than rising costs) in the US and UK should not be seen as a threat. Indeed increasing rates are normal at this stage of the cycle and certainly healthy, especially after such a prolonged period of accommodative policy and we anticipate this should not heavily impact the macro environment that should remain very supportive of the prospects for UK growth.

However, it is natural to expect that bonds should suffer from the rising rate environment, especially those delivering a fixed coupon and those with a long duration where expected cash flows will be discounted using higher rates. And the same should be expected of property strategies which are used as bond proxies. This means that there is a lot of capital at risk from rising bond yields even on long lease strategies despite the fact that they offer a relative yield advantage. That might be acceptable in the world of actuarial valuations that assume liabilities also fall alongside valuations, but not if you are a scheme sponsor trying to plug a deficit and few schemes have the luxury of a surplus that allows capital to be eroded whilst driving cash flow off a shrinking asset base.

As usual, the main questions with rates tightening should remain about the pace and speed of rate hikes and on how central bankers manage market expectations to avoid generating “surprises”. We believe that the current rates’ normalisation path will continue although this does not mean the end of growth; but the recent adjustments have signaled the end to the “bonds bubble”. There are, however, ways for fixed income investors to take advantage of this environment as economies rotate into a growth phase.

One of these is real estate income but it requires a strategy where returns are driven not by total returns but by the cash flow available from good quality property and real income growth from occupier demand.

The AEW UK Real Return Fund was launched 2 years ago and as at 31st December 2017 was distributing a 5.3% yield from a portfolio of 35 properties, with a weighted average lease length of over 17 years and 77% of income linked to inflation.The strategy offers clear alignment between the Fund and the needs of investors, as well as a foot inside both equity and bond camps: a real asset growth strategy with relatively high levels of sustainable income as the hunt for yield continues.

Written by

Ian Mason, Director and Portfolio Manager of AEW UK Real Return Fund 20

Fluent in real estate

LONDON PARIS BOSTON LOS ANGELES HONG KONG SINGAPORE | AEW.COM Global Dividend Matters 2121

The value of investments will fluctuate, which will cause prices to fall as well Fluent in real estate as rise and you may not get back the original amount you invested. Equity income is a core investment strategy for pension schemes, insurance companies and other institutional portfolios that has rewarded investors with attractive returns over time through the combination of income and capital growth.

It is also widely acknowledged that the inflation-beating aspect of equities has been driven by the income component – a phenomenon which applies all over the world. Dividend yield and dividend growth have been the dominant forces behind real global equity returns over the long term. As the chart below shows, the short-term share-price movements that Equity dividend can preoccupy investors’ minds have been in reality secondary to the compounding effect strategies have of reinvested income over many years. been in the spotlight Chart 1: Breakdown of real equity returns by country since theas investors

have prioritised Breakdown of real equity returns by country (1970 – March 2016) income-generative investments in 8.0%

bond yields and low 6.0% interest rates 4.0%

2.0%

0.0% Average annual real return return real annual Average -2.0%

-4.0% UK US Canada France Germany Australia Japan

Dividend yield Dividend growth Multiple expansion Dividends account for the dominant part of equity returns Source: SG Quantitative Research, 31 March 2016 Written by Venturing beyond the comfort zone Stuart Rhodes, Portfolio Manager Equity dividend strategies have been in the spotlight since the onset of the financial crisis as investors have prioritised income-generative investments in an environment of low bond yields and low interest rates. When growth was scarce, safety was highly prized and investors sought out the defensive characteristics of equity income, often without heed to value.

Over the past 18 months market sentiment has shifted and today, defensive strategies are facing a more challenging environment. A defensive bias is not always conducive to defensive returns. Interest rates are rising in response to a global economic recovery and against this new backdrop dividend strategies need to find more balance if they are to shrug off their perception as bond proxies. Dividend strategies need to apply flexibility and venture beyond their comfort zone of defensiveness to perform successfully in today’s more buoyant market conditions. Focus on growth, not yield

In our view, the focus on income by many equity investors since the financial crisis has raised questions about the risks associated with high dividend-yield investments. We share this concern, not because of the current market climate, but because of our fundamental belief that a high yield is not an automatic indicator of value. In fact, it is often an indication of a company in trouble or a company with limited growth prospects.

The financial crisis provided a perfect example. There were plenty of stocks during that time with an optically high yield but the lure proved to be illusory in most cases as the LONDON PARIS BOSTON LOS ANGELES HONG KONG SINGAPORE | AEW.COM dividends never materialised. 22 22 22

Conscious of this potential pitfall, we have a clear preference for dividend growth over the highest yielding stocks in the market, based on our core philosophy that companies generating rising dividends, bought at sensible valuations, will deliver excellent total returns through the combination of income and capital growth. Rising dividends create upward pressure on the share price to perform so that dividends and share prices go hand in hand.

In our view, a strict focus on dividend growth also provides a solid foundation to deliver a rising income stream for investors. A dividend growth strategy can provide an investment solution to meet a variety of needs in an institutional portfolio, including total return, rising income and premium yield. For those wishing to reinvest their income, the benefits of compounding may enhance returns further, with time being the critical factor: the longer the timeframe, the greater the rewards. Chart 2: Focus on dividend growth 30

15 Dividend (£) Dividend 10

0 A global portfolio can also provide UK

Dividend (stock yielding 6%, no growth) Dividend (stock yielding 4%, 10% growth) pension schemes The power of long-term compounding and insurers with a Source: M&G, 2017. Illustrative figures only diversified income stream Go where the dividends grow sourced from a The benefits of dividend growth investing are available worldwide, including the UK, variety of countries continental Europe, the US, Asia and emerging markets. A global approach can offer and sectors access to the greatest opportunity set, granting access to an array of companies, industries and themes which are not available in the UK.

A global portfolio can also provide UK pension schemes and insurers with a diversified income stream sourced from a variety of countries and sectors, in contrast to the domestic market where dividends from the FTSE All-Share Index are highly concentrated in oil, pharmaceuticals and banks. A blend of styles

We believe strongly that valuation should be a key element of the decision-making process to ensure that a portfolio is focused on good investments, not just good companies. The prolonged outperformance of defensive stocks is a case in point because the quest for safety and security led to valuations becoming extremely stretched in this part of the market. Telecoms and utilities have suffered from their bond proxy status recently as interest-rate expectations changed, but in the case of consumer staples their fall from grace has been exacerbated by something more fundamental. Food companies, for example, have seen growth rates in their operating performance slow meaningfully, reflecting the competitive pressures in their underlying industry.

A series of disappointing results has subsequently prompted investors to reconsider the high multiples they have been willing to pay in the past. The combination of downward earnings revisions and a de-rating of unsustainably high valuations leaves many defensive stocks vulnerable to further underperformance. 23 23

Defensive stocks do not always deliver defensive returns. In the context of shifting valuations, we believe it is important that dividend strategies have the flexibility to invest beyond the defensive stocks most commonly associated with equity income. We therefore select stocks from three distinct categories, supplementing the defensive core (quality) with cyclicals (assets) and growth (rapid growth) which provide different style characteristics. Chart 3: Three drivers of return

Sources of dividends Company characteristics Dividend profile (typical weighting)*

Quality Disciplined companies with reliable growth In the context of (50-60%) shifting valuations, we believe it is important that Assets Asset-backed cyclical companies dividend strategies (20-30%) have the flexibility to invest beyond the

defensive stocks Rapid growth Structural growth driven by geography or most commonly (10-20%) product line associated with equity income Designed to cope with different market conditions Source: M&G, 2017. *Internal guidelines subject to change

It has been difficult in recent years to have conviction in the valuation of ‘quality’ stocks, but healthcare has been one area where new ideas have been plentiful. The sector’s underperformance in 2016 resulting from concerns around US drug pricing presented an opportunity to invest in profitable, growing businesses on attractive valuations. Tobacco remains the last bastion of value in an otherwise expensive consumer staples sector and we continue to struggle with utilities and telecoms because we can always find more growth elsewhere.

The cyclical exposure gained through our ‘assets’ category is typically the area of the portfolio where value characteristics are most pronounced. We aim to invest in companies which operate in economically sensitive industries – companies with physical assets such as those in the industrial sector or businesses with financial assets such as fund management companies – but have the capital discipline to sustain dividend growth across economic cycles. Cyclical businesses with this specific profile are difficult to find because dividend cuts tend to be the norm during economic downturns, but they do exist and provide a valuable source of alpha during certain market conditions – the recovery in 2009 and 2010 being a good example. This is the area of the market where valuations are most compelling in our view and we see significant upside, particularly in the energy- related sphere.

The ‘rapid growth’ segment provides a different dynamic again by generating the highest rates of growth in the portfolio with annual dividend increases typically in the region of 15-20%, driven by long-term structural themes such as technology or emerging market trends.

The outcome of this three-prolonged approach is a balanced portfolio which is designed to cope with a variety of market conditions.

For Investment Professionals only. This document reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance The distribution of this guide does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.

The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook.

M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. 24

IT TAKES IM GINATION TO GO FURTHER TO FIND VALUE

We understand that meeting your long-term requirements means working closely with you to find investment solutions for your specific needs – targeting the right blend of risk and return through an active value management approach that generates performance for investors. The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance. www.mandg.com/institutions

For Investment Professionals and Qualified Investors only..

This document does not constitute an offer or solicitation. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. MAR 2018 / IM1594

IM1594_Imagine_PensionsAge_Advert_204x271.indd 1 28/03/2018 16:29 COCOs:COCOS: TheThe EvolutionEvolution ofof aa MarketMarket 25

We chart the growth of CoCos from the aftermath of the global financial crisis IT TAKES to today. High yields are hard to find without taking undue risk in today’s world. But the Contingent Capital (CoCo) market currently offers yields in excess of those available on traditional high yield bonds, and with the backing of investment grade issuers. In addition, the returns it generates tend to have a low correlation with other fixed income asset classes – and it is relatively IM GINATION liquid. This all sounds a little too good to be true, but it is not. So how can this be?

TO GO FURTHER TO It is instructive to look at the situation before the global financial crisis. Light-touch regulation had allowed banks’ balance sheets to swell in size, with relatively slim levels of capital supporting them. The true riskiness of the assets was under-estimated, and when FIND VALUE the sub-prime crisis struck the US, the reverberations caused the failure of several banks in Europe. The Contingent We understand that meeting your long-term requirements Capital (CoCo) means working closely with you to find investment Regulators reacted swiftly and aggressively. Banks were ordered to hold far more capital, market currently and measures were put in place to ensure that a failing bank would not have to rely on its solutions for your specific needs – targeting the right blend government for a bailout again. Risk-measurement systems were also tightened, making offers yields in of risk and return through an active value management the holding of certain types of assets, such as collateralised debt obligations, economically excess of those approach that generates performance for investors. unviable. available on traditional high The value of investments will fluctuate, which will cause The effect was dramatic. European banks raised €600bn of fresh equity through rights fund prices to fall as well as rise and you may not get back issues, while they shrunk their balance sheets at the same time as retaining as much profit yield bonds, and the original amount you invested. Past performance is not as they could. This increased equity levels meaningfully, but the process was slow and with the backing of a guide to future performance. bore an economic cost. There was a drive to develop a new form of capital, which would investment grade satisfy regulators in its ability to absorb losses under duress – but would be cheaper and issuers www.mandg.com/institutions quicker to issue than equity. So, with regulatory blessing, the AT1, or Additional Tier 1 CoCo, was born. IMPROVING CAPITAL RATIOS

AT1s fell between two stools: the bonds can be converted into equity, or be written down, under extreme stress; as a result, they did not find their way into mainstream bond indices. Unsurprisingly, they did not find their way into equity indices either, so the traditional buyer base did not invest in the securities. This meant buyers had to be tempted in with attractive yields; the first such bonds were issued with coupons above 8%.

Time has mellowed investors, and yields have dropped, but the complexity of the product and its non-index status has still left some AT1s yielding in excess of 6%, with three times the spread of the same issuers’ Tier 2 bonds.

Importantly, the likelihood of AT1s actually being converted is very low, in our view. Capital ratios have increased hugely across Europe, while balance sheets have been de-risked. Written by As an example of this, the UK ran a stress test of its banks in 2017, where losses for the system were more than five times as high as during the financial crisis, and yet the weakest of the banks, RBS, ended this stress test with a capital ratio significantly higher Lloyd Harris than that with which HBOS entered the crisis. This is a meaningful improvement in Co-Manager solvency. AND Regulation has also been clarified over the last two years. The levels at which AT1 coupons need to be passed were vague until the first quarter of 2016; however, these have now been made clear. Banks themselves are also keen to protect their CoCos, as the capital is much cheaper than equity. Unicredit, for example, chose in December 2016 to raise €13bn of fresh equity to recapitalise rather than being forced to trigger its CoCos. The latter route would have closed the market in the cheapest form of Tier 1 capital to the bank. Rob James HOUSEHOLD NAMES Co-Manager

With regulators and companies both acting in favour of the AT1 holder, and with the For Investment Professionals and Qualified Investors only.. regulation surrounding the coupons now determined, we feel the asset class is ripe for

This document does not constitute an offer or solicitation. The services and products provided by M&G Investment Management Limited are available fresh investment. only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. MAR 2018 / IM1594

IM1594_Imagine_PensionsAge_Advert_204x271.indd 1 28/03/2018 16:29 26

To date there are about US$150bn of the securities in issuance from some of the world’s biggest and best-known banks. The largest issuance has come from HSBC, UBS, Barclays and Credit Suisse – all household names. The estimate is that by the time the banks have issued all the CoCos they are able to, the market will have increased to about US$250bn. Demand also appears to be growing: an issuance by Julius Baer last year was initially thirty times oversubscribed.

Liquidity in the asset class is high – probably the best in the entire credit market – and certainly vastly better than in the high yield market.

So what is the downside? There are certainly a number of tank traps out there. When a bank fails, it does not tend to do so in a smooth fashion, allowing for the gradual erosion of capital levels. It fails properly, overnight. Bank failures are usually preceded by a ‘run,’ The estimate is where deposits are withdrawn and the bank becomes illiquid. This, of itself, should not that by the time the lead to a failure, as central banks have made liquidity available to the system since the banks have issued crisis. But it is a symptom usually of a deeper malaise: a capital problem. all the CoCos they Once confidence in a bank has gone, nothing can save it. Last year in Spain, Banco are able to, the Popular Español was struggling under the weight of historic bad debts; the requirement market will have to write them down to realistic levels was too much for its capital base. A run started, increased to about and the regulator intervened. The bank’s equity, AT1 and Tier 2 bonds were all written off, US$250bn before the remaining business was sold to Santander. This case teaches two important lessons. First, a weak bank is dangerous and should be avoided; and second, in the end, equity, AT1 and Tier 2 face the same risk in extremis – that of total loss.

PORTFOLIO CONSTRUCTION

With the above in mind, the process used to construct a portfolio of CoCos is key. Within the Old Mutual Financials Contingent Capital Fund, there are three separate stages we apply in order to weed out those banks with weakness in their balance sheets and capital structures. • First, there is a creditworthiness test, based on the principles that would allow a fund to invest in a corporate bond • Next, there are two CoCo-specific tests which measure the buffer between the current position and when coupons would have to be turned off

For example, these tests have previously ruled out Banco Popular (never held in the portfolio) and Deutsche Bank.

Our fund offers a very pure exposure to the asset class, with at least 75% invested in CoCos at all times, and daily liquidity. The yield on the fund is currently about 6%; it can also offer a degree of capital appreciation from new issue premia and spread-tightening. It is expected that the vast majority of returns will derive from the fund’s yield, though.

We believe these characteristics will prove highly attractive for yield-seeking investors.

For Professional Investors in Europe ex Switzerland only. Please remember that past performance is not a guide to future performance. The value of investments and the income from them can go down as well as up and investors may not get back any of the amount originally invested. Exchange rates may cause the value of overseas investments to rise or fall.

This communication provides information relating to a fund known as the Old Mutual Financials Contingent Capital Fund (the “Fund”), which is a sub-fund of Old Mutual Global Investors Series plc. Old Mutual Global Investors Series plc is an investment company with variable capital established as an umbrella fund with segregated liability between sub-funds which is authorised and regulated by the Central Bank of Ireland pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011, as amended. Registered in Ireland under registration number 271517. Registered office: 33 Sir John Rogerson’s Quay, Dublin 2, Ireland. This communication is issued by Old Mutual Global Investors (UK) Limited. “Old Mutual Global Investors” is the trading name of Old Mutual Global Investors (UK) Limited and Old Mutual Investment Management Limited. Old Mutual Investment Management Limited, Millennium Bridge House, 2 Lambeth Hill, London EC4V 4AJ. Authorised and regulated by the Financial Conduct Authority FRN: 208543. Old Mutual Global Investors (UK) Limited, Millennium Bridge House, 2 Lambeth Hill, London EC4P 4WR. Authorised and regulated by the Financial Conduct Authority FRN: 171847. A member of the Investment Association.This communication has been prepared for general information only. It does not purport to be all-inclusive or contain all of the information which a proposed investor may require in order to make a decision as to whether to invest in the Fund. Nothing in this document constitutes a recommendation suitable or appropriate to a recipient’s individual circumstances or otherwise constitutes a personal recommendation. No investment decisions should be made without first reviewing the prospectus and the key investor information document of the Fund which can be obtained from www.omglobalinvestors.com. Certain paying agents have been appointed in connection with public distribution of the shares of the company in certain jurisdictions. Shares are sold by Prospectus only. The prospectus, KIID and/or other relevant offering documentation is available free of charge at: Austria: Erste Bank der oesterreichischen Sparkassen AG, 1010 Wien, Petersplatz 7, Austria. Belgium: CACEIS Belgium SA, B-1000 Brussels, Avenue du Port 86 C b320, Brussels. Germany: Skandia Portfolio Management GmbH, Kaiserin-Augusta-Allee 108, 10553 Berlin, Germany. France: BNP Paribas Securities Services, Les Grands Moulins de Pantin, 9 rue du Debarcadère 93500 Pantin, France. Hong Kong: Old Mutual Global Investors (Asia Pacific) Limited, 24th Floor, Henley Building, 5 Queen’s Road, Central Hong Kong. Italy: Allfunds Bank S.A., Estafeta, 6. (La Moraleja) Complejo Plaza de la Fuente – Edificio 3 – C.P. 28109 Alcobendas, Madrid; Societe Generale Securities Services S.p.A, Via Benigno Crespi 19A – MAC2, Milan and BNP Paribas Securities Services, Piazza Lina Bo Bardi No.3, Milan. Luxembourg: BNP Paribas Securities Services, Luxembourg Branch, 33 rue de Gasperich, L-5826, Grand Duchy of Luxembourg. Spain: Allfunds Bank, C/ La Estafeta 6, Edificio 3, 28109 Alcobendas, Madrid, Spain. Switzerland: First Independent Fund Services Ltd. is the Swiss representative and BNP Paribas Securities Services, Paris, succursale de Zurich, is the Swiss paying agent. Taiwan: Capital Gateway Securities Investment Consulting Enterprise, 9F/9F-1, No. 171, Songde Road, Xinyi District, Taipei City, Taiwan, R.O.C. United Kingdom: Old Mutual Global Investors (UK) Limited, 2 Lambeth Hill, London, EC4P 4WR, United Kingdom. The Fund is recognised by the FCA. Other: Old Mutual Global Investors Series plc, c/o Citibank Europe plc, 1 North Wall Quay, Dublin 1, Ireland.OMGI 03_18_0097 27 IT’S A COMPLEX FINANCIAL WORLD OUT THERE.

WE MAKE SENSE OF IT.

Old Mutual Global Investors is the London-based asset management arm of Old Mutual Wealth. We manage £43.5bn* on behalf of UK and International clients, including public pension schemes, sovereign wealth funds and financial institutions.

We don’t believe in house style. Instead, our fund managers actively manage assets using their own expert judgement, giving them the freedom to seize opportunities in a fast changing market.

Today’s complex, interconnected and increasingly globalised world requires fund managers to be more transparent and accountable than ever. But more importantly it calls for a simple, clear and sensible investment approach.

Please remember that past performance is not a guide to future performance. Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested.

www.omglobalinvestors.com [email protected]

For investment professionals only. *Source: OMGI, AUM as at 31/12/2017. This communication is issued by Old Mutual Global Investors (UK) Limited (trading name Old Mutual Global Investors), which is a member of the Old Mutual Group. Old Mutual Global Investors is registered in England and Wales under number 02949554 and its registered office is 2 Lambeth Hill London EC4P 4WR. Old Mutual Global Investors is authorised and regulated by the Financial Conduct Authority FRN: 171847 and is owned by Old Mutual Plc, a public limited company limited by shares, incorporated in England and Wales under registered number 3591559. OMGI 04/18/0031. Models constructed with Geomag.

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