Monthly Fund Focus: Bull market alert, Hedging risk, Biotech Opportunities and UK Smaller caps

With markets, the US ones in particular, in a bullish mood over the summer months, and volatility still well below long-term averages (even after the recent tech sell-off), our monthly look at funds continues its search for ideas that could hedge downside risk, focusing this time on managed futures funds. On a more optimistic note, we also examine the case for investing in UK small-cap funds, and if you’re feeling especially bullish, we reiterate why a UK-listed biotech fund might be worth a closer look.

Bull market alert

The online stockbroking platform Interactive Investor has started publishing a handy list of their top 50 funds, traded quarterly by private clients. I always find these valuable exercises because they give us insight into the market mood. The graphic below contains the first 25 funds in that list, and nothing in it should come as any great surprise. Highlights include: Investors are favouring a global approach rather than seeking funds that invest in a specific region; nearly one in three funds (15) in the ii Top 50 Fund Index invest in global shares; Technology strategies account for seven of the top 50 funds; Investment trusts dominate – 20 make the top 50 cut; The US market is the second-most popular region, with seven funds featuring; Lower down the list, the UK has only three funds, India has two, and Europe and Asia Pacific one each.

This is a reassuring list in many respects, as there are no weird or insanely risky funds in the first 25. However, there is a strong bias towards risky assets and equities, and by default, towards US equities—which comprise 60 and 70% of most global equity funds—and thus to US mega large-cap tech stocks. The Magnificent Seven.

In the list, I count only three funds (gold, Greencoat UK Wind, and the money market unit trust from Royal London) with an avowed risk-off (cautious) strategy, plus four funds (Fundsmith, JPMorgan Global Growth and Income, Vanguard Lifestrategy 60%, and City of London) with a more defensive equity strategy.

In a sense this makes sense. Equity markets are in a bull market, and one way of measuring that is to look at measures of equity market volatility, notably the Vix index, which tracks turbulence in the S&P 500 index. For much of the last year, this index has been remarkably calm – as I write this, it’s picked up a smidgeon to move above 18 but this is well below the long-term average for this closely watched index.

Yet a recent article in US investing magazine Barrons puts some flesh on the bones of the history of volatility metrics. It’s based on research by a firm called DataTrek, which says that since 1990, the index’s average daily close has been 19.49. The 30-day rolling average for the measure is currently at 12.73. But DataTrek reminds us that statistically the Vix has traded at low levels for longish periods of time. “The fact that the VIX is abnormally low by statistical measures is entirely consistent with a bull market, and this has happened in every bull market since the 1990s,” he told Barron’s in an interview.

VIX readings lower than 15.55 have happened before in long periods: 1991-1996, 2004-2007, 2011-2019, and the present since 2020. Except for 2018, the S&P 500 is up in all of those years, Colas says. “Current low VIX readings are not an anomaly, but rather a historically reliable signal that U.S. large-cap stock prices can and should advance from here through the rest of the year,” Colas wrote. Realized volatility, or past volatility, has been on the decline as well. According to Macro Risk Advisors, the S&P 500’s realized volatility currently stands in the lowest 1% of historical levels, going back to 1990. The Cboe Realized Volatility Index, which measures market volatility for the past 21 trading days, stood at 6.4 last week, compared with just below 10 at the end of May, according to Dow Jones Market Data.

I think that the world’s biggest, most liquid market is in fine form and possibly complacent about the risks is an understatement. We are living through quite extraordinary times. Dylan Grice a former strategist at French investment bank SocGen and now at hedge fund Calderwood Capital puts it pithily as follows: “Over the last seven years, the S&P500’s excess return has annualized at 11.9%, roughly the 85ᵗʰ percentile since the 1970s. The Nasdaq 100 has been even stronger, posting 18% over the last seven years (8ᵗʰ percentile). Historically speaking, that’s unusually strong, and almost as good as it’s ever been. It may well continue. Indeed, for all we know, the AI revolution driving today’s market may be underpriced!”.

Given that I’m a professional cynic this triumphant exceptionalism fills me with dread. As experienced investors, I’m sure you can all come up with all sorts of things that might go wrong and puncture the melt-up prospect: geopolitical risk, valuations, slowdown, Nvidia in trouble, Taiwan… Surely, now might be the right time to start moving some money towards more defensive strategies, perhaps even hedging out market risk.

Hedging risk – Managed futures funds

The obvious trade is to switch into a risk on/risk off mode and switch any bumper proceeds into risk-free assets, cash or Treasuries. But Treasuries don’t strike me as ‘risk-free’ in an era of rising government deficits and worries about bond vigilantes dumping gilts and Treasuries. Cash or money market accounts have less risk but have their obvious downsides (not least when it comes to charging fees) in an era where inflation rates will probably stay well above the target 2% level, dictated by central bankers. In these circumstances, it might be worth investigating strategies that hedge risk, with one strategy standing above all – managed futures.

A useful working definition of managed futures strategies can be found HERE: “Managed futures strategies have historically generated positive long-term absolute returns independent of overall market direction, providing a differentiated source and pattern of returns when compared to traditional stock and bond portfolios. Through their ability to take long or short positions across a diverse set of global markets, these strategies have tended to display low long-term correlation to traditional stocks and bonds, which may provide much-needed diversification benefits, especially during periods of market crisis or dislocation”. There are a number of elements:

• The strategies use highly liquid futures and forward contracts
• They operate on long and short periods
• Trend following they tend to be lowly correlated with different market regimes
• Many of the funds that use this strategy are hedge funds, and some of them started off as commodity-focused trend followers, hence the term CTA
• Most of the successful funds in this space charge a large amount in fees and are highly quantitative, using advanced computing power

Managed futures funds don’t always produce the returns they promise. The chart below shows returns for the last few decades: many CTA and managed futures funds had a dismal 2010s.

I do not like investing in complex hedge funds that charge an arm and leg for poor returns. But I do think for the right kind of cautious investor, these strategies make some sense – if you can find a low-cost implementation. Luckily, over the last decade, we’ve seen a profusion of lower-cost ETFs launched in the USA that aim to replicate CTA and managed futures strategies – but in a lower-cost, more transparent ETF wrapper. There are now over a dozen such ETFs in the US and more coming every year.

Over here in the UK, there are no managed futures ETFs, but there is a useful alternative. One of the leading US hedge fund replication specialists, DBi, has launched a conventional unit trust or OEIC structure called the iMGP DBi Managed Futures fund. This effectively echoes or mirrors the firm’s US strategy but in a wrapper that is recognisable to UK fund investors. There’s a sterling version of the Luxemburg domiciled fund (Bloomberg ticker IMDBMIG LX, ISIN LU2552452950), which has capped costs at just under 1%. According to the end April fund fact sheet, year-to-date returns for the strategy are a gain of 12%, over 5 years 8.9% annualised returns and since inception 6% pa.

Fund description: Seeks to replicate the pre-fee returns of a representative basket of leading managed futures hedge funds. Aims to minimize three key risks of hedge fund investing: low liquidity, concentration risk and selection bias. Takes active positions in futures contracts across the asset classes while offering daily liquidity and lower fees. The iMGP DBi Managed Futures fund aims to generate long-term capital growth by replicating the pre-fee performance of a representative basket of leading managed futures hedge funds. Factor analysis is used to determine the key positions of these funds, which are then replicated through highly liquid futures contracts across equities, fixed income, currencies and commodities. Structured as a UCITS fund, it is an efficient way to access this style of investing that reduces costs, mitigates single-manager risk and offers daily liquidity.

For some investors, a managed futures fund could be a useful alternative to a cautious allocation to short-duration bonds or an exposure to cash. If managed futures strategies like iMGP DBi deliver on what they promise, they might deliver cash-plus-like returns with relatively low volatility, independent of the macroeconomic regime (inflationary, deflationary) we find ourselves in.

RTW Biotech Opportunities

RTW has undergone a profound transformation in the last few years. I’ve been a fan of this fund for at least the last two years, and I continue to own stock and add to that holding regularly. When I first started writing about the fund, it was seen by many in the market as more focused on life sciences venture capital, with more of an emphasis on private investments. That puts it in the same category as another UK-listed fund, Syncona, which has been deeply unpopular in the UK and which currently trades at a discount of over 40%.

But RTW has been transformed over the last few years into a vehicle that is primarily invested in listed biotech firms, admittedly on the smaller cap end of the spectrum. The great majority of its portfolio investments are now public companies and private companies are probably no more than 12 to 18 months away from an IPO. The takeover of Arix – another UK-listed life sciences investor – was also instrumental in that transformation, delivering a healthy pile of cash, which it has now broadly deployed.

From a low point in NAV terms in late spring 2022, we’ve seen the NAV climb steadily to the current $1.95 a share—the NAV increased by 7.7% in June alone, with the fund boasting a NAV of $655m. By comparison, the Russell 2000 Biotech Index and the Nasdaq Biotech Index returned -6.51% and +2.6%, respectively. The RTW share price discount has also tightened from a peak of around 40% to its current level of just under 20%.

The current increase in the NAV is being driven by gains in a firm called Avidity, which has driven returns for the second quarter in a row. According to RTW, “The company shared Phase 1 data for its second program, FSHD, another muscular dystrophy with no approved drugs that ends with patients in wheelchairs. Treatment improved muscle damage markers and increased muscle strength. After some struggles the past couple years, second generation RNA medicines are now delivering exciting breakthroughs.”

The Arix deal has also allowed the fund to ramp up its programme of new investments. RTW completed investments in six new private companies in the first half of the year, including two in obesity – this included a firm called Hercules which according to RTW is “one of the largest biotech company creations this year. Its clinical-stage pipeline includes an injectable GLP-GIP and an oral GLP in-licensed from Hengrui, one of China’s leading biopharma companies.”

RTW has also benefitted from M&A activity and new IPOs. One such deal was J&J’s takeover of Numab, a bispecific immunology company, which was bought for $1.25bn. To reflect the deal, the company’s holding value of Numab was increased by 2.86x. In terms of IPOs, Artiva Biotherapeutics has just completed its listing, valuing it at $116 million. As of 30 June 2024, Artiva represented 0.13% of the Company’s NAV.

I’d also note that broker sentiment is improving regarding RTW. Investment bank Jefferies and their highly regarded analysts Matt Hose only last week brought out a note suggesting the fund was a buy.,

“We see RTW as uniquely positioned among life science funds, as its approach of full lifecycle investment across the capital structure widens the opportunity set and allows for various points at which to crystallise value. Its private marks seem fair given frequent revaluations and a strong track record of uplifts to IPOs/exits, something that will become increasingly pertinent as the fund once again makes greater use of private investing following a shift away from public market opportunities. Risks include a key man (Roderick Wong) and a lack of formal discount control/continuation votes. The latter provides limited share price catalysts, although in NAV terms the portfolio will likely benefit from the IPO window opening, in addition to industry trends underpinning biotech M&A. RTW trades on a 25.4% discount to our estimated NAV, and we initiate coverage with a Buy recommendation.”

I would point to a possible tightening of the discount as a crucial short-term driver of the share price. The great majority – over two-thirds – of the portfolio is now in publicly listed businesses, which puts the fund in the same peer group as Biotech Growth Trust and BB Biotech – both of which I also rate highly. These long-established funds have a significant small-cap bias – as does RTW – and Biotech Growth Trust trades at a roughly 9% discount, while BB Biotech trades at an 8% discount. RTW does have greater private investment exposure but many of these businesses are very late stage (no more than 18 months), and thus a more significant discount compared to Biotech Growth and BB) is justified but not one that is a shade under 20%. My own sense is that a 10 to 12% discount would be more appropriate, which would imply a 9 to 7% tightening of the discount over the remainder of the year.

Time for UK Smaller caps?

I’m not going to add very much to the immense tidal wave of commentary about the UK general election except to say that.

• The markets didn’t seem terribly concerned.
• Compared to some countries (looking at you the French) we might seem to have a chance of more stability at the governmental level in the next few years
• Labour has a tough job facing them. I don’t envy them the task, especially with a wave of Reform voting and a rebellious left flank populated by Green MPs, and independent Muslim MPs
• I’d forget about any prospect of tax cuts for the next few years

As a boring economic and investment type I’m more inclined to look at the hard data points and make the following points:

• We are fast approaching the first interest rate cut in the UK, probably in early autumn
• The UK market is cheap on any sensible measure
• M&A activity in the UK market is picking up (see next section)
• Consumers are now enjoying positive income growth, with inflation looking like it is plateauing below 3 to 3.5%
• Many international investors will be looking for ways of diversifying away from exuberant US equity markets

The M&A point is crucial. Recent research from broker Peel Hunt shows that many interested buyers—hedge funds, PE funds, and international investors—think many UK corporates are cheap and represent good value.

Charles Hall is head of research at the broker, which has very publicly warned that the UK market – funds and operating companies – is in danger of falling into a death spiral because of a lack of interest in the UK and negative policies. As an investment advisory firm, they have been admirably blunt about the headwinds, so when they come out with some positive news it’s worth taking note. Hall recently circulated a research note that the pace of takeover activity for UK companies generally, and specifically smaller market cap companies, is increasing. Here are some choice quotes from the report:

• M&A activity is on the up. Bids announced YTD and still live amount to an equity value of £43bn. Including the bids announced last year and completed this year, and delistings from the UK, the total value is £95bn.
• Going up the market cap – Of the 32 transactions announced in 1H, 17 were in the FTSE 350, 3 in the FTSE Smallcap and 10 on AIM. In the whole of FY23, there were 39 transactions announced, of which 2 were in the FTSE 350, 14 in the FTSE Smallcap and 19 on AIM.
• Increase in pace – There has been an acceleration in both the number and scale of transactions over the last few quarters, with 2Q being the busiest period both by number (21) and value (£26.5bn).
• More corporate buyers – Last year, the majority (56%) of offers were from financial buyers. However, corporate buyers (72%) have dominated in 2024 as the rate environment and economic outlook have become clearer, demonstrating the value of UK companies.
• Multiple offers – There have been 6 competitive situations YTD (Alpha, C&R, DS Smith, Hipgnosis, Spirent and Wincanton) and 8 raised offers.
• High premiums – The average premium thus far in FY24 is 40%, with some offers materially higher than the undisturbed price (e.g., Wincanton +104%, Spirent +86%, IDS +73% and Keywords Studios +69%).
• Overseas appetite – Overseas bidders are c.60% of the total YTD.
• Sector focus – Tech and Real Estate have been the most active sectors.

I suspect that we’ll see even more activity in the smaller cap end of the London market. To underline that point I was particularly drawn to an analysis by Charlie Morris of ByteTree. His point last week was that UK smaller caps, in particular, have fallen far behind their peers internationally.

“Having been highly correlated with global equities for three decades, UK small-caps have fallen behind. $100 in the world index back in 1994 would be worth $947 today, and in the UK smaller companies, $691. Over 30 years, they were not supposed to keep up with global equities but smash them. The high point on the purple relative chart was in May 2007 when UK small-caps were 70% ahead of the world over 12 years. Since that time, it has been carnage.

Chart: UK Small-Caps Relative to the World Total Return in USD – 30 Years

Source: Bloomberg

“Rebasing the chart to May 2007 shows UK small-caps lagging the world by 65%, which means they need to double to catch up. The good news is that they will, and that’s why the smart money is getting interested. It starts with the smart money, and the big money follows.”

“To compare against smaller companies elsewhere, I have used MSCI data for consistency, with dividends reinvested and priced in US dollars. There’s a surprise. UK small-caps kept up with US small-caps from the pre-financial crisis May 2007 peak right up until the pandemic in 2020. The US smalls then ripped, leaving the UK behind. Interestingly, European, Emerging and Japanese small-caps stayed in a tight group for 15+ years. This similarity is remarkable and suggests to me that small caps, in general, will be a market-beating force for years to come.”

“Comparing valuations across regional small-caps isn’t easy, but we can get a pretty good idea by comparing the price the market is willing to pay for sales, i.e. the price-to-sales ratio. UK smalls were up there with the US smalls, which remain lofty. Yet the UK smalls have fallen back down into the general pack. In conclusion, they are too good to be this cheap and deserve to trade at a premium.”

If we accept this analysis, which I do, then I think it’s worth focusing on the diverse though slightly moribund (in investor interest) world of UK-focused mid and smaller-cap investment trusts. The logic here is obvious – as large caps get snapped up, investors (trade, PE and foreign) will move down to the cheapest segment of the market where liquidity is poorer, and bargains abound. With this strategy in mind this week, I’ve been exploring the funds’ database of Numis analysts, looking at a series of measures of recent returns.

In the All-Companies segment, which has a clear mid-cap bias leaning larger cap, there are two stand-out funds: Fidelity Special Situations and the Aurora Investment Trust (where I am a non-executive director). The latter has a very explicit value focus on a concentrated portfolio, whereas the former is a broader portfolio. As I have a clear bias in favour of Aurora—where I own a fair bit of stock—I’m not going to make any great observations on this mid- to large-cap arena.

Instead, I’ll focus on the smaller cap end of the fund’s spectrum. Using that Numis data, I’ve zeroed in on UK small-cap and micro-cap funds, except activist funds and UK equity income. The main metric I have used is Net asset value performance over discrete 1,3,5, and 10-year time frames against the benchmark, which is either the FSE Small Cap index or the long-standing Deutsche Numis Smaller Cos inc AIM ex ICs index. I’ve also deliberately excluded funds with a market cap below £100m, mainly because I’m worried they are sub-scale, and this might be a tad illiquid.

You can see the highlights of this analysis in the big table below which looks at both price returns and total returns.

Looking at past performance, one fund stands out above all – Strategic Equity Capital. One other fund also has an impressive track record, Rights and Issues. Both of these funds have pretty consistently beat their respective benchmarks consistently. The slight challenge with Rights and Issues is that it’s now undergoing a change of manager, which might hit future performance – assuming, of course, that past performance has any relevance to future returns.

The chart below shows the performance of SEC versus Rights and Issues over the last four years. SEC stands out and is in black while Rights and Issues is in green.

Looking at Strategic Equity Capital, we can see the top ten holdings in the box below:

The next chart below shows all the important sector allocations. Notice the heavy bias towards the UK tech sector.

Fund Details for SEC

• Description: Actively managed, it maintains a highly-concentrated portfolio of 15-25 high-quality, dynamic, UK smaller companies, each operating in a niche market offering structural growth opportunities. SEC aims to achieve investment growth over a medium-term period, principally through capital growth. The team looks to find companies with the potential to double shareholder value every five years. The SEC team applies Gresham House’s highly disciplined private equity approach to public markets, with constructive corporate engagement and thorough due diligence. SEC has a concentrated portfolio of 15-25 high-conviction holdings with prospects for attractive absolute returns over our investment holding period.
• Portfolio value is likely to be concentrated in the top 10-15 holdings
• fund manager Ken Wotton
• Net assets £168m, market cap £155m (at 31^st March 2024)
• Current holdings: 16
• Ongoing charges 1.20%
• Performance fee: 10% above rolling 3-year FTSE Small Cap ex IT Total Return +2% p.a., subject to high watermark

~