Rathbones Group

We believe that a disciplined investment strategy incorporating an asset allocation framework is the key to providing consistent risk-adjusted returns to meet our clients’ objectives. We divide up the various investable asset classes into three distinct categories.

The ‘Liquidity’ portion covers the safe and secure investments such as government bonds, high quality corporate bonds and cash. These should have low levels of volatility, at least in comparison to other asset classes, and thus should be readily realisable even during periods of market stress. It is this portion of the portfolio that should match any short-term requirements, including any liquidity needs. The weighting will also to a material extent reflect your risk tolerance.

The second category is termed ‘Equity Risk’. This represents investments which are highly correlated with, or sensitive to, the economic cycle and investor sentiment. Thus, as the economy recovers and optimism returns these assets should perform well but, on the flip side, as economies weaken or fall into recession they may decline in value. Investments such as equities plus higher yielding corporate bonds are good examples of what is included in the Equity Risk category. These investments should, given their more volatile and risky nature, generate the bulk of the returns of a portfolio being invested for the long term.

The last category is ‘Diversifiers’. These should, in theory at least, be relatively uncorrelated to the economic cycle and aim to generate returns independent of economic and market conditions. This portion should thus provide further diversification to a portfolio comprised solely of equities and bonds and therefore reduce the overall risk profile of long-term portfolio. Examples of Diversifiers are infrastructure assets, commodities, commercial property and absolute/targeted return funds.

The key to our approach is to ensure that we combine these different categories of investments (Liquidity, Equity Risk and Diversifiers or ‘LED’) to meet your objectives. Their relative weightings will vary as different opportunities or risks arise, or if your investment requirements (including your risk profile) change.

Our LED investment philosophy was born out of the lessons learnt from the Global Financial Crisis in 2008. It remains under constant review and senior investment committees (and in particularly our Strategic Asset Allocation Committee, supported by our macro economists – see more on this below) host regular offsite sessions to continually challenge both the philosophy and its application. For example, assets that are candidates to be included in the ‘Diversifiers’ part of the portfolio are regularly stress-tested against stringent criteria to ensure any potential new diversifier displays the risk and return characteristics consistent with what we expect this part of our clients’ portfolios to achieve.

Our Strategic Asset Allocation Committee (SAAC) is made up of the most senior and experienced fund managers in the firm. The Committee’s aim is to determine our views on the outlook for the various asset classes in which we invest for our clients.

We use a variety of quantitative and qualitative inputs to guide our asset allocation decisions. The committee’s work is well-resourced, being supported by our own in-house research team and intelligence drawn from a variety of other sources, for example third party investment strategists, policymakers, surveys and economists. We regularly use research from the following firms: Capital Economics, Cornerstone, BCA Research and Gavekal. Each group utilises distinct methodologies to arrive at their conclusions which prevents confirmatory bias.

Our views incorporate macro-economic issues such as:
 Geopolitics
 Economic growth expectations
 Central bank policy
 Interest rates
 Inflation
 Liquidity

These factors are analysed in tandem with specific asset class information such as risk premiums, volatility, credit spreads, earnings growth, cash flow, dividend growth and valuations.

The ‘LED’ (Liquidity, Equity Risk, Diversifiers) approach detailed earlier is embedded into the framework and this helps us to control and manage risk.
SAAC’s work is essential to help our investment managers form an opinion on the state of the world economy and the investment opportunities available. High level asset class ‘models’ constructed by SAAC aim to produce an effective risk-adjusted combination of asset classes and these provide guidance for managers.

Our investment managers then produce bespoke investment portfolios using the models as their guide and reference point for a variety of mandates.

After our asset allocation strategy is defined, the next step is to populate the portfolio with the most appropriate investments including individual securities and pooled funds (collectives).

We research all investment ideas across a range of eight criteria, which analyse the underlying businesses or pooled funds. We assess risk across four key areas, which are related to meeting client requirements and our long-term approach to preserving and enhancing the value of wealth. These processes generate investment opportunities in individual equities and fixed income securities, as well as collective funds from across the whole market.

EQUITY SELECTION
Our philosophy as long-term investors is to identify high-quality global companies at attractive valuations which are strategically positioned to take advantage of some of the key mega-themes shaping our future. To do this we have a robust, repeatable process that starts with quantitative screening and ends with meeting our portfolio companies regularly. We believe this allows us to challenge our thought process continually and to identify new and interesting opportunities.

Quantitative screen
With a global universe of around 9,000 companies available to us, we aim to own the best quality companies aligned with the mega-themes of tomorrow.
We run an initial quantitative screen regularly to refine our investment universe and this focuses in on several key financial indicators, including:
— Free cash flow (FCF): We seek companies that generate strong FCF, a testament to their financial health and ability to invest in growth, pay dividends or buy back shares, thus creating value for shareholders.
— Revenue growth: We focus on firms with robust revenue growth, both at an absolute level and relative to their sector, and ideally outpacing the broader equity index too.
— Profit margins: We prefer companies with strong profit margins relative to other firms in their sector, and this is often indicative of pricing power and/or cost advantages.
— Balance sheet strength: We assess the financial resilience of companies, considering debt levels and other balance sheet indicators in relation to industry norms.
— Attractive valuations: There is no point investing in a company if all of the ‘good news’ is priced in. Good businesses only become great shares to own when purchased at attractive prices. We use a variety of different measures to ensure we don’t overpay, including FCF yield vs sector and benchmark, discount cash flow model analysis and a relative strength indicator that can highlight shares that are ‘overbought’.

Thematic analysis
Having identified those companies that meet our minimum financial requirements for investment (generally numbering around 700), our thematic knowledge and insights play a critical role in identifying catalysts that can contribute to sustainable sector growth and stock outperformance.
We have identified six mega themes that help us to identify companies that have the potential to deliver sustainable growth over the long term. This narrows our target universe further to circa. 300 names.

Qualitative Analysis
Our understanding of individual company risk comes from assessing the attractiveness of the company’s products and services and the strength of its management team. Essentially, we are trying to understand how resilient a company should be under a variety of different economic conditions and whether a company can sustainably increase its earnings over time.

This involves analysing the growth prospects of the company as laid out by the management team, as well as the competitive environment. Companies with a durable competitive advantage, strong brands or a technological edge that creates pricing power and ultimately significant market share are likely to be more predictable. These types of company should be relatively resilient in difficult market conditions, thus making them less risky from an investment perspective.

To mitigate investment risk within the portfolio, we integrate ESG factors into our stock selection process as these can have a material impact on company performance. We focus on the extent to which a company has developed robust ESG strategies and demonstrated a track record of managing its own ESG risks and opportunities.

We actively look for companies with sound financial and ESG characteristics. We use a range of external information sources which aid us on this front such as MSCI, Sustainalytics, Fitch, S&P and SASB. Amongst other things, these tools provide sustainability analysis to improve our understanding of the most important ESG issues (risks and opportunities) facing a particular company. We do not rely on third party systems, however, and our analysts and dedicated Stewardship Team conduct proprietary ESG analysis as part of their fundamental research into companies.

We review quarterly results calls and attend company ‘capital market days’ to confirm if we have conviction in company strategy.

Our combination of significant internal research resource and external research analysis (which provides a wider context and a healthy challenge to internally held views) sets us apart from many other investment firms which are heavily reliant on either the former or latter.

Overall, around 150 companies at any one time are eligible for potential inclusion in client portfolios and these represent our ‘watchlist’

Portfolio implementation
We look to blend the most attractive long term global opportunities across geographies and our mega themes with a strong firm valuation discipline to achieve a diversified portfolio of 45-60 global equities. Sector, country and currency risk are monitored to ensure diversification of risk.

Our ‘sell discipline’ kicks in when our ‘suspect screen’ identifies stocks that have both underperformed and experienced earnings and cash flow downgrades. This has proved to be a useful way of identifying structural deteriorations in investment theses, and it helps to prevent subjective attachment to investment ideas.

FIXED INCOME SELECTION

Theme-based investment
Individual ideas are generated from a blend of ‘top-down’ and ‘bottom-up’ thematic views. A list of areas from where themes are generated is included below. This is not an exhaustive list but gives a general view of how ideas are generated.
— Macro
— Sectoral
— Regional
— Supply
— Demand
— New issuance
— Regulatory issues
— Interest rate policy

Credit analysis
Quantitative analysis forms an important part of all layers of our fixed income investment process. However, our credit analysis approach is a good example of how we mix quantitative and qualitative approaches to arrive at conclusions. These decisions are primarily based on the core investment principles of the ‘four C’s plus’ model. This is a text book way of managing fixed income assets, with the added level of investment philosophy of Conviction.

The four C’s are:
— Character – Looks at management integrity, and the likelihood of repayment of loans (operating records of management are important)
— Capacity – Looks at the availability of cash-flows and assets to repay obligations
— Collateral – Looks specifically at assets offered as security as well as other assets managed by the company
— Covenants – Looks at the prospectus and how the details within that affect the lending agreement and any restrictions on the bond.
The ‘plus’ is:
— Conviction – To achieve long term above average performance, investors must think differently to the market. This may involve contrarian investing, a sceptical evaluation of orthodox thinking, patience and discipline, but ultimately a determined conviction.

Valuation
Once we have developed our themes and carried out in-depth credit analysis, we then review the current valuations of bonds in the market. This involves looking at where bonds sit on the credit curve, and at relative value trades. We also try to identify bonds that despite their weaker credit analysis score are technically too cheap. New issue markets can add an extra level of ‘alpha’ here.

From a technical perspective we use a number of techniques for buy/sell disciplines. These include ‘Fibonacci’ and ‘Bollinger’ graphs as well as ‘z-scores’ that help in the rich/cheap analysis, as well as views on outright yield and spread relative to others.

Risk management
Rathbones operates a ‘three lines of defence’ model to support our risk management framework. Responsibility and accountability for risk management are effectively broken down into three lines as follows:
• First line: senior management and operational business units are responsible for managing risks, by developing and maintaining effective internal controls to mitigate risk.
• Second line: the risk function and compliance function maintain a level of independence from the first line. They are responsible for providing oversight and challenge of the first line’s day-to-day management, monitoring and reporting of risks to both senior management and governing bodies.
• Third line: the internal audit function is responsible for providing an independent assurance to both senior management and governing bodies as to the effectiveness of the group’s governance, risk management and internal controls.

In addition to the framework above, Rathbones has within the first line an investment process and risk function that operates independently of portfolio management teams and reports ultimately to the Head of Investment Management.

Rathbones employs external auditors (currently Deloitte) to produce a report annually under the framework set out by the International Auditing and Assurance Standards Board (IAASB) International Standard on Assurance Engagements 3402 (ISAE 3402) ‘Assurance Reports on Controls at a Service Organisation’.

Investment risk oversight
Client portfolios are monitored by senior management in performance and volatility terms on a quarterly basis. Subject to thresholds, performance that is over or under the relevant benchmark must be explained by the investment manager and reported back to senior management.

Our investment risk team monitors many aspects relating to portfolio construction to ensure that the composition of portfolios is consistent with clients’ investment mandates. This includes issues such as portfolio ‘concentration’ risk, large holdings relative to the size of the portfolio, and asset allocation outliers (beyond agreed tactical ranges). Exceptions outside of pre-agreed tolerances are identified for follow-up with investment managers.

Managing risk within portfolios
Risk management sits at the heart of our investment process. To manage risk, we use a combination of risk measurement systems, including Axioma (the main tool we use), Bloomberg and StatPro.

We use Axioma to stress test portfolios and decompose absolute and active risk. Axioma is an ex-ante or forward-looking risk analysis tool that evaluates risk using a multi-asset, multi-factor regression model. This approach differs from the more traditional type of risk measurement, which relies on historical portfolio data. Axioma builds a portfolio risk profile using a portfolio’s current assets and it estimates each asset’s exposure to fundamental risk factors. Risk is then aggregated into headline metrics (volatility, tracking error, VaR etc.) using exposures, factor-level risks, and interactions or correlations between these common factors.

Stress tests help us understand how portfolios and their underlying securities might react to periods of market stress. They provide insight into how defensive or cyclical a portfolio might be. There are two main types of stress test: ‘uncorrelated’ and ‘correlated’. The uncorrelated stress test is constrained to only those shocks that are outlined in the test, for example a ‘50% correction in the S&P 500’ or ‘the VIX (volatility) index doubling’. This works well when the aim is to isolate the impact of one particular shock. The correlated version allows for a selection of a few shocks and then – by way of mapping through correlations – building an entire propagated stress test. At Rathbones, we employ both correlated and uncorrelated shock tests.

Axioma also offers a large number of scenarios based on real historical market events. There are the more prominent scenarios like the credit and financial crisis between 2007-2009 and the dotcom crash in the early 2000s, as well as the less severe scenarios such as the ‘diversion of monetary policy in 2013’. Because of the flexibility Axioma offers, we can calibrate our own historical scenarios.
Since risk is aggregated using fundamental factors, it can be decomposed or broken down using these same attributes or characteristics. Risk attribution (decomposition) is crucial to good risk management. It allows us to identify a portfolio’s sources of risk. We can determine how much of a portfolio’s risk is generated through exposure to a particular style and how much by exposure to a particular currency, industry or country. Every security or asset in the portfolio will have its own exposures to these risk factors. Risk factors have their own returns and indeed risk profiles. They are recognised (by the market) as drivers of risk and return.

Risks that cannot be attributed to any one factor are assigned to each security (and portfolio) as specific risks. Also known as idiosyncratic or non-systematic risk, this is the portion of risk that securities do not have in common with another security. Each security’s non-systematic risk is specific to that security and that security only. Unlike systematic risk, specific risk can be diversified away. At Rathbones, we keep a close eye on the level of specific risk contained in our portfolios. Some specific risk is absolutely necessary, but excess specific risk needs to be diversified away.

Finally, we can also produce Value-at-Risk (‘VaR’) numbers based on either Axioma’s multi-asset fundamental model or its multi-asset statistical model. These are parametric versions of VaR, but Axioma also offers historical and Monte Carlo VaR. A practical way of looking at VaR is as a potential maximum drawdown in a high stress, but not necessarily ‘black-swan’-type event.

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All client investments (excluding cash which is held by Rathbone Investment Management Ltd as an authorised banking institution) are held separately from Rathbones’ own assets in our nominee account, Rathbone Nominees Limited. This ensures that each client’s investments are ‘ring-fenced’ from the assets of Rathbones in the unlikely event that the company went into liquidation. Rathbone Nominees Limited appoints sub-custodians, such as CREST and Bank of New York Mellon, to hold individual investments. Part of the role of the nominee company is to assess and monitor the sub-custodians and ensure they remain appropriate. There are no additional charges for our nominee services as they are included as part of our management fee.