Shard Capital has a particular view about how to protect and grow clients’ wealth; a big part of the recipe consists of convertible bonds. (These bonds yield interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder. A convertible bond protects investors' principal on the downside, but allows them to participate in the upside should the underlying company succeed.)
“The theory behind convertible bonds has helped shape our investment approach, namely that our investment philosophy gives equal priority to the management of risk as it does to management of returns,” Knacke and Hollings said.
Convertible bonds fit with a particular view of risks, they said.
“A risk profile where you make more for a given move up than you would lose for a corresponding move down is referred to as a positive asymmetric risk profile. This is the risk profile which investors tend to get via exposure to stocks through convertible bonds. For this reason, the classic convertible risk profile lies at the heart of Shard Capital’s portfolio construction process and philosophy. We always look to replicate this asymmetry when we invest on behalf of clients, both at the single stock/bond/fund level and at the aggregate portfolio level,” the men continued.
“We take a dynamic, high conviction and active approach to asset allocation, investing capital when it is compelling to do so, not because we have to track a particular benchmark. We take a multi-asset, multi-strategy approach to portfolio construction, investing across asset classes, including cash, fixed income, equities and alternatives,” Knacke and Hollings said.
Knacke and Hollings think that central banks’ big expansion of the money supply in recent years – aka “quantitative easing” – brings certain risks, which also explains their investment philosophy.
“Central bankers are aware of the various asset bubbles that their policies have created and therefore understand the need to tread a very fine line between paying lip service to fighting inflationary pressures, as opposed to actually doing something about them. In this reality, all that central banks can really do is `talk tough’ on inflation whilst at the same time proceeding very cautiously. The simplest way for central banks to try to prove their inflation-fighting credentials is to taper bond purchases,” they said.
“Because central banks are more concerned with the long end of the bond market than the short end, they will likely skew tapering to the short end, causing these rates to rise slightly, whilst at the same time trying to keep yields pegged at the longer end. That said, given how sensitive most risk assets now are to interest rates, even a gradual approach to tapering runs the risk of upsetting equity and bond markets,” Knacke and Hollings said.
“On balance, at Shard Capital we think central banks will be able to manage this process effectively but given the potential risks involved if they don’t, we have a number of hedges in place which should help limit losses if this (less likely) scenario does in fact pan out,” they said.
Knacke reckons that many conventional investment management views have been torn up by the long run over ultra-low interest rates.
“For many HNW clients you don’t require daily liquidity. The market still shies away from funds that have weekly or monthly liquidity. The era of 60/40 asset allocation [equities/bonds] has come to an end,” he said.
We asked Knacke and Hollings about the trend of big inflows into private debt, credit, real estate and infrastructure.
“Given where interest rates are and the risks present across financial markets, it is unsurprising that investors, advisors and wealth managers are switching out of traditional asset classes and looking at private markets in search of higher returns,” they said.
“However, investing in private markets does require a different approach given they require investors to be patient, long-term and be in a position to take the liquidity risk associated with such a long-term investment. While interest rates remain low, the growth in private market investment is likely to continue. But investors should realise that private markets aren’t immune from interest rate rises (or other risks for that matter). Governments around the world have accumulated a colossal amount of debt over the last decade and more recently taken on even more debt to deal with the COVID pandemic,” Knacke and Hollings continued.
“In order to pay-off this debt, governments and central banks need to have a period of sustained global growth or alternatively a period of high inflation. While both scenarios may seem unlikely to some, they would result in a regime change and in particular the likelihood of rising interest rates and the cost of capital going up,” they said.
“However, given the amount of debt outstanding, the consequences of rising rates are potentially catastrophic. When rising interest rates start impacting discount rates, and capital markets decide to re-value asset prices materially lower, what will happen to private markets when valuations are also re-rated materially lower? And if that isn’t bad enough, investors will also face the impact of the liquidity risk associated with such investments,” they added.