An ethical breakdown

If DFM growth rates have peaked, then wealth managers need to get smarter about the kind of services they offer to clients, and how they do so. Specialisation is one answer to that: hence the rise of discretionaries offering dedicated Aim, decumulation or sustainable portfolios.

Our MPS tracker charts the decisions being taken in DFMs' regular model portfolios, but it does also encompass some of the above. And with sustainable investing increasingly representing a mainstream pursuit, the funds which form these portfolios are likely to play a much bigger role all round in future.

But our initial analysis of wealth managers' top sustainable picks helps highlight that portfolio construction in this area can still differ markedly from the norm. The chart below shows the five most popular funds in dedicated sustainable or ethical model portfolios run by DFMs:

The presence of global and UK equity funds in the top five makes sense, given these markets include large companies with the resources to ensure they stay in line with ethically minded investors.

But one area has a notably diminished presence. No US funds feature in the top five, and indeed just three US equity products - all passives - feature in ethical ranges across our entire database. 

Given the enduring influence of US stocks on returns, it's a curious finding that might run counter to the claim investors can go ethical without potentially missing out on performance. But part of this may come down to the stocks that have led US market growth in recent years. As we've discussed, the tech giants have become another dividing line between ethical investors and more traditional investment approaches.

The chart's top choice, Rathbone Ethical Bond, is unsurprising: despite a recent dip, the fund outstrips most mainstream corporate bond funds over three and five years. But its popularity is not replicated within conventional MPS offerings: our data shows that just three wealth firms hold it within their regular models.

Why? The benchmark-agnostic Rathbones fund, together with Kames Ethical Corporate Bond, may be in vogue with sustainable investors as much because of its flexibility as its performance. Dedicated strategic bond funds are thin on the ground in the ethical space, so those seeking to replicate their usual bond exposures have had to have a rethink.

Big decisions for small caps

We didn’t have to wait long for the next high-profile manager departure: Schroders announced on Friday afternoon that Jenny Jones would be stepping down in March. Add to that the departure of T Rowe Price smaller companies manager Ryan Burgess and it was a notable day for US small caps.

From discretionaries’ perspective, the exits are examples of how succession planning has improved at fund firms: both asset managers have longstanding co-managers in place. 

Still, it’s a good time to give further consideration to the prospects for US small and mid-sized companies in general. Ms Jones’s Schroder US Mid Cap fund is one of the more popular US equity funds in our database, not least when you consider wealth managers’ reticence to get involved lower down the cap scale. 

But it’s been a wild ride lately for small caps in particular: down more than a quarter from their 2018 highs by the end of last year, they’re now enjoying their best start to a year since 1987 courtesy of a 10 per cent rebound.

After such a steep fall, a rally was hardly surprising: more than three quarters of such stocks were in correction territory by the turn of the year, which points to indiscriminate selling. 

But threats haven’t gone away, and the biggest concern remains leverage. SocGen quant analyst Andrew Lapthorne is among those to have emphasised the sheer amount of debt taken on by US smaller companies over recent times. A pause in the Fed’s hiking cycle may have provided a temporary breather, but it seems unlikely such businesses will regain the brief safe-haven status they enjoyed last summer.

That accolade was awarded in part because these companies tend to be focused on the domestic economy, and hence relatively insulated from trade-war tensions. No such luck for US mid-caps, which suffered last year for the opposite reason: the industrial and financial sectors are a big part of the mid-cap index. And this rock-and-a-hard-place scenario for US Smids could yet reassert itself.

Delegation game

Ten days ago we wrote about the not-totally-outlandish concerns that still linger with regard to portfolio delegation. Absent a Brexit deal, could fund firms be forced to shift managers to continental Europe in order to comply with regulations?  On Friday, we saw the first evidence that moves were being considered…albeit in a different direction. 

BlackRock and Goldman reportedly have contingency plans that would see them move some managers further still from DFMs’ reach - to the US. They would then relocate to mainland Europe once the UK and EU agreed a regulatory framework.

That remains a worst-case scenario situation, but the fact such considerations are now emerging underlines where we are with the whole process.

So it’s a relief that the Central Bank of Ireland’s deputy governor gave a speech last Thursday which provided some reassurance. Specifically: “firms that delegate portfolio management to the UK can have sufficient confidence that this will continue to be allowed post 29 March”. It may not have come from an EU-wide body, but that does represent some form of sorely-needed assurance from the continent’s policymakers.