The 2019 Financial Year has been one of the toughest on record for Pendal, with investor caution about the world’s prospects exacerbated by ongoing geopolitical turmoil. Our business is heavily reliant on global investment flows, which, by their very nature, are cyclical and heavily influenced by investor sentiment. Despite record market levels in some regions, investors have become more risk averse, which has affected flows into our own investment strategies. A number of our key strategies have also underperformed.
Headwinds are part of the cyclical nature of our business and whilst challenges may persist, I am confident about the future given the quality of our people, strength of our balance sheet and our clear strategy to invest and seek opportunities to grow our business.
Significantly, lower performance fees were the primary factor for a 19 per cent reduction in our Cash NPAT. Performance fees declined 89 per cent, from $54.5 million the prior year to $5.9 million. Operating profit, pre-performance fees, was down by eight per cent and total funds under management were $100.4 billion, a slight decline from $101.6 billion the previous year. Average funds under management, which is a key driver of revenue, was down one per cent to $98.8 billion. A change in the asset mix that we manage on behalf of clients also impacted margins, as investors switched out of equities and into lower margin asset classes, such as cash.
There were outflows in our UK and (in particular) European investment strategies, amid the tide of uncertainty surrounding the Brexit negotiations and concerns about growth in the EU, which led to outflows of $2.7 billion from our European strategies and $0.4 billion from our UK strategies. In contrast, we continued to see good flows from US clients totalling $0.5 billion, predominantly into our International and Emerging Market strategies. In Australia, we saw strong interest in our Cash and Fixed Income strategies, which raised $2.2 billion through the institutional channel. Outflows from the Westpac book totalled $3.3 billion for the year largely because of the ongoing run down of the legacy book and withdrawals reflecting changes in the Westpac superannuation portfolios.
There was significant volatility in markets over the past 12 months. The first quarter of the financial year was particularly weak, on anticipation of interest rate hikes – which quickly turned to multiple rate cuts in the New Year. Global trade tensions, which escalated in the first half of the 2019 calendar year, have contributed to a much more sanguine outlook for growth, with the prospects of recession rising. The impact of the US-China trade war is being felt strongly in highly open economies including in Europe where investor concerns were exacerbated by the ongoing uncertainty surrounding Brexit.
With a lack of inflation globally, central banks have been responding by lowering rates and maintaining a very accommodative stance on monetary policy. Official interest rates have been cut, and global bond yields have fallen sharply, leading to a surge in the outstanding amount of negative yielding debt. In turn, this has
turbo-charged asset markets in a way that has distorted them, and created a challenge for active managers, particularly value managers. We have witnessed this first-hand, and those investment strategies with a value bias have been significantly underperforming.
A feature of the market rally has also been the ‘narrow leadership’ – when a small group of stocks is contributing to the bulk of market returns – led by large cap growth stocks. Large cap growth stocks have substantially outperformed value stocks, alongside a rally in ‘bond proxies’. Ultra-low interest rates partly explain this phenomenon, but so does the advent of technological innovation and adaptation that has created dominant businesses with high growth and high profitability.
Growth in passive investments further fuelled the willingness to invest according to market size and not company value. Active managers who have witnessed passive money being invested in increasingly riskier, and arguably more expensive assets in the past, are reluctant to chase the market.
Whilst this environment of dovish central banks has favoured passive management, the embedded risks in market indices warrants consideration and navigation that only active management can provide. Over longer periods, active management that focuses on investing in stocks with good fundamentals has mitigated risks embedded within markets and added value for investors. Despite many equity indices running at historical highs, market valuations (as measured by the index P/E multiple) have stayed somewhat stable, disguising the valuation divergence beneath the headline index. The chase to defensive yield and growth, amid a low interest rate and growth environment, has pushed these stock valuations to significantly higher levels. Companies not in those categories, irrespective of the quality of the fundamentals, have been de-rated. This has been particularly acute for value managers.
This occurrence is not unique to equity market indices. Looking at the global corporate bond market, for example, there has been a substantial increase of less creditworthy borrowers in the system. Growth of lower-rated, BBB bonds has gone from 25 per cent in 2006 to around 50 per cent of the global corporate bond market. Regardless of quality, passive managers have gravitated towards these issuers on the back of a mandate to replicate the index, in a period where yield is being chased, albeit with a riskier proposition.
A number of our investment strategies have underperformed in this environment and, while this is disappointing, we remain steadfast in our investment approach that has produced strong results for our clients over the long term. Arguably, given the nature of markets, this is the time to take active positions. Speaking to our investment managers, there are compelling investment opportunities that are being ignored as investors apply a high discount to a world of uncertainty.
We know that challenging times often present the best opportunities. Cyclicality and expectation of ‘mean reversion’ are still the ways of the financial world, and there are growing signals that chasing yesterday’s winner is an increasingly risky strategy. This requires patience – but it can be rewarded very swiftly, as when markets turn, they can do so quickly.
A resolution to the US-China trade war, a breakthrough on Brexit, a normalisation of interest rates or even regulatory imposition on high profile tech stocks could easily bring about a material change in investor sentiment.
As independent investment managers without a single ‘house view’, we draw on our experience and knowledge, supported by detailed research, to create highly active portfolios that are not simply following market sentiment. This means in certain periods we will endure periods of underperformance as long as the belief in the investment strategy we adopt remains sound.
We stay true to our commitment to investment independence, the attraction and retention of investment talent, and diversification across markets, clients and geographies.
Our strategy is to ensure that where mistakes have been made, we learn from them, but we must also remain resolute, even in extreme periods. Our clients will ultimately reward us for doing what we believe is in their best interest.
Pendal relies on its strengths – our people, our product and our distribution. They represent my priorities in ensuring the Pendal Group will continue to pursue long-term growth in a way that delivers value to shareholders and clients alike. We direct our energy and resources into the consistent execution of our strategy and into areas where we see the best opportunity for long-term growth. We stay true to our commitment to investment independence, the attraction and retention of investment talent, and diversification across markets, clients and geographies. Our balance sheet remains free of debt and this provides a very solid platform for growth.
As a talent management business, it is incumbent on us to continuously seek investment talent that creates long-term value for clients and shareholders. To that end, we maintain a program of broadening our investment capability, either through development of internal talent and new extension strategies or by attracting new investment talent to the business.
Globally, compliance costs are being driven higher by a trend of increased regulation. As I observed last year, this is raising barriers to entry and makes it difficult and costly for teams to ‘go out on their own’. Pendal’s business proposition becomes even more attractive to talented investment managers whose values align with our own. In an environment where positive industry flows have been difficult to achieve, we have witnessed an increased level of activity in discussions about attracting talent to the business.
Our senior executive team was significantly boosted this year with the appointment of two regional CEOs to lead our JOHCM business. Having dedicated CEOs for our US business and our UK, Europe and Asia business will sharpen our focus, enable us to better seek out opportunities and increase our ability to anticipate and react to changes in the market. In Nick Good (in the US) and Alexandra Altinger (in the UK, Europe and Asia), we have executives of the highest calibre whose successful track records demonstrate a commitment to growth.
We have appointed a permanent Global Chief Risk Officer as well as a new Investment Director for JOHCM and Pendal Australia. All these appointments come with significant experience and deep market knowledge. They are excited to be with the firm, they provide me with a strong team to navigate the market and industry challenges and to execute on our growth strategy.
This year has seen a focus on supporting products that were launched the previous year, as well as streamlining our product range where there has been little client demand. The previous year’s focus was on developing solutions that met investor income needs.
We see growing demand for income offerings as a result of an ageing population worldwide, driven by increasing life expectancy and a likely shift to income-generating, low volatility investment strategies. In 2018, we launched three products to be marketed in this space, being the JOHCM Global Income Builder Fund, the Pendal Dynamic Income Fund and the Pendal Multi-Asset Target Return Fund. I am pleased to report that post-launch, these strategies have received good early support. The JOHCM Global Income Builder Fund has gained early representation on a number of platforms in the US and is raising assets, and the Pendal Dynamic Income Fund is also receiving acceptance from the private client channel in Australia. Combined, these strategies have raised over $171 million. While it is early days, they are adding to a more diversified revenue stream.
We have used the company’s balance sheet to provide seed capital to support the launch of these funds and to grow strategies to a size that makes them a more viable investment option for clients. Equally, where a strategy is lacking client demand and has little prospect of raising funds, we pragmatically discontinue those strategies to re-allocate capital to areas where the best prospects lie. Following a review, it was decided the JOHCM US Small Midcap and JOHCM Global Smaller Companies strategies would be closed in the first quarter of the 2020 Financial Year, despite investment performance exceeding their respective benchmarks since launch back in 2014. After five years, the funds raised had been minimal and with little prospect of raising any substantial amounts in the future, it was deemed unviable to continue to offer these strategies. This released seed capital to support new and existing opportunities.
An area of opportunity is in ESG/Responsible Investing, where clients are increasingly wanting to see how we consider ESG factors in our investment decisions. Laws and regulation around ESG are growing, both in terms of geography and in terms of themes, such as diversity, climate change, human rights, plastic, and privacy. EU regulation is arguably the most ambitious with new requirements coming into effect in 2020.
More clients are asking about thematics and impact solutions. They want reporting that tracks the footprint of investments and (increasingly) links to Sustainable Development Goals set by the United Nations General Assembly. ESG is real and there is growing interest in incorporating climate-related factors in asset allocation and stock analysis. To succeed, ESG requires expertise and a commitment to engage and invest in data, analytics and reporting.
Pendal Group has strong heritage in ‘responsible investing’ spanning 35 years. The Pendal Sustainable Balanced Fund was launched by the Bankers Trust group in 1984 as the BT Australia Charities Trust. We have been at the forefront of ESG development and already have investment strategies where we manage $2.5 billion on behalf of clients around specific ESG criteria. We measure carbon intensity in some of our equity portfolios and make this information available to clients, including for use in their own reporting.
As part of our investment in the area, we moved to 100 per cent ownership of Regnan, a specialist ESG and engagement firm. We have been associated with Regnan from its very beginning. Its expertise adds to the Group’s capacity to support our investment and sales teams in specific ESG related matters. We have an opportunity to build Regnan into a globally recognised responsible investment business, and to participate in this space in a highly credible way by attracting the right talent and expertise.
While the Pendal Group is well positioned, there is still a strategic imperative to develop a distribution and operating platform that enables more efficient execution of our priorities and enhances client service. In difficult times, good and effective distribution is of greater importance. We expanded our on-the-ground distribution reach to the US West Coast this year, and made key hires in the UK sales team.
While Brexit has consumed the UK and Europe, the Australian market has been going through its own transformation in the wake of the Hayne Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Hayne produced a re-think from the Australian banks about the extent of their participation in the provision of personal advice. They have either completely exited advice or significantly scaled back operations.
Advisers are also voting with their feet, with a significant number switching to privately owned groups and away from the institutional owned model. It is a period of significant change, which has manifested into significantly reduced flows in the Australian wholesale channel. Nevertheless, we expect the dislocation to settle and feel positive about our medium and longer term prospects. We have responded to this rapidly changing landscape by creating a more channel-focused approach with end-to-end accountability for each of our three key segments (banking and insurance; independent licensees; and private bank/family offices) in the wholesale market. This approach allows each team to focus exclusively on their sub-market and ensures we are well positioned to win business.
Over the last 12 months, the Australian business has been working with Westpac to detach the back-office services provided by Westpac and transfer to new providers. This presents an opportunity to redesign our processes and improve our operating platform efficiency, with technology needing to play an important part. Key will be us being more tech-enabled in a way that improves the client experience and provides an operating platform that our sales force can better leverage off. This will be a multi-year investment and will significantly change our operating platform.
We continue to look to the future with confidence, aware of the need to continue to invest despite market cycles and industry challenges, including pressure on revenue, fees, the growth of passive, rising regulation and industry change. Despite recent period of underperformance, we remain certain that our high conviction, investment-performance-led approach will serve our clients well, and deliver long-term growth in shareholder returns.
The quality of our people, our desirable product offering, supported by a strong balance sheet and cash flow gives us the confidence to continue to invest in and grow our business.
I take this opportunity to thank our teams across the globe for their continued hard work and dedication.
Emilio Gonzalez, CFA
Group Chief Executive Officer