Asset allocation: Seneca’s Elston targets UK mid-caps as rate rises loom

With interest rate hikes looming on both sides of the Atlantic, Seneca Investment Managers chief investment officer Peter Elston is hunting for value in European and UK equities.

In November, the target equity level for the £104.2m CF Seneca Diversified Income fund was inc reased from 41 per cent to 42 per cent in response to recent market declines.

Elston says: “We will remain slightly overweight equities. Dividend yields are generally above historic averages, which tells me they represent reasonable value.”

The fund holds a 5 per cent overweight position in Europe as it is at an earlier stage of its  recovery cycle than other regions, such as the UK and US, he says.

In a bid to boost inflation on the continent, European Central Bank president Mario Draghi last week extended the €60bn monthly quantitative easing programme until March 2017.

Elston says: “This time a year ago inflation was very close to 0 per cent in Europe and we felt Draghi was likely to increase QE, which he did. We felt that would be good for Europe. We are overweight Europe and continue to be so. We will continue to be underweight US as there are better opportunities elsewhere.”

Within equities, Elston says the UK is still “reasonable value” and currently represents 23.5 per cent of the fund.

In the UK Elston focuses on mid-caps rather than larger stocks, arguing there is more opportunity to find “hidden value” for investors.

Among the largest exposures to mid-caps, the fund has 1.3 per cent in Marston’s, 1.1 per cent in National Express and 1 per cent in Marks & Spencer.

Emerging market bond exposure was reduced in November in favour of US and global bond funds, “both of which we expect to have relatively low sensitivity to any rise in interest rates”.

This includes the Axa US Short Duration High Yield bond fund and the Royal London Short Duration Global High Yield fund, which represent 3.9 per cent and 3.2 per cent of the fund’s holdings respectively.

Compared with other areas of fixed income, Elston says he finds it hard to get value in G7 government bonds.

He says: “Real interest rates are very low or negative. As they can’t go much lower, when rates go up, government bonds in particular will perform poorly.”

Joining a year ago as global investment strategist, Elston was promoted to chief investment officer six months ago.

He arrived at the company a few months after Seneca acquired the Liverpool fund business of Miton Group in a £6m deal.

As a first change to the fund’s strategy, Elston introduced a “clearer” investment style.

He reduced the number of holdings from 74 to 62.

Elston says: “We had too much diversification and that is not a good idea because you can’t add too much value. So we’ve changed that and it is now a very concentrated portfolio.”

Elston also stresses the importance of value investing, especially in the current market environment. “While the strategic asset allocation remains quite fixed, tactical asset allocation is focused on the short to medium-term views.”

When deciding on asset allocation, Elston says he uses business cycle analysis with unemployment rates as a key indicator. US unemployment, for example, currently sits at 5 per cent compared with 10.7 per cent in Europe.

Elston says: “That means monetary policy in Europe will remain loose much longer than in the US  and so there is much more scope for profitability to improve.”