MFS Meridian® Funds - Prudent Capital Fund: Strategic Outlook and Portfolio Positioning Update

MFS Meridian^® Funds – Prudent Capital Fund:
Strategy Outlook and Portfolio Positioning

UNLESS OTHERWISE STATED, THE DATA REFERENCED IS AS OF 31 JANUARY 2024
THIS INFORMATION IS FOR MARKETING PURPOSES ONLY
Recorded on 28 February 2024

Important Risk Considerations
The fund may not achieve its objective and/or you could lose money on your investment in the fund. Stock: Stock markets and investments in individual stocks are volatile and can decline significantly in response to or investor perception of, issuer, market, economic, industry, political, regulatory, geopolitical, and other conditions. Bond: Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio’s value may decline during rising rates. Portfolios that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil, all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The price of an instrument trading at a negative interest rate responds to interest rate changes like other debt instruments; however, an instrument purchased at a negative interest rate is expected to produce a negative return if held to maturity. Derivatives: Investments in derivatives can be used to take both long and short positions, be highly volatile, involve leverage (which can magnify losses), and involve risks in addition to the risks of the underlying indicator(s) on which the derivative is based, such as counterparty and liquidity risk. Value: The portfolio’s investments can continue to be undervalued for long periods of time, not realize their expected value, and be more volatile than the stock market in general. High Yield: Investments in below investment grade quality debt instruments can be more volatile and have greater risk of default, or already be in default, than higher-quality debt instruments. Strategy: There is no assurance that the portfolio will achieve a positive rate of return or have lower volatility than the global equity markets, as represented by the MSCI World Index, over the long term or for any year or period of years. In addition, the strategies MFS may implement to limit the portfolio’s exposure to certain extreme market events may not work as intended, and the costs associated with such strategies will reduce the portfolio’s returns. It is expected that the portfolio will generally underperform the equity markets during periods of strong, rising equity markets. Please see the prospectus for further information on these and other risk considerations.

 

What is the philosophy behind the Prudent Capital strategy, and what are you trying to achieve for clients?

Barnaby Wiener: So the primary objective of the prudent strategy is to preserve the real value of our client’s capital and to grow it over time. We think the key to making money is not losing it. Hence you see a big focus on downside protection, both in terms of the asset allocation and the security selection. We care about absolute risk and return, not relative. Our portfolio looks nothing like the benchmark, and we’d be concerned if it did. Our strategy is based around a relatively concentrated portfolio of high-conviction equities supplemented by a broad spectrum of fixed income investments. A fixed income allocation could be as high as 50% of the total, depending on the risk environment. We also use derivatives as a means of protecting capital. Finally, we think our primary competitive edge is our timeframe. In a world where most investors are thinking in months and quarters, we think a time horizon that’s measured in years and even decades can be highly profitable.

The year 2023 was a strong one for the Fund. What were the main drivers?

Ed Dearing: 2023: I think the fund did a decent job. We captured about 70% of the upside in the market whilst remaining very defensively positioned throughout. So the net equity exposure in the portfolio ran around about 50% for most of the year. And so the equity portion of the asset allocation performed very strongly relative to MSCI World. And what were the main drivers of that? I think there were two big drivers during 2023. One was our bets on technology. So within the technology space, we tend to try to own the businesses that are immune from competition to tolerance. So if there’s human progress, if an area of technology grows, these businesses might not benefit the most, but they will benefit significantly from that. So within the space, Microsoft was a big contributor to us, Google, Oracle, Adobe. These businesses all have monopoly-like positions within growing verticals and unregulated pricing power.

So that was a big contributor. The other big contributor was our exposure to travel. And there our philosophy is very similar. So over time, travel volumes, people moving around the world tends to grow in line with or above GDP, which is a great thing to have because it means that if you just take a proportionate amount of share of that, your business should grow in line with or above GDP. In actual fact, the three businesses that we own in travel, so Safran, which controls 70% of the global narrow body engine market, Booking, which is the dominant online travel agent and Amadeus, which is the dominant global software platform for airlines, all grew disproportionately faster than their markets. In part because they gained share, in part because they captured the volumes coming through organically as travel recovered, but also because given the inflationary tailwinds of the last few years, and given their unregulated pricing power, they saw big revenue uplifts as those volumes came back. So those were the big drivers within travel, and those are the two buckets that help drive performance.

Have there been any changes to the strategy?

Shanti Das-Wermes: I think it’s important to highlight that the philosophy of the fund and of the strategy just hasn’t changed, but certainly we have learned and we’ve analyzed what has happened in the last couple of years. And on the margin there are some changes that we’ve made on the strategy. On the one hand, one of the changes we’ve done is we’ve moved to a much more active hedging or managing of our FX exposure effectively trying to minimize the impact that that can have on the portfolio, particularly as we’re finding ideas across the globe.

The next thing that we’ve done is we’ve also broadened out the tools that we are using from a risk management perspective. So that would refer to stress testing, risk reviews, etc., just to really understand a little bit better how the multi-asset portfolio is positioned across asset classes. There was also a broadening out of our option strategy. So typically we try to protect against systematic risk, and in the absence of very attractively priced protection has happened, for example, in 2022. We have broadened out again on the margin to some single stock options, particularly where we can isolate some idiosyncratic risk. And finally, I think this is something that Dave can elaborate a bit more, the fixed income side of the composition of the fixed income sleeve and portfolio has certainly changed over the last few years as well. So that’s something that continues to evolve as we look forward.

How is the portfolio currently positioned and why?

Ed Dearing: I think the most succinct way to describe it is very, very defensively, very conservatively. So our current allocation is roughly 50% equities. Around about 3% in gold. We have a small allocation to tail risk protection in the options. And then 46, 47% of the portfolio is in fixed income. A couple points to mention on that: So in general, equity markets are very expensive at the moment. There are pockets of value. We are finding some interesting ideas, but if you look at a long-term chart of, for example, the EBITDA sales of the S&P 500 or cyclically adjusted price-to-earnings ratios, equities are very expensive right now, and forward returns are likely to be quite low.

On the other hand, if you look at the fixed income universe, actually you’re being paid very, very attractive returns, particularly in shorter-dated instruments and particularly in risk-free instruments. So for example, I think about the long-term returns on MSCI World from our benchmark since 1969, the inception of the index. It’s returned seven and a half to 8%, and that’s at the end of quite a long period of strong performance by equities. If I look over at the fixed income space, you’re actually getting returns that are close to that sort of level, but with much, much, much less risk. And so from our perspective, it makes sense to have a very high allocation towards fixed income. And thankfully we have Dave here to talk through what we own within fixed income and why we like it so much.

How is the portfolio positioned in terms of its fixed income allocation?

David Cole: Well, as Ed mentioned, we hold roughly between 45 and 50% of the portfolio’s assets within fixed income securities. Although the composition of that, those holdings, have changed over time, whereas towards the inception of the portfolios and the strategies, we consistently would hold short-dated US Treasuries as well as a 10% — roughly — allocation towards corporate credit. Today, with interest rates being very different around the world, with central bank policies being very different around the world from five years ago, we’re finding a much broader opportunity set for which to select different asset types as well as bottom-up-security-level types of work. So specifically, we still hold a material amount of positions in US Treasuries. Our nominal US treasuries yield roughly five and a quarter percent, and these are on average about seven months of duration, so fairly short. We’ve also made an allocation to TIPS inflation-protected securities where we’re earning real yields of two and a quarter, two and a half percent over CPI, which is running close to 3% here in the US. So good real yields in that environment as well as we still maintain a little over 10% within corporate credit.

I would say the composition of the corporate credit holdings today is different from where it was maybe four or five years ago. We’ve seen better opportunity in some, I would say, a little bit more speculative, a little bit more risky types of corporate credit where we’re underwriting what we think are good risks at 10 to 15% types of two-year, three-year returns. On average, the yield of the credit holdings is a little over 8%. It’s about eight and a quarter percent. And similarly, the duration is about three years.

We’re often asked, "Well, why aren’t you taking duration up? Aren’t you worried? If you’re worried about downturns, interest rates could be a lot lower in the future." And while that’s true, the shapes of the yield curve has already priced in a fair amount of that type of outcome in terms of lower interest rates in the future. We’re not averse to adding duration, and certainly we consider doing so regularly, but we see the valuation just being a lot more attractive at the front end of the curve. And again, where we can earn a spread on top of cash with manageable amounts of duration, we just feel more comfortable and think that’s better risk/return for our investors and our clients.

 

 

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