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January 5, 2021 - Mark Northway
|It is always hard to know what will happen with markets. We’re not in the business of offering predictions. Instead, like some of the successful sovereign and endowment funds whose approach we aspire to, we prefer to rely on the evidence.
But with underwhelming market returns – and with alpha becoming ever more elusive – it is fair to say that we are likely to see a profoundly different investment environment over the coming year(s). Expectation management will become crucial.
It is also fair to say that global markets look expensive in a historical context. They looked this way before the Covid-19 crisis. The correction we saw in the spring didn’t seem to fully account for the world’s financial and economic problems. Since then markets have rebounded. The S&P 500 sits, at the time of writing, over 15% above its level at the beginning of 2020.
This doesn’t seem to tally with the economic evidence – or with the human experience of lockdown. US GDP fell by an estimated 32.9% in the second quarter of 2020 alone). There is an awful lot of bad news out there.
In this environment, sticking to evidence-based rules seems a good option. Being careful not to let a subjective view influence actions helps in resisting the temptation to engage in tactical allocation or market timing.
Looking into the future, fixed income markets tell you that you can invest for 20 years for a contractual return very close to zero. This, like it or not, is what investor expectations should be based on.
Historically, equity markets yielded a long-term premium to fixed income of somewhere in the region of 4%. There are signs that this premium has eroded in recent years and may now be closer to 2%. If we think about an internally consistent implied term structure, then markets are not holding out much promise in terms of expected equity return.
This is the fact set that clients must use to manage their expectations. Anyone getting over-optimistic from this point onwards could be in danger of disappointment.
We know that alpha is elusive and that finding managers that can consistently deliver alpha is a very difficult thing to do. But in the upwards moving stock market we have seen over recent years it’s very difficult to find a catalyst that makes people change their approach to asset management.
Investors do not see the need for change when they are making money, even when their portfolio is underperforming relative to the market. At the same time, that underperformance is not always apparent to the end investor because many asset managers only compare their performance to that of their peer group. What looks like a strong manager is too often just the best of a bad bunch.
So, an investor should look for his or her portfolio to achieve two things: be best in class and at least match the return of the target market.
We have ended up with an asset management market with too many participants, too many decision processes, and too much focus on asset acquisition. Collectively these add little to the end investor … other than high costs.
This very strongly suggests we are long overdue a Darwinian rationalisation of the active investment management sector. There are too many underperforming players that need to be thinned out in order for the industry to generate value for its client base.
Both advisers and investors should think carefully about their investment goals, their expectations, and the best way to bridge the gap in a volatile, low return environment.
With best wishes for 2021.
These are the Pillar 3 disclosures made by Sparrows Capital Limited (“Sparrows”) in accordance with the UK Financial Conduct Authority’s (“FCA”) Prudential Sourcebook for Banks, Building Societies and Investment Firms (“BIPRU”).
The European Union Capital Requirements Directive (“CRD”) created a regulatory capital framework consisting of three ‘pillars’ namely:
Pillar 1 – sets out the minimum capital requirements that firms are required to meet;
Pillar 2 – requires firms to take a view on whether additional capital should be held against capital risks not covered by Pillar 1; and
Pillar 3 – requires firms to publish certain details of their risks, capital and risk management process.
The rules in BIPRU 11 provide that Sparrows may omit one or more of the required disclosures if it believes that the information is immaterial. Materiality is based on the criteria that the omission or misstatement of material information would be likely to change or influence the assessment or decision of a user relying on that information for the purposes of making economic decisions. Where Sparrows considers a disclosure to be immaterial, this will be stated in the relevant section.
Sparrows is also permitted to omit one or more of the required disclosures where it believes that the information is regarded as proprietary or confidential. Proprietary information is that which, if it were shared, would undermine Sparrows’ competitive position. Information is considered to be confidential where there are obligations binding Sparrows to confidentiality with its clients and counterparties.
Where Sparrows has omitted information for any of the above reasons, a statement explaining this will be provided in the relevant section.
Unless stated as otherwise, all figures contained in this disclosure are based on Sparrows’ audited annual reports for the year ending 31 December 2020.
These Pillar 3 disclosures will be reviewed on an annual basis as a minimum. The disclosures will be published as soon as is practical following the finalisation of Sparrows’ Internal Capital Adequacy Assessment Process (“ICAAP”) and its annual accounts.
The information contained in these disclosures has not been audited by Sparrows’ external auditors and does not constitute any form of financial statement.
Sparrows’ Pillar 3 disclosures are published on its website.
Scope and application of CRD requirements
These disclosures are made in respect of Sparrows, a BIPRU firm authorised and regulated by the FCA, providing financial advice and discretionary investment management services.
Risk management objectives and policies
Sparrows’ risk management policy reflects the FCA requirement that it must manage a number of different categories of risk. These include: liquidity; credit; interest rate; market; and operational risks.
Sparrows manages all cash and borrowing requirements to maximise potential interest income whilst ensuring it has sufficient liquid resources to meet the continued operating needs of its business. This is supported by a robust budgeting and forecasting process that has the full involvement of the senior management team.
The main credit risk for Sparrows relates to income from fees, the risk being that a client does not pay amounts due for services provided by Sparrows. In most cases, management fees are charged to clients on a quarterly basis. Concentration risk is defined as the risk of loss of income through external changes having a disproportionate impact on overall income due to a reliance on revenue from certain sectoral, geographic areas and/or businesses. Credit risk concentrations include significant exposure to an individual client or group of clients and credit exposures to clients in the same economic sector or geographic region.
A significant proportion of Sparrows’ income is received from clients that are part of the same group as Sparrows’ major shareholders. This ongoing interest in the activities of Sparrows by the group mitigates the risk of the group jeopardising Sparrows’ income flow.
Sparrows is exposed to country risk as a number of clients are based in a non-European Economic Area country. As these clients are all high net worth or ultra-high net worth long-term investors with spare capital invested in globally diversified liquid financial instruments, the risk of being unable to meet unforeseen financial needs and payment of Sparrows’ fees is low.
Based on the analysis of concentration risk, the risk of non-payment of fees has been assessed as minimal.
Sparrows has no exposure to interest rate risk as it has no debt, no margin, and no client cash deposits.
The main market risk for Sparrows relates to falls in the value of assets under management following a market downturn, which would lead to lower management fees. To mitigate its market risk, Sparrows regularly analyses various different economic scenarios to model the impact of economic downturns on its financial position.
Operational risk is defined as the potential risk of financial loss or impairment to reputation resulting from inadequate or failed internal processes and systems, from the actions of people or from external events.
Major potential sources of operational risk include outsourcing of operations, IT security, internal and external fraud, implementation of strategic change and regulatory non-compliance.
Sparrows operates a robust risk management process that is regularly reviewed and updated by its Board. The Board formally reviews all significant risk issues at least annually as part of the ICAAP.
All senior members of staff bear responsibility for internal controls and the management of business risk as part of their accountability to the Board. All staff are responsible for identifying the risks surrounding their work, implementing controls over those risks and reporting areas of concern to their senior member of staff.
Sparrows operates a simple business model. Accordingly, many of the specific risks identified by the FCA do not apply. For example, the firm has no material outsourcing arrangements and does not hold client assets.
Pillar 1 requirement
In accordance with the FCA rule GENPRU 2.1.45R (calculation of variable capital requirement for a BIPRU firm), Sparrows’ capital requirement has been determined as being its fixed overhead requirement and not the sum of its credit risk capital requirement and its market risk capital requirement.
The Pillar 1 capital requirement for Sparrows was £384,000 as at 31 December 2020.
Pillar 2 requirement
Sparrows’ overall approach to assessing the adequacy of its internal capital is set out in its ICAAP report. The ICAAP involves separate consideration of risks to Sparrows’ capital, combined with stress testing using scenario analysis. The level of capital required to cover risks is a function of impact and probability. Sparrows assesses impact by modelling the changes in its income and expenses caused by various potential risks over a 1-year time horizon. Probability is assessed subjectively. In addition, Sparrows has reviewed the outputs of its risk reviews to quantify any risks identified. This has identified a number of key business risks, which (having reviewed the guidance in BIPRU 2.2.61-65) Sparrows has classified against the risk categories outlined in FCA rule GENPRU 1.2.30R.
Sparrows Pillar 2 capital requirement, which is its own assessment of the minimum amount of capital that it believes is adequate against the risks identified, has been assessed as no greater than its Pillar 1 requirement.
There is a considerable surplus of reserves above the capital resource requirement deemed necessary to cover the risks identified.
The main features of Sparrows’ capital resources for regulatory purposes, as at 31 December 2020 are as follows:
|Tier 1 capital (called up share capital, share premium account, profit and loss account, externally verified interim net profits)||1,140|
|Total of Tier 2 and Tier 3 capital (broadly long and short term subordinated loans)||–|
|Deductions from Tier 1 and Tier 2 capital||–|
|Total capital resources, net of deductions||1,140|
Sparrows holds regulatory capital in accordance with the CRD. All such capital is classified as Tier 1 capital and is therefore of the highest quality.
Remuneration Code Disclosures
Sparrows is subject to the BIPRU Remuneration Code. This section provides further information on Sparrows’ remuneration policy.
BIPRU Remuneration Code Staff
Sparrows has identified, and maintains a record of, BIPRU Remuneration Code staff (“Code staff”), i.e. staff to whom the BIPRU Remuneration Code applies. This includes senior management and members of staff whose actions may have a material impact on Sparrows’ risk profile. All of Sparrows’ Code staff fall into the “senior management” category of Code staff (rather than the “risk taker” category) for the purposes of the BIPRU Remuneration Code.
Decision Making / Remuneration Committee
Sparrows does not have and is not required to have a Remuneration Committee. The Board is responsible for Sparrows’ remuneration policy including determining the framework and policy for remuneration and ensuring it does not encourage undue risk-taking; agreeing any major changes in remuneration structures; reviewing the terms and conditions of any new incentive schemes and in particular, considering the appropriate targets for any performance-related remuneration schemes; and considering and recommending the remuneration policy for senior staff taking into account the appropriate mix of salary, discretionary bonus and share-based remuneration.
In determining remuneration arrangements, the Board will give due regard to best practice and any relevant legal or regulatory requirements including the BIPRU Remuneration Code.
Link between pay & performance
There is a discretionary variable pay element to the Sparrows’ remuneration package.
Quantitative information on remuneration
The FCA rules require certain firms to disclose aggregate information on remuneration in respect of its BIPRU Remuneration Code staff broken down by business area, senior management and other Code staff, including “risk takers”.
Sparrows has only one business area – investment management & advice.
Sparrows has 5 Directors but no material “risk takers”. Director remuneration is agreed formally at Board meetings. The link between performance and pay is inevitable in a small firm, but Sparrows’ risk-averse strategy and robust risk management systems mitigate any risks.
We do update this Policy from time to time so please do review this Policy regularly.
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