Going to work
How unstable markets forged the tough core of the Baillie Gifford Sustainable Income Fund
JUNE 2023
As with any investment, capital is at risk. Any income is not guaranteed.
Welcome to another edition of SOURCE, a publication that shines a light on select funds and their managers. This time, we sat down with Steven Hay of Baillie Gifford to delve into the Sustainable Income Fund.
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investment profile
sector overview
fund manager q&a
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Using a variety of asset classes such as infrastructure, real estate and equities can mitigate inflation risk in investors’ portfolios, says Baillie Gifford’s Steven Hay
Positioned to last
Asset allocators often blame central banks for being behind the curve when tackling inflation. As interest rates rise, investors can earn higher nominal returns from cash deposits and bonds. However, these still lag inflation rates, leaving investors concerned about the purchasing power of their portfolios. This will remain a significant risk to returns, according to Steven Hay, head of income research at Baillie Gifford. And it will be a real challenge to grow income and keep pace with the changing environment, he says. Before joining the Edinburgh-based asset manager in 2004, Hay worked at the Bank of England for seven years, providing insights to the bank’s Monetary Policy Committee. As a result, he has a good understanding of the policy backdrop when investing across different asset classes. He claims a multi-asset approach is well suited to the current investment environment. Each of the asset classes held in the Baillie Gifford Sustainable Income Fund (previously known as the Multi Asset Income Fund) has a bespoke, income-oriented portfolio. The strategy brings together the best of Baillie Gifford’s income ideas. ‘Real assets like property and infrastructure could offer a way to mitigate the impact of inflation and provide attractive investment opportunities. It is important that the focus is on income rather than simply capital return when managing these assets,’ he says. Equities play a critical role in providing real income growth over time. ‘Equities are traditionally seen as having some inflation-mitigating properties because companies are able to raise their prices to match inflation. And the types of equities we are looking for are the ones that have genuine pricing power. The largest equity holdings include the likes of Novo Nordisk, Microsoft and Procter & Gamble – companies which have weathered economic storms previously and emerged in a position of strength. ‘We also have fixed income in our portfolio, where we can achieve a high nominal yield for the first time in several years. Though inflation and rising interest rates pose a particular challenge for fixed income securities, I think these risks are now largely in the price, meaning prospects for returns are more attractive from this point. ‘Thus, by allocating to areas of the market that provide high levels of fixed income, along with those growing income faster than inflation, the portfolio is well-positioned to withstand inflationary pressures over time.’
Meet the manager
The long haul
Inflation impacts everyone differently. Some clients are concerned about the returns from their cash earnings or fixed income holdings not keeping pace with inflation, while others have worries about the volatility of equity dividends in a higher inflation environment. ‘Multi-asset income aims to provide an income that is resilient to shocks. At Baillie Gifford, we try to achieve the highest level of sustainable monthly income for our clients,’ says Hay. ‘It’s the highest level of income that we can generate while keeping pace with inflation on the capital side. We really prioritise looking for long-term income rather than short-term yield. We want to increase the pounds and pence income that we deliver to clients year-in and year-out, rather than maximising short-term income returns, which often prove unsustainable.’ He adds: ‘Our experienced Portfolio Construction Group of four experienced investors makes asset allocation decisions to deliver on the long-term investment objectives of the strategy.’ Hay believes this combination of active asset allocation and Baillie Gifford’s bottom-up security selection means this strategy is well-placed to deliver attractive returns for income-seeking clients.
“We want to increase the pounds and pence income rather than maximising short-term income returns, which often prove unsustainable.”
Investors often look into sustainable investments hoping they can replace traditional assets in their portfolio with ones that are compatible with the green transition. However, while investors who opt for a sustainable approach align themselves with some of the most powerful growth trends, this can also reduce diversification. Thus, applying a multi-asset approach can address these problems by balancing portfolio risks to improve risk-adjusted return potential. But it is challenging to think about sustainability in a consistent way across different asset classes. Sustainable investing is now well-established in equity investing, but it remains challenging for multi-asset investors to get a sense of how their investments rank in sustainability terms. Baillie Gifford has made significant enhancements to the way it assesses sustainability across other asset classes, including sovereign bonds, for example. Hay and his team ask one key question of each underlying holding in this strategy: is this investment compatible with a sustainable economy? The inputs vary for each asset class, yet the team uses consistent sustainability scoring across all asset classes – meaning investors are able to understand the portfolio’s overall sustainability credentials. ‘Building out a sustainability framework across a variety of asset classes has been a challenge, therefore we try and keep it simple. ‘We aim to consider all factors that are material and relevant to the return potential and risk profile of each investment. An understanding of environmental, social and governance risks and opportunities is important for the long-term sustainability of income and that’s why it’s at the heart of our investment process.’ This article does not constitute, and is not subject to the protections afforded to, independent research. Baillie Gifford and its staff may have dealt in the investments concerned. The views expressed are not statements of fact and should not be considered as advice or a recommendation to buy, sell or hold a particular investment.
Finding sustainability
Investment profile
Steven joined Baillie Gifford in 2004 and is Head of the Income Research Team. Prior to joining Baillie Gifford, Steven was a Fixed Income Investment Manager with Scottish Widows. His experience includes seven years undertaking analysis and research for the Bank of England’s Monetary Policy Committee, and involvement in managing the UK’s foreign exchange reserves. Steven graduated BAcc (Hons) in Economics and Accountancy from the University of Glasgow in 1992 and MSc in Economics from the University of Warwick in 1993.
Head of Income Research
Steven Hay
How the Baillie Gifford Sustainable Income Fund measures up to other funds in its peer group
Dotting the i’s
As well as generating higher total returns than the average fund in the sector, it has done so with a lower maximum drawdown and annualised standard deviation.
Risk metrics since inception (Aug 2018–Apr 2023)
Baillie Gifford Sustainable Income total returns since inception
The portfolio has comfortably outperformed the average fund in the category since it was launched in August 2018, returning 25.6% to investors – more than 10% greater than the 15.3% gain made by the average fund in the IA Mixed Investment 40-85% shares sector. It has delivered in both strong and weak markets, participating in market rallies and minimising losses during corrections. In 2019 the fund was in the second decile following gains of 19%, compared with the average fund's 15.9% return. During 2022's market sell-off the fund limited losses to 9.5% compared with a 10.1% fall in the value of the average fund. The returns during the latest market recovery have been particularly impressive with gains of 9.8% since the start of October 2022 to the end of April 2023, compared with a 6% gain of the average fund.
Sector overview
Source: Morningstar as at 30 April 2023. Performance is based on total return in GBP, calculated gross of tax, bid to bid, ignoring the effect of initial charges and with income reinvested at the ex-dividend date. Fund performance is generated using the Baillie Gifford Sustainable Income B Acc share class.
The portfolio is in the top quartile in the peer group during 2023 year-to-date. Its returns are in the second quartile over 1 year and 3 year time frames.
Baillie Gifford Sustainable Income rankings in Morningstar's GBP Flexible category
Source: Morningstar as at 30 April 2023. Performance is based on total return in GBP, calculated gross of tax, bid to bid, ignoring the effect of initial charges and with income reinvested at the ex-dividend date. Fund performance is generated using the Baillie Gifford Sustainable Income B Acc share class in the IA Mixed Investment 40-85% Shares sector compared against the oldest share class of each fund with performance until Apr 30, 2023 and data accurate as at 1st June 2023.
The portfolio has comfortably outperformed the average fund in the category since it was launched in August 2018, returning 25.6% to investors – more than 10% greater than the 15.3% gain made by the average fund in the IA Mixed Investment 40-85% shares sector. It has delivered in both strong and weak markets, participating in market rallies and minimising losses during corrections. In 2019 the fund was in the second decile following gains of 19%, compared with the average fund’s 15.9% return. During 2022’s market sell-off the fund limited losses to 9.5% compared with a 10.1% fall in the value of the average fund. The returns during the latest market recovery have been particularly impressive with gains of 9.8% since the start of October 2022 to the end of April 2023, compared with a 6% gain of the average fund.
The very best of ideas
If inflation was the dominant theme in 2022, what does it mean for returns in 2023?
A truly exceptional year, 2022 was dominated by high inflation, rising interest rates and a surge in bond yields. Years like these are thankfully rare. Declining inflation and the end of central banks’ rate hiking cycles could provide a positive tailwind for most assets in 2023, including fixed income. Whatever 2023 has in store, we see more opportunities than we see dangers ahead.
Keeping pace with these higher levels of inflation is a key challenge for income investors. It’s a very corrosive thing if your income is not keeping pace with inflation over time. It’s times like these investors can be tempted to maximise short-term income to keep pace with their outgoings, but we believe that it is essential to look after our clients’ capital too – after all, that is what will pay for tomorrow’s income. Sustainability is another challenge faced by income investors because of the types of investment multi-asset income managers have had in their portfolios. For example, oil and gas might be high dividend payers and an attractive investment in the very short run, but these are not the types of investments that we deem to be compatible with a sustainable economy.
Is income investing changing? What are the key challenges investors face during inflation or times of high interest?
Put simply, our approach involves investing exclusively in companies and countries that are compatible with a sustainable economy. For example, companies that are damaging to the environment will see increasing adverse challenges – not only in terms of regulation and public opinion, but also in terms of the longevity of their business models. Looking forward, in a rapidly changing world, we believe clients will achieve better long-term outcomes by investing in companies and countries that are doing the right thing over time.
Why should multi-asset investors consider a sustainable approach?
“We believe clients will achieve better long-term outcomes by investing in companies and countries that are doing the right thing over time.”
Fund manager Q&A
Bond yields have often overshot when core inflation spikes heading into an economic downturn. And one of the biggest things we will observe closely in 2023 will be where bond yields settle because these will be the discount rates that are used for all assets. In 2022, there was a very high degree of correlation between equities and bonds, which could fall in 2023 as different themes evolve. Therefore, this year may be a mixed year where we begin to see the diversification benefits from owning a range of asset classes restored.
What will drive multi-asset returns this year?
ESG has been established in equity analysis for many years, but across some other asset classes, it’s more nascent and there isn’t a consensus about the best approach. That’s a challenge for multi-asset managers. As a team, we work hard to try and achieve consistency across the portfolio. There is always one question we ask of every company and country we invest in: is this investment compatible with a sustainable economy? The investors at Baillie Gifford think hard about how to do that within each class. We have a deep underlying knowledge of each holding so, as a team, we are well-placed to tackle the important ESG questions for the assets we invest in. Other managers may outsource or use a passive, index-based product where they don’t have the underlying expertise on each of the companies or countries that they invest in to be able to do that. That’s where our approach - with bottom-up, income-focused portfolios for each asset class – is a bit different. Another critical component is setting engagement priorities with companies and countries. As long-term investors, we are well-placed to make meaningful differences over time. We are fortunate at Baillie Gifford to have a depth of experienced ESG professionals, including an ESG specialist for our Sustainable Income strategy. We focus on the material factors when it comes to engagement, which varies depending on the nature of the investment. Within this strategy, our engagements range from dialogue with governments about their climate change ambitions, through to discussing pricing policies with the pharmaceutical companies we invest in.
What are the key ESG risks for multi-asset managers, and how do you tackle these?
Within our Sustainable Income Fund, we start by modelling income and capital returns, in order to develop a strategic asset allocation that delivers our long-term objective of growing the income (and capital) in line with inflation over five-year periods. Having a variety of asset classes to choose from is a real advantage when investing for income. The strategy typically has about one-third invested in equities, a third in real assets (property and infrastructure), and a third in fixed income assets. When deciding upon asset allocation, the Portfolio Construction Group considers the shorter-term, tactical changes that can be made to take advantage of market conditions as they evolve. Within each asset class, we have a bespoke income portfolio managed by our asset class specialists. Stock selection is one of the most important steps at Baillie Gifford and that shines through in this strategy, too. Getting the stock selection right is key to delivering good returns within each asset class that we hold in the Sustainable Income Fund. Provided we hold the right mix of assets over time to deliver on those objectives, and find some of the world’s most exciting, bottom-up income opportunities along the way, the Fund can provide clients with income to last a lifetime.
How are investment decisions made at Baillie Gifford and what is the process you use?
Baillie Gifford’s Steven Hay reveals how he repositioned his assets for the fickle age
Baillie Gifford’s Steven Hay likes things au naturel, which means he doesn’t rely on things like options to generate income for his Sustainable Income fund. Instead, his team focuses on the natural income – dividends and bond coupons – that rolls off the portfolio year after year. ‘We’ve got four very experienced multi-asset investors managing the asset allocation and we have bespoke income portfolios within each asset class.’ In the past year, he’s had to adapt to the raft of unpleasant setbacks that affected the global economy, but the Fund has come through with flying colours, all the while keeping his holdings sustainable.
Baillie Gifford’s Steven Hay likes things au naturel, which means he doesn’t rely on things like options to generate income for his Sustainable Income fund. Instead, his team focuses on the natural income – dividends and bond coupons – that rolls off the portfolio year after year. ‘We’ve got four very experienced multi-asset investors managing the asset allocation and we have bespoke income portfolios within each asset class.’ In the past year, he’s had to adapt to the raft of unpleasant setbacks that affected the global economy, but the Fund has come through with flying colours, all the while keeping its holdings sustainable.
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