Fund Review

Defensive Capital Fund

September 2020

Brooks Macdonald

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Contents Executive summary Page 4

About Brooks Macdonald

Defaqto Ratings

Quantitative review

Investment objective Page 5

Fund information and classification

Asset allocation

Top 10 holdings Page 6

Liquidity

Performance - total and discrete returns Page 7

Risk Page 8

Drawdown

Fund size and fees

Qualitative review

Philosophy Page 9

People

Process Page 11

Risk management Page 12

Glossary Page 13

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This document is designed to provide the reader with a quantitative overview of the fund reviewed. The review then goes on to examine information of a more qualitative nature, which has been obtained through an interview process with the fund manager/s.

The qualitative information covers specific areas including the fund manager’s philosophy, their people, and the processes they employ. Additional information is also provided on their research capability, the resources they have at their disposal and how they manage risk. All of this information goes towards creating this comprehensive Fund Review.

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4

Executive summary

About Brooks Macdonald

Brooks Macdonald Defensive Capital Fund Patrick Norwood, CFA

Fund Review

The Brooks Macdonald Defensive Capital Fund was launched in 2006 and changed to its present strategy in 2010

It is a long-only diversified asset fund that aims to produce positive absolute returns over rolling three year periods

This has been achieved in 87 out of 89 months since its 2010 change in strategy, plus the fund has produced positive returns in every calendar year since 2010, apart from 2018

Potential asset classes are divided into four groups - those giving a defined payout, those with attractive coupons or yields, those trading at unjustified discounts to their net asset values and those providing exposure to non-standard investments such as private equity or renewable energy

Assets are invested in based on their expected risk/reward trade-off as well as their liquidity and correlation characteristics

Return and risk are modelled for each potential asset class using proprietary models

Implementation is usually a combination of direct and indirect exposure

The fund typically has 100-120 holdings, with assets held for

around 2 years on average

As well as the performance track record, the manager believes the fund’s main differentiators to be:

They look at things differently, for example considering unloved asset classes and assets with little broker coverage

The fund is long-only and less complicated/more easily explainable compared to some other absolute return funds

Brooks Macdonald was established in 1991 and has been a member of the London Stock Exchange’s Alternative Investment Market (AIM) since 2005. They have around £13bn in assets under management (AUM) as at end-2019. Within this total, collective investment scheme AUM is over £1bn.

The founding directors and staff retain some ownership of the company. Other major shareholders include institutional fund management companies (for example Liontrust Asset Management and Octopus Investments), through various investment vehicles.

Brooks Macdonald has approximately 500 employees.

The Defensive Capital Fund launched in December 2006 but converted to an OEIC and changed strategy to a more defensive mandate in March 2010.

Investment Fund Services Limited are the fund’s ACD.

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Quantitative review

Fund information and classification

All analysis using Morningstar data to 31 July 2020

Launch date 21 December 2006

Fund Manager Niall O’Connor

Domicile GBR

Assets Active

Approach Return Focused

Type OEIC

IA sector Targeted Absolute Return

Morningstar category* Alt - Multistrategy

Defaqto Diamond Rating Type Absolute Return

Diamond Rating 5

The fund is designed to provide investors with an opportunity to attain the low volatility of bonds while maintaining the exposure to potential equity upsides. The fund aims to achieve long-term capital growth that is independent of equity market performance and positive absolute returns over rolling three year periods.

The fund has a Defaqto risk rating of 3.

The assets comprising the biggest portions of the portfolio are convertibles (bonds where the holder has the option to convert them into equity), autocalls (structured notes issued by investment banks and which pay fixed coupons provided the equity index on which they are based has not fallen by more than a pre-set amount) and real assets (assets that

have significant inflation protection or will perform well if inflation rises), with these three classes together making up nearly 60% of the fund.

Investment objective

Asset allocation

*Note: The Morningstar Category is used in all comparative analysis, over the following pages.

Note

This asset allocation chart is drawn using the 16 asset classes (including ‘other’) that we use in our modelling.

This may differ slightly from the asset allocation described by the fund manager, due to various asset class roll-up and mapping variances.

-10% 0% 10% 20% 30% 40% 50%

Cash - Short Term Money Market

UK Index Linked Bonds

UK Government Bonds

UK Corporate Bonds

Global (ex-UK) Fixed Income

Absolute Return

Commodities

Global Property

Private Equity

UK Equity

Europe (ex-UK) Equity

North America Equity

Developed Pacific (ex-Japan) Equity

Japan Equity

Emerging Markets Equity

Other

Net Asset Allocation

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Liquidity

Top 10 holdings Convertible bonds comprise four of the top 10 holdings in the portfolio (as at 31 July 2020).

As can be seen from the table below, the portfolio is quite liquid, with numbers from Brooks Macdonald showing that two thirds could be liquidated within a week and over 90% within a month.

Name Sector Country % of assets

Greencoat UK Wind - United Kingdom 2.2

Gold Shares Note (SG) - - 2.2

ADO Properties Real Estate Luxembourg 2.1

NKY Autocall 5.8% (HSBC) - - 2.1

Pacira 2.375% Conv Bond 2022 (USD) - United States 2.1

Endeavour Mining 3% 2023 Conv Bond (USD) - Cote D’Ivoire 1.9

Sony 0% 2022 Conv Bond (JPY) - Japan 1.9

Nomura 5x US CPI Inflation Option (USD) - - 1.9

VPC Speciality Lending - United Kingdom 1.9

Zillow 1.5% 2023 Conv Bond (USD) - United States 1.9

Date 31 July 2020

Total Number of Equity Holdings 8

Total Number of Bond Holdings 20

Assets in Top 10 Holdings (%) 20.1

Days to liquidate holdings % of portfolio

1 - 7 days (%) 67

8 - 30 days (%) 25

31 - 180 days (%) 6

181 - 365+ days (%) 2

Source: Brooks Macdonald, August 2020

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Performance - total and discrete returns The fund’s value fell during the COVID-19 market volatility earlier in the year, although it has since regained almost all of that loss.

According to figures from Brooks Macdonald, the fund has achieved its objective of positive rolling 3 year returns in 87 out of 89 months since its 2010 change in strategy. Including the track record of the less defensive predecessor strategy, the fund has achieved positive rolling 3 year returns in 119

out of the 124 months since launch.

The fund has also produced positive returns in every complete calendar year since its 2010 change in strategy apart from 2018. The negative return over 2018 was due to almost all asset classes having poor returns during the year and the fund being long-only (one needed to have the ability to invest short to do well in 2018).

-5%

0%

5%

10%

15%

20%

25%

31/07/2015 31/07/2016 31/07/2017 31/07/2018 31/07/2019 31/07/2020

5 Year Total Return

IFSL BrooksMacdonaldDefensive Cptl Fd 5YrTRCPI

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Year 2016 Year 2017 Year 2018 Year 2019 Year 2020 to date

Discrete Returns

IFSL Brooks MacdonaldDefensive Cptl Fd TR

CPI TR

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Drawdown

Risk

The fund’s annualised volatility was relatively low over the 5 years to end-July 2020, at just under 6%.

The number of positive return months comfortably outweighed the number of negative return months over the 5 years to end-July.

Last 60 Months

Max Drawdown -21.1%

Positive Months 38

Negative Months 22

Worst Month -13.8%

Fund size and fees

The size of the fund is just over £570m. Capacity for the fund is currently seen at about £1bn with the existing team and asset classes but could be up to £2.0-£2.5bn if the team were to be expanded and other asset classes are considered.

Charges are fairly competitive for this type of fund (the numbers for Defaqto’s Absolute Return Diamond Ratings have the fund’s OCF in the second most favourable quintile).

AUM £573m

Date 31 July 2020

OCF Estimated 1.10%

OCF Actual 0.62%

Transaction Fee Actual 0.27%

Performance Fee (Yes/No) No

Performance Fee Actual n/a

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00%

An

nu

alis

ed R

etu

rn

Annualised Volatility

5 Year Risk & Return

IFSL Brooks Macdonald Defensive Cptl Fd

31/07/2020

9

Qualitative review

People

The main aspects of the fund’s investment philosophy are:

Diversified assets - the fund invests in a range of assets including equity-linked, bond-linked and assets with linkages to returns from alternative sources

Diversification - risk is diversified by investing across a range of assets, in different parts of the capital structure, a range of geographies and across currencies

A long-only strategy (as opposed to relative value, arbitrage or pair trading) - this allows the fund’s performance to be predictable both in advance (ex-ante) and explainable (ex-post)

Investing in mostly senior assets, ideally also where there is low leverage, leading to lower volatility

A focus on rewards versus risk should also lead to low volatility while generating positive returns, even in flat markets

Additional opportunities for the fund manager to add alpha include: information arbitrage in lower cap and/or poorly researched assets not covered by the sell-side (with this opportunity expected to increase post-MiFID II); taking advantage of structural supply/demand imbalances; investing in unloved/out of favour sectors; and the often large discount on many assets for their illiquidity.

Assets are seen by the manager in terms of four categories:

Defined payout where the risk/reward balance looks attractive

Attractive coupon or yield

Trading at an unjustified discount to net asset value

Providing exposure to non-standard investments such as private equity or renewable energy

Niall O’Connor is the Fund Manager for the Defensive Capital Fund.

Niall joined Brooks Macdonald in 2013 and the Defensive Capital Fund team in 2016. His 20 years of investment management experience includes the development of derivative pricing and risk models.

Also part of this team is:

Emma Richmond, who manages all operational and regulatory aspects of the fund.

George Marlar, who joined the team in late 2019. He is the team’s Research Analyst.

A Convertibles Analyst will also be joining the team in mid-September.

The manager does not manage any other funds or have any additional responsibilities.

Philosophy

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Source: Brooks Macdonald, September 2020

Niall O’Connor

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Process

The fund’s potential universe is those assets that have well-defined returns: the entirety of the bond market (with the general exception of government bonds as their yields are too low) as well as structured notes; investment companies (with those investing purely in large cap listed equities only if trading at a significant discount to net asset value); and a range of alternative assets as well as derivatives for both investment and efficient portfolio management purposes.

All assets for the fund are selected primarily on a risk versus reward basis - upside potential should exceed downside potential on a risk-adjusted basis.

There are also secondary considerations for liquidity and uncorrelated returns. Assets with a lower correlation can have a less favourable risk/reward trade-off while those that are less liquid need to have a more favourable trade-off.

The team have developed proprietary models for each asset class, enabling them to model returns and volatility for a range of market scenarios. Investments are selected based on their potential return profile compared to their volatility and downside potential but also other risks such as quality, cover levels and seniority in the capital structure (where applicable).

Sub-asset classes that are attractive on the above basis are sought after and then it is determined whether the best exposure can be available directly or if indirect exposure via a specialist investment company or fund would add value. Most exposures feature a combination of both direct and indirect holdings.

In terms of the four categories of asset class, the fund’s current universe encompasses:

Defined payout where the risk/reward balance looks attractive - structured notes and convertibles

Attractive coupon or yield - investment companies

engaged in loans, corporate bonds and ZDPs

Trading at an unjustified discount to net asset value - investment companies

Providing exposure to non-standard investments - investment companies investing in private equity or renewable energy

The proprietary modelling mentioned above can also show the manager the likely impact that changing any of the underlying positions would have on the overall portfolio.

Top-down macroeconomic factors including economic growth expectations, the interest rate cycle and sector overviews will also have an influence on the asset allocation and security selection decisions. Brooks Macdonald’s economic research is used to assist with this part of the process.

The fund typically has between 100 and 120 holdings. The current number is 106. Assets will be sold if:

They have become more expensive, either on an absolute or relative basis, so the risk/reward ratio no longer looks attractive

The original investment thesis does not play out

External circumstances change to invalidate either the risk/reward or the investment thesis

Turnover has recently been about 55%. Historically the number was around the 40% mark and the manager expects it to return towards that level. Average holding periods are therefore of the order of two years.

No leverage is utilised within the fund and there is no gearing at fund level (although some of the investments may use gearing as an investment strategy).

Source: Brooks Macdonald, September 2020

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Risk management

The manager seeks to allocate his risk budget roughly equally across:

Autocalls and other structured notes, net of equity hedges

Convertibles

Discounted assets

Specialist lending, structured credit and fixed return assets

Real assets

There are various soft limits for the fund, including: maximum position size of 2%; maximum exposure to any one theme of 5%; top 10 holdings aggregate maximum of 25%; maximum exposure to any one company of 3%; maximum structured notes issuer exposure of 5%; portfolio duration of less than 2 years; a minimum of 60% of the fund in GBP (post hedging); and the ability to sell at least half of the fund within 3 days. In addition, the fund is not permitted to invest more than 10% in other collective investment schemes.

Individual holdings and the portfolio as a whole are monitored, using a proprietary model, on a range of metrics, including liquidity, FX exposure and volatility primarily but also seniority, term and the fixed versus floating mix.

The various asset classes are also each monitored on two metrics specific to that asset class, for example: delta and years to maturity for convertibles; and adjusted discount to NAV and dividend yield for structured credit, specialist lending and discounted assets.

The fund is formally monitored and reviewed by the ACD, but also the Brooks Macdonald Investment Risk team and by the Brooks Macdonald Investment Committee, with monthly and quarterly monitoring and review by various parts of Brooks Macdonald.

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