Aberdeen Latin American Income Fund — Outperforming a volatile market

While there have been divergences in performance between Latin American securities and UK shares (in sterling terms) during the last five years, over the period as a whole, they have performed broadly in line (Exhibit 2, LHS). While IMF economic growth forecasts for Latin America are below those for advanced economies in 2019 (0.6% versus 1.9%), in 2020, the outlook for Latin America is superior (2.3% versus 1.7%). Economic drivers in the region include population growth, a more affluent middle class and low labour costs. In terms of valuation (Exhibit 2, RHS), looking at forward P/E multiples, Latin America appears attractive versus the world market in both absolute and relative terms. The growth and valuation prospects in Latin America may appeal to investors seeking attractive opportunities outside of the main developed markets, such as the US or Europe.

ALAI is a Jersey-incorporated closed-end investment company, launched on 16 August 2010. The fund is managed by ASI, which aims to generate a total return with an above-average yield, primarily via investing in Latin American securities. ALAI’s performance is benchmarked against a sterling-based composite index comprising 60% MSCI EM Latin American 10/40 index and 40% J.P. Morgan Government Bond Index EM Global Diversified (Latin America carve-out). The manager invests in equity, equity-related and fixed income securities; at end-June 2019, the fund held c 61% in equities and c 39% in government bonds. Guidelines dictate that at least 25% of gross assets are held in equities, with at least 25% in fixed income investments, but there are no restrictions on geographic, sector or market cap exposure. At the time of investment, a maximum 15% of gross assets may be held in a single company, with up to 25% in non-investment grade government debt. Unlisted securities may be held at the manager’s discretion, and derivatives are permitted (up to 50% of gross assets) for efficient portfolio management and to mitigate risk. The manager may employ gearing (up to 20% of net assets at the time of drawdown); at end-June 2019, net gearing was 11.3%.

We met two of ASI’s investment managers, Viktor Szabó (emerging market debt team) and Brunella Isper (global emerging markets equities team), who shared their thoughts about the outlook for Latin America. Szabó says his team favours the region over other emerging markets, noting that from a top-down macro perspective, ‘these are interesting times’. He suggests that Asian economies are most at risk from the US-China trade dispute, including its implications for the global supply chain. The manager says that in Q418, Latin America suffered from falling commodity prices, but emerging markets were supported by more dovish Federal Reserve policy from early 2019, which led to very strong share prices across most regions in H119. He notes that on a global basis, bond yields have continued to fall and so far this year there have been significant inflows into emerging bond markets, reflecting the low-yield, low-growth environment. Szabó says that investors are desperately searching for yield and within the global bond market, there is c $15tn of assets with negative yields (mostly in developed markets, but also creeping into emerging markets).

The managers highlighted important features and developments in Latin America:

Szabó says that a historically important theme in Latin America has been its problems with corruption (a main weakness in terms of economic, social and governance (ESG) standards). However, the manager argues that tolerance for corruption is diminishing and the perception of immunity from prosecution is gone, which is a big change from three to five years ago. Politicians are now winning elections based on anti-corruption and increased legislation policies, such as in Brazil and Mexico. He says there is an underlying structural improvement in the region, away from corruption, and is hopeful that this will continue, as he considers it would be very beneficial for investor sentiment towards Latin America.

ASI employs a team-based approach, seeking high-quality investments trading on reasonable valuations that can be held for the long term. For equity investments, the global emerging markets equities team seeks companies with stable growth or are benefiting from structural improvements, with robust balance sheets and strong management teams. Potential investee companies undergo bottom-up, proprietary research; regularly meeting company managements is a key element of the investment process, and there is a keen focus on a company’s ESG track record. ALAI’s equity portfolio turnover is c 15% pa, implying an average seven-year holding period, although some positions have been in the portfolio for more than a decade.

ASI’s emerging market debt team seeks high-quality securities that generate a sufficient level of income. Analysis is undertaken on a bottom-up basis, focusing on the perceived prospects of each individual country. ALAI invests only in government or quasi-government issuers, rather than corporate debt, which can be illiquid. Investments are generally made in local rather than hard currencies, but the managers can hedge or take forward currency positions.

ALAI’s two investment teams communicate regularly to consider portfolio positioning (including the level of gearing), combining macro and micro inputs and discussing findings from recent trips and company meetings. The relative exposure between equity and debt represents the teams’ views on the outlook for Latin America; a higher equity weighting denotes a more bullish outlook. Country and sector weightings will also change depending on where the managers see the best value and opportunities. ASI’s investment approach is very risk aware; it has an independent performance and risk team to ensure that funds adhere to their investment guidelines and that managers are aware of their risk exposures.

Exhibit 4 shows ALAI’s portfolio breakdown at end-June 2019. Over the preceding 12 months there was a 10.2pp shift from fixed income into equities. The number of holdings remained steady at 65, while the top 10 concentration was broadly unchanged (45.4% versus 44.5%). The fund’s active share at end-June 2019 was 48.2%, versus 60.6% a year earlier. (This is a measure of how a portfolio differs from its benchmark, with 0% representing full index replication and 100% no commonality.)

In terms of geographic exposure, the largest change over 12 months to end-June 2019 is a higher weighting in Brazil (+10.4pp), with lower weightings in the other countries in the region led by Colombia (-3.7pp), Uruguay (-2.9pp) and Mexico (-1.4pp).

So far in 2019, on the equity side, there have been two new holdings and one complete disposal (see below). Isper comments that stock market volatility has afforded opportunities to modestly top up and trim positions, although over this year the position in Petrobras has broadly doubled, as the team has greater conviction in the investment case and the company has been trading at an attractive valuation.

Within the fixed income portion of ALAI’s portfolio, the manager has meaningfully reduced the Argentine weighting and increased the duration of its Mexican bond exposure in anticipation of lower interest rates. Elsewhere, the Brazilian exposure has increased, while the Colombian exposure was reduced.

Over the last 12 months to end-July, ALAI’s investors have enjoyed strong absolute total returns (NAV +21.5% and share price +20.1%, well ahead of the +17.3% of the benchmark). Isper highlights positive contributions from the holding in Brazilian department store retailer Lojas Renner, as well as having no exposure to Mexican companies América Móvil (telecoms) and Grupo Televisa (media), which performed relatively poorly. The underweight position in Brazilian oil company Petrobras detracted from performance. Within fixed income, Brazilian asset selection added to performance, while the fund’s Uruguayan exposure detracted from returns.

In terms of relative performance, ALAI is ahead of its composite benchmark over one year (a period characterised by elevated stock market volatility), and broadly in line over three years, while its NAV total return has lagged modestly over the last five years and since the fund was launched in 2010. Of note to UK investors, ALAI has outperformed the FTSE All-Share index over the last three years and very convincingly over the last 12 months.

As shown in Exhibit 10, over the last three years, ALAI has generally traded within a range of a c 10% to c 16% discount. Its current 14.0% discount to cum-income NAV is towards the wider end of the 9.3% to 16.7% range over the last 12 months. It is also wider than the average discounts of 14.1%, 13.3% and 12.2% over the last one, three and five years, respectively.

Renewed annually, the board has the authority to repurchase up to 14.99% and allot up to 10% of issued shares to manage a discount or premium. In H119, 1.1m shares were repurchased at a weighted average discount of 13.0% and so far in FY19 (ending 31 August), 2.0m shares have been bought back (3.4% of the share base) at a cost of £1.4m.

ALAI is a Jersey-registered investment company with one class of share; there are currently 58.2m ordinary shares in issue (a further 6.1m are held in treasury). It has a three-year £8m, multi-currency, revolving credit agreement with Scotiabank (Ireland), of which £6.5m is drawn (the fund is not permitted to have fixed, long-term borrowings). At end-June 2019, net gearing was 11.3%.

Aberdeen Standard Fund Managers is ALAI’s alternative investment fund manager and is paid an annual management fee of 1.0% of the company’s NAV (charged 40% to the revenue and 60% to the capital accounts). The fund’s ongoing charge ratio (OCR) is capped at 2.0%, with any excess fees rebated. In FY18 the OCR was at the 2.0% cap (1.98% in FY17).

Having been rebased from 4.25p in FY16, due to the depreciation of Latin American currencies, ALAI’s annual dividend has remained at 3.50p per share for the last three financial years (it was 1.1x covered in FY18. The fund distributes dividends quarterly, in January, May, July and October. At end-FY18 (after allowing for the final dividend), ALAI had revenue reserves of £1.7m (c 80% of the last annual dividend), with the board seeking to build these to give a full year of cover. It currently offers a 4.9% yield.

ALAI is one of two funds in the AIC Latin America sector. Its NAV total return is ahead of its peer group over one year, marginally ahead over five years, while trailing over three years. The fund has a wider discount and a higher ongoing charge (due the impact of fixed costs on a smaller base), and a broadly similar level of gearing. ALAI and BlackRock Latin American have markedly different investment strategies, but both offer attractive dividend yields.

We also compare ALAI with a range of open-ended funds investing in Latin America, although its government bond exposure is a unique feature. Its NAV total returns are above the average return of the open-ended funds over all periods shown. ALAI’s dividend yield is also very attractive compared with the average of the open-ended funds.

ALAI’s board has four independent, non-executive directors. Richard Prosser has been the chairman since the fund’s launch in 2010, while George Baird has also been on the board since launch. As part of the board’s refreshment programme, Hazel Adam became a director on 27 April 2018. The newest member of the board is Heather MacCallum (since 24 April 2019); she is a chartered accountant and was formerly a partner of KPMG, Channel Islands. MacCallum is a non-executive director and chair of the audit committee of Jersey Water and Blackstone/GSO Loan Financing and is a non-executive director of Kedge Capital Fund Management.