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This is a financial promotion for First State Diversified Growth Fund for professional clients only in the EEA and elsewhere where lawful. Investing involves certain risks including:

The value of investments and any income from them may go down as well as up and are not guaranteed. Investors may get back significantly less than the original amount invested.

  • Currency risk: changes in exchange rates will affect the value of assets which are denominated in other currencies.
  • Emerging market risk: emerging markets may not provide the same level of investor protection as a developed market; they may involve a higher risk than investing in developed markets.
  • Derivative risk: the use of derivatives may result in large price fluctuations and gains or losses that are greater than an investment in the underlying asset.
  • Credit risk: the issuers of bonds or similar investments may not pay income or repay capital when due.
  • Interest rate risk: interest rates affect the value of investments; if rates go up, the value of investments fall and vice versa.

Reference to specific securities or companies (if any) are included to explain the investment strategy and should not be construed as investment advice, or a recommendation to invest in any of those companies.

For a full description of the terms of investment and the risks please see the prospectus and Key Investor Information Document.

If you are in any doubt as to the suitability of our funds for your investment needs, please seek investment advice.

As good as it gets?
2017 year in review

A year in review

The First State Diversified Growth Fund (DGF) returned 7.2%, (B GBP Acc gross of fees) and 6.5% (B GBP net of fees), during 2017. Fund performance was generated from a wide range of drivers, both in terms of active asset allocation and the investment strategies selected within the Fund, combined with a strong focus on risk management, as major political and economic events unfolded.

These figures refer to the past. Past performance is not a reliable indicator of future results. For investors based in countries with currencies other than the share class currency, the return may increase or decrease as a result of currency fluctuations.

Performance figures have been calculated since the launch date. Performance data is calculated on a net basis by deducting fees incurred at fund level (e.g. the management and administration fee) and other costs charged to the fund (e.g. transaction and custody costs), save that it does not take account of initial charges or switching fees (if any). Income reinvested is included on a net of tax basis. Source: Lipper IM / First State Investments (UK) Limited.

Global economic fundamentals across emerging and developed economies improved in 2017. The acceleration in GDP has been broad-based and wide-reaching with roughly two-thirds of the world’s population seeing higher purchasing power. Stronger capital spending has created a rebound in global trade in spite of the populist and protectionism backdrop of 2016. This buoyant environment has surprisingly unfolded without much evidence of inflation picking up; notably a lack of wage growth across economies that appear to reflect “full employment.”

One of the most surprising aspects of 2017 was how calm financial markets were in the face of a number of headwinds. Comparing the rate hikes of the Federal Reserve and the reduction in its balance sheet with the ‘Taper Tantrum’ episode of 2013, investors were relatively sanguine with interest rate markets largely unchanged in much of the developed world.¹ We entered the year with high political risk; five major elections across Europe, the swearing in of Trump, Brexit negotiations starting, and a congress in China. Across Europe (Germany, Netherlands, France) the right-wing threat to mainstream parties was mitigated, US equity and bond markets have performed well in the face of Trump, and while Brexit negotiations have taken a while to get going there seems to be progress. Finally, although China shows (several) warning signs, it has been one of the strongest performing markets this year.

Whilst the performance of financial markets generally reflected the improved global economic picture, the pace and direction of change, by region, has varied considerably.

United Kingdom: Post the Brexit vote,UK growth has been resilient due to a significant downward adjustment in the exchange rate, giving service and manufacturing sectors a boost, combined with an already growing economy with a relatively low unemployment rate. That said, GDP growth has been mediocre, with slowing consumer spending and higher private debt a concern. Disappearing sources of domestic inflation could prove problematic for central bank policy in the face of high imported inflation, leaving monetary policy in limbo. Elevated political uncertainty, pertaining to the UK’s place in the single market, remains the main worry over the medium-term. The direction of the UK is unclear, in our opinion.

Continental Europe: The economic recovery continues and is broad based. Both exports and credit growth are expanding at healthy paces and surprises to growth looks to be to the upside. A beneficiary of the strong demand in German exports has been the uplift to growth for Central and Eastern European countries such as Poland, Hungary, Czech Republic, which are highly integrated into German supply chains. Further, the recovery in peripheral Europe is ongoing with unemployment rates across Europe expected to continue to fall.

United States: Currently economic conditions continue to improve with the Federal Reserve raising rates three times in 2017 to combat inflation pressures, whilst the political turmoil has had negligible effect on markets. So far, there has been no progress on rebuilding infrastructure, but the lower dollar could provide a boost to manufacturing, alongside wage pressure and potential fiscal stimulus (tax cuts and infrastructure spending). Whilst 2017 saw a number of political crises they, somewhat surprisingly, did not affect financial markets, with the S&P500 returning over 20%.

Japan: The incumbent prime minister, Abe, was re-elected in an impressive showing, maintaining his two-thirds super majority in the lower house. The drive to create an inflation target of 2% was strengthened at the December meeting; aggressive monetary easing continues with the Bank of Japan maintaining interest rates at negative 0.1 percent and a target 10 year bond yield at zero. Monetary policy is helping to bring life back to the economy with the last seven quarters showing positive real growth and the unemployment rate at multi-decade lows. Abe’s government is also actively trying to encourage Japan Inc. to raise wages. One of the more interesting policy tools is the plan to reduce corporate tax rates to 20% for firms that increase employee wages and undertake investments.

Investment process
Within our investment process we have two building blocks. The first, which we call Neutral Asset Allocation (NAA), sets longer-term asset allocations. The second part, which we call Dynamic Asset Allocation (DAA), allows us to exploit short-term opportunities in markets. The first step of our NAA process is to set the economic climate for each country. We use the economic climate assumptions within our set of proprietary stochastic simulation models to determine forward looking risk premia and expected returns. The process of determining the NAA uses these expected returns for the building blocks of the portfolio allocations incorporating the return objectives, constraints, and investment horizon of the portfolio. Our DAA process, on the other hand, takes into account the shorter-term market dynamics to deliver additional returns and abate portfolio risks, such as tail events. This part of our investment process, which includes our Investment Signals and qualitative overlay, is formally reviewed each week and looks at (among other things) markets and fundamental data to take advantage of possible dislocations.

Performance and activity

The Fund’s Neutral Asset Allocation (“NAA”) provided 4.6% of the annual return and the Dynamic Asset Allocation (“DAA”) added 2.3%.

Within the NAA, the returns came from a number of asset classes. Equities provided 3.1% of returns (with the large majority coming from developed markets), sovereign bonds and cash added 1.4% (mostly from emerging markets) and credit contributed 0.5%. Commodities and foreign currency exposures each detracted -0.2%.

Consistent with our positioning, the US, UK and Europe (France, Germany, Netherlands and Italy) provided the majority of the performance contribution within equities. As equity valuations in most major developed markets became elevated over the year, with the US looking particularly expensive in our view, we reduced the Fund’s exposure throughout the year. With 20-20 hindsight this reduction was made early considering the performance of equities, with the US and emerging markets being standouts.

Within fixed income the largest contributors to performance were allocations to emerging market local currency debt and corporate credit, while inflation-linked strategies across the UK, US and Australia ended the year flat. The most notable change to positioning was the sale of high yield. It became increasingly difficult to find catalysts to drive spreads significantly tighter and as such, we felt high yield credit was not offering sufficient rewards for the risks, and we exited the Fund’s allocations in November.

The Fund started the year with minimal foreign currency exposure, although in June we increased foreign currency (USD and EUR) due to: (1) the deterioration of the UK economy which was seen in GDP, consumer spending, business investment and net trade; and (2) the UK general election result which resulted in a weak minority government. With prolonged uncertainty surrounding the economic outcomes of Brexit, foreign currency exposure reduces the overall portfolio risk. The Fund also had a small allocation to commodities, which was exited in April. It detracted 0.2% from performance.

Within DAA, Investment Signals provided a strong contribution to returns, while Protection Strategies reduced the volatility of the Fund as planned, but as expected during rising markets, detracted from performance.

Our Investment Signals added 2.6% to performance in 2017. Within Investment Signals the equity positioning detracted while fixed income and currency provided positive contributions. We have more than 20 Investment Signals, of which one (convexity within fixed income) is explained below. The Signals provide us with uncorrelated returns when there are few attractive long-only asset classes available (such as now).

Source: First State Investments as at 31 December 2017

Insights from our Investment Signals
We don’t believe that global markets are completely efficient. This is due to liquidity requirements, regulatory constraints, mandatory hedging and even simple home biases (i.e. local allegiances to home markets) allow dislocations to exist and to be exploited. Thus as part of our DAA we use Investment Signals to aim to generate additional returns and act as an ongoing risk control by reallocating capital when capital markets deviate from ‘fair value’. Investment Signals provide a structured approach to evaluate the attractiveness across, and within, asset classes based fundamental investment rationales. The fixed income convexity Signal measures the slope and curvature of bond yields at different maturities across the globe. We consider convexity a positive attribute for bond holders and a valid investment rationale within our DAA process. The Signal ranks the attractiveness of global bonds on convexity which we periodically update and review for implementation. The convexity Signal provided a positive performance contribution to the Fund in 2017.

We started the year favouring equities based on our Investment Signals, switching in May to reduce equities in favour of positions within fixed income and currency. Within equities, the largest detractors were due to short positions in China and the US. In the figure below, we have shown our equity positioning by strategy. Within fixed income allocations, South African and Italian rates positions were positive standouts, while emerging markets rates views were positive in aggregate in 2017.

Source: First State Investments as at 31 December 2017. Contribution might differ from official performance due to date source, pricing and timing.

Source: First State Investments as at 31 December 2017

Protection strategies were mostly employed at the beginning of the year, when political risks were more prevalent and allocations to risk assets were higher, e.g. President Trump’s inauguration and the multitudes of pivotal European elections. A specific example was the placement of protection strategies during the French elections, with Macron ultimately becoming President. Primarily, put options on equity and credit indices were employed, taking advantage of low implied volatility to reduce risk, whilst retaining the benefit of high prices.

The interaction between NAA and DAA

As the portfolio contains the longer-term valuation driven NAA and the shorter-term insights of our DAA, it is important to appreciate the interaction between the components. One of the key features of DAA is to generate additional returns and abate portfolio risks. As shown in Figure 3, the return contributions from the component parts is complementary; reducing Fund volatility. This is a positive feature and fundamental to our investment process.

Performance since inception

The investment objective of the Fund is to provide growth by achieving a positive return of 4% (gross of fees) in excess of the UK Retail Price Index over a rolling five year period.

Since inception, the Fund has exceeded its investment objective (UK Retail Price Index + 4%), with an annualised return of 6.8% (B GBP Acc gross of fees) and volatility of 7.4%. During the same period, the equities-based FTSE 100 Index has returned 8.9%, but with almost twice the volatility (13.7%).

Economic Outlook

2017 provided strong global growth. Labour markets remain tight in the US, UK, Japan and Germany, although slack still exists in Southern Europe. Lower commodity prices have provided an offset to the closing output gap and core inflation remains low. We expect more of the same in 2018 as easy financial conditions and support from fiscal policy should continue the expansion. One of the key measures that we will be paying close attention will be wage growth. Until we see supply constraints begin to place upward pressure on wages, there is little reason for central banks to start tightening.

We do see a number of risks facing the world economy with asset markets being vulnerable due to stretched valuations. Some of the ‘known unknowns’ are the future of the North America Free Trade Agreement and the World Trade Organisation, Italian elections and a potential conflict on the Korean peninsula. These are areas in which we may decide it prudent to use protection strategies within the Fund, especially as low implied volatility provides reduces the cost of these strategies across the equity and fixed income spectrum.

Monetary tightening in the US has still not resulted in higher longer-term bond yields, meaning discount rates are still low. This has largely underpinned valuations in a number of asset classes. One of the central tenets of the last decade has been that loose central bank policy has supported risk assets such as equities and credit. If Trump’s fiscal plans, such as increased infrastructure spending, proves inflationary, US bonds yields could go a lot higher, led by a rising term premium – and increase volatility.

Source: First State Investments. * Ex-ante volatility reflects the expected annual volatility if positions remain unchanged.

Portfolio positioning

To meet the investment strategy we design the longer-term asset allocation based on our view of economic fundamentals (NAA) incorporating shorter-term opportunities in markets (DAA).

As asset class expected returns have fallen, we reduced exposure to risk assets, such as equity and corporate credit, within the NAA and increased the relative weighting of DAA. This can be seen in the chart below (Figure 4) where most recently the two components have approximately equal contributions to portfolio risk, as measured by volatility.

We consider that in the current low return environment it is critical to have the flexibility to change the blend between NAA and DAA to aim to deliver a real return of 4% for the Fund (gross of fees).

Figure 4 shows the Fund's risk contribution from NAA and DAA. As can be seen in the figure; as risk contribution of NAA has declined, DAA is playing a more vital role in generating returns.

Our NAA provides exposures to markets we believe are attractive on a risk and reward basis, and that offer a good expected return for the level of risk over a five year period. Our equity allocation remains low. Within fixed income we prefer emerging market debt denominated in local and hard currencies such as the USD. The Fund is avoiding corporate credit due to tight spreads, and we have no allocations to longer duration sovereign bonds due to our view that inflation in the longer-term will increase yields.³

Within the DAA, our Investment Signals continue to prefer fixed income and currencies over equities, with a general preference for emerging market exposure vs. developed across all three asset class.

In the current low return environment, we believe it is crucial to be flexible, to actively change the blend between NAA and DAA return drivers. Our investment process and philosophy allows us to maximise the probability of achieving the Fund’s investment objective, providing real returns to our clients.


This document has been prepared for informational purposes only and is only intended to provide a summary of the subject matter covered and does not purport to be comprehensive. The views expressed are the views of the writer at the time of issue and may change over time. It does not constitute investment advice and/or a recommendation and should not be used as the basis of any investment decision. This document is not an offer document and does not constitute an offer or invitation or investment recommendation to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any material contained in this document.

This document is confidential and must not be copied, reproduced, circulated or transmitted, in whole or in part, and in any form or by any means without our prior written consent. The information contained within this document has been obtained from sources that we believe to be reliable and accurate at the time of issue but no representation or warranty, express or implied, is made as to the fairness, accuracy, or completeness of the information. We do not accept any liability whatsoever for any loss arising directly or indirectly from any use of this information.

References to “we” or “us” are references to First State Investments.

In the UK, issued by First State Investments (UK) Limited which is authorised and regulated by the Financial Conduct Authority (registration number 143359). Registered office Finsbury Circus House, 15 Finsbury Circus, London, EC2M 7EB number 2294743. Outside the UK within the EEA, this document is issued by First State Investments International Limited which is authorised and regulated in the UK by the Financial Conduct Authority (registered number 122512). Registered office: 23 St. Andrew Square, Edinburgh, EH2 1BB number SCO79063.

Certain funds referred to in this document are identified as sub-funds of First State Investments ICVC, an open ended investment company registered in England and Wales (“OEIC”). Further information is contained in the Prospectus and Key Investor Information Documents of the OEIC which are available free of charge by writing to: Client Services, First State Investments (UK) Limited, Finsbury Circus House, Finsbury Circus, London, EC2M 7EB or by telephoning 0800 587 4141 between 9am and 5pm Monday to Friday or by visiting Telephone calls may be recorded. The distribution or purchase of shares in the funds, or entering into an investment agreement with First State Investments may be restricted in certain jurisdictions.

Representative and Paying Agent in Switzerland: The representative and paying agent in Switzerland is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich, Switzerland. Place where the relevant documentation may be obtained: The prospectus, key investor information documents (KIIDs), the instrument of incorporation as well as the annual and semi-annual reports may be obtained free of charge from the representative in Switzerland.

First State Investments (UK) Limited and First State Investments International Limited are part of Colonial First State Asset Management (“CFSGAM”) which is the consolidated asset management division of the Commonwealth Bank of Australia ABN 48 123 123 124. CFSGAM includes a number of entities in different jurisdictions, operating in Australia as CFSGAM and as First State Investments elsewhere. The Commonwealth Bank of Australia (“Bank”) and its subsidiaries do not guarantee the performance of any investment or entity referred to in this document or the repayment of capital. Any investments referred to are not deposits or other liabilities of the Bank or its subsidiaries, and are subject to investment risk including loss of income and capital invested.