Sebastian Lyon: why soaring gold is not yet a bubble

In our latest Insider Interview, Kyle Caldwell puts the questions to Sebastian Lyon, manager of Trojan Fund and Personal Assets Ord (LSE:PNL), which both adopt a capital preservation approach. Lyon names four key areas the fund and investment trust invest in to both grow and protect investor returns.

Among the defensive armory is gold. Lyon explains why gold has been a key driver of performance over the long term. The yellow metal has also been a strong performer in 2024, and Lyon considers the gold price soaring, and why it is not yet a bubble.

The fund manager also shares his view on the biggest risks for stock markets, and outlines one area of the bond market where he's finding plenty of value.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider interview. I'm Kyle Caldwell, and today in the studio I have with me Sebastian Lyon, fund manager of the Trojan Fund and Personal Assets investment trust. Sebastian, thanks for coming in today.

Sebastian Lyon, manager of Trojan Fund and Personal Assets: Kyle, thanks very much. It's a pleasure to be here.

Kyle Caldwell: So, Sebastian, to kick off, could you explain the investment approach? You can invest across a variety of different assets. So, which types of investments do you typically invest in?

Sebastian Lyon: Well, Kyle, the main investments that I run, the Trojan Fund and Personal Assets investment trust, are capital-preservation vehicles. What we're trying to do is protect the value and then grow it. And also income is residual. So, we're not desperately trying to generate a high level of income, the capital preservation is more important. We don't want to reach for yield and make a mistake.

We have a sort of go-anywhere policy, really, in terms of the fact that we're a long-only fund, so we don't short, we don't buy derivatives particularly, but we do buy traditional investments which we feel can generate good long-term, risk-adjusted returns for our investors.

Primarily the biggest driver to our returns over the 24 years that I've been running this mandate has been equities, UK and US equities primarily. So, we start with stocks. We have a qualitative bias towards those stocks and those are the things that [have] probably driven about two-thirds of the returns of the fund, and then the balance is in complementary other assets, which will probably do well when equity markets are doing less well.

We have the potential to invest in fixed income, index-linked bonds, which I know we'll come on to, we could invest in commodities, particularly gold, which we think has a very special role within the portfolio, and then cash and liquidity, short-dated bonds.

We're not frightened of having cash. Our cash levels go up and down depending on whether we think the prospective returns are good or less good. So, we've had as much as a third of the portfolio in liquidity, in cash, and as little as 5%. It's not a hot potato burning a hole in our pocket. It's something we use very carefully on the basis of where we see the prospective returns. We're not frightened to have liquidity over short to medium-term periods.

So, those are really the four key asset classes which drive the overall returns of the portfolio.

Kyle Caldwell: So, the two portfolios, I've seen them described as mirror funds. How similar are they, and are there any major differences?

Sebastian Lyon: There aren't really any major differences between Trojan Fund and Personal Assets trust. One is an open-ended fund and one is an investment trust. Generally speaking, the assets are very similar. I wouldn't say they're absolute mirrors.

The way that I run money is I tend not to micromanage the portfolio. So, if we get flows in on a daily basis, or flows out on a daily basis, I don't micromanage and fiddle. That just increases costs, frictional costs. So, I don't do that.

We'll tend to remove the portfolios as and when those adjustments take [place], maybe over months or over six-month periods. But if you look at the portfolios, they're very similar, but they're not absolutely identical, and that's the way I run it.

In terms of the differences, for Personal Assets there's a different fee structure and there's a board that's there to keep me honest, frankly. It is a board that is very engaged in the trust. I've been an investment adviser since 2009, and fund manager on the trust since 2020. We have five board meetings a year. They are engaged, they're aligned, and they're big shareholders in the trust themselves.

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The one difference, which is important to point out compared to some investment trusts, in fact many investment trusts, is that we do have a hard discount control mechanism, which is written in the articles of Personal Assets. So, there are many keen investment trust investors who say they'll buy Personal Assets when it's on a 10% discount. It hasn't been on a 10% discount ever in its life, to my knowledge, certainly not since the 1990s.

We have a discount control mechanism, which means it trades close to, and by that I mean plus or minus 2%, to net asset value (NAV), so the widest discount you'll see is probably a 2% discount and the highest premium you'll see is a 2% premium.

So, that's the difference compared to other investment trusts. But there are still people who like the investment trust model and prefer Personal Assets to Trojan, and similarly the other way round.

Kyle Caldwell: So, if you're looking for a bargain, Personal Assets is not the trust for you?

Sebastian Lyon: No, I'm afraid it's an affordable luxury.

Kyle Caldwell: In terms of the bond market, around a third of both strategies are in US TIPS. Could you explain what US TIPS are, and why you're focusing on this particular part of the bond market?

Sebastian Lyon: So, index-linked bonds and TIPS, that is Treasury Inflation-Protected Securities, which are the US equivalent to the UK index-linked, are sort of hybrid bonds, if you like. They do two things, they work like fixed-interest securities with the exception that you get inflation. So, you get CPI [consumer prices index] or you get, in the UK, RPI [retail prices index].

What that means is when there are periods where there's high levels of inflation, you effectively get that inflation paid to you. Now, for long periods of time, as was the case in the last decade, you had a relatively low period of inflation, so you were getting a bond-ish type return. But occasionally, and as we saw in 2021, 2022 and 2023, we saw a 40-year high in the UK for RPI and in US CPI. And we got, as investors in those bonds, that inflation.

So, they performed much better, on the basis that you keep duration short, but on the basis you don't take huge long-term duration risk with the bonds, i.e, you take shorter-term risk, you get that inflation. And the bond doesn't move materially in price, but you get paid that in terms of both capital value and the income. So, that is why they are, to some extent, beneficial.

The other thing one has to look at is the valuation of those bonds. At the moment, US TIPS are yielding a 2% real yield. So, you are getting inflation plus 2%. So, if you hold it for the duration of that bond, let's say it's a 2028 bond, you will get 2%, plus whatever the inflation level is, 3%, 4%, 5%. If it's 9%, you'll get 9%.

We have our liquidity, which is our short-dated bonds and our cash, but we think these are sort of, if you like, a hybrid in the middle whereby they are liquidity effectively, but they have the potential to have a better return than cash.

They are relatively low-risk investments as well. So, we've held them for quite a long time. They were really helpful during that period of inflation.

There's a lot of strong views now that inflation has come back down and it'll stay low, that's certainly possible. But I think in a post-Covid world and in a world of higher geopolitical risk, in a world where there is less globalisation, where commodity prices are generally speaking more volatile, there's a risk that inflation could come back again. And if that is the case, then TIPS will not be a bad place to be.

Kyle Caldwell: Another key defensive asset that you have is gold. You have around 10% in gold in both portfolios. Gold has performed really well year to date. Could you explain why? And is 10% the typical amount you have in gold? Would you go any higher than that?

Sebastian Lyon: So, there's two answers to that question. The first is why do we hold gold and why 10% or thereabouts? And the other thing is what's happened to the gold price?

The first thing is we hold gold and have held gold in the portfolio going back to 2004/2005. It's compounded at 11% per year in sterling times, perhaps a little bit more than that. But it's done it at a different time to the stock market most of the time. And so it performs differently from other asset classes and fixed income as well. So, it's a really good diversifier for us.

And to some extent it does a job of, hopefully, making us returns when perhaps other asset classes aren't making the return. It's sort of almost in lieu of derivatives or portfolio protection, and yet it costs us very, very little compared to derivatives.

Now, it doesn't do the job always by design. But then derivatives don't always do what you expect them to do, and they're very expensive. Whereas gold in the past has generally done what we would hope it would do. So, it's been a very helpful contributor to the portfolio.

In terms of the size of the holding, we think, and this is sort of almost by process of elimination, around 10%, plus or minus two, so sort of 8% to 12%, is about the right level. Holding 1%, it's just not going to move the needle. It's not going to do the job in the portfolio that you want it to do. If gold gets very extended, then clearly we'll bring it back down to the mid-single digits. But if it's out of favour, we'll generally be adding, as we were back in 2020, 2021, 2022, and prior to that, and actually 2018 when it got very depressed.

To answer your question about this year, I think gold's been fascinating and it's often associated with sort of swivel-eyed loons. But who has been buying gold this year? Why has the gold price been going up? It's actually not the swivel-eyed loon brigade at all, it's central banks. It's been men and women in suits who have decided to increase their exposure to gold.

Poland has specifically stated, I think they're going to increase their reserves from 15% of the reserves to 20% of the reserves. That is a process which is not going to take two or three days, or two or three months, or even two or three years. It's a long process. When central banks start buying gold for their reserves, and it is a reserve asset, which I think people forget about, then they tend to do it for a prolonged period of time. Why are they buying? Why have they been buying so consistently? I think it comes back to February 2022.

Frankly, the invasion of Ukraine changed everything from the perspective of the gold price. Back then, interest rates were beginning to go up. Everybody was thinking, we don't need to hold gold because there's an opportunity cost because interest rates are moving up. We're making money on our cash. We don't necessarily need to hold a non-interest bearing asset. But that was the wrong thing to do on the basis that what these central banks were recognising was that on the invasion of Ukraine, $320 billion of Russian assets were confiscated effectively through the international monetary system and sanctions were imposed on Russia.

Other central banks looked at this and they thought this is the weaponization of the US dollar, strategically we want to decrease our exposure to the US dollar within our reserves, and we would like to increase our exposure to other assets. They could have bought euros, they could have bought other currencies, but they decided to increase their exposure to gold.

Pretty much month on month since February 2022 central banks around the world, this includes Poland, but [also] the Czech Republic, Singapore, and obviously China in a very big way, [who] do it much more privately than other central banks, have been buying month on month pretty much for those two, two and a half years.

So that is what has been going on with the gold price and it hasn't been to do with interest rates. It's been to do with strategic decisions on behalf of central banks and interestingly, and why I think that gold is not necessarily in a bubble yet, although it's been very helpful, is because Western investors have been selling. So, since 2020/2021, if you look at exchange-traded fund (ETF) exposures in the West, whether it be UK-listed or US-listed ETFs, they've actually been declining in terms of the number of ounces.

That has just begun to turn in the last month or two, few months, maybe the last quarter, but throughout the period where the central banks have been buying, Western investors have been selling. So, the idea that there's some sort of massive bubble out there, it might turn into a bubble, but it certainly isn't a bubble yet.

But that role within the portfolio is key. And importantly, we don't allow it to run away. So, we keep it at 12%. This year we have sold twice, both at about $2,450 and about around $2,600, for both Personal Assets and Trojan Fund. Just modestly, to keep it a 12% level because we don't want the risk tail to wag the dog. We want to manage that risk quite carefully.

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Kyle Caldwell: Given your focus on capital preservation, what are the main risks for markets that you're seeing at the moment?

Sebastian Lyon: Well, I think there are always plenty of risks out there and it's the things that are unexpected that affect markets. There's obviously a lot of talk at the moment about the Budget. I don't think that's going to materially affect equity markets.

Similarly, there's a lot of focus, thanks to the 24-hour news view, of the US election. I think that while that might affect markets very briefly in the shorter term, rather like it did with the election of Donald Trump back in November 2016, eight years ago, that was a sort of one-day, two-day change and, really, things settled down quite quickly.

So, actually, famous last words, I don't think the Budget or the US election are necessarily going to move markets dramatically.

What I do think is likely to affect markets on a negative fronts is geopolitics. Because geopolitics, as we saw with Ukraine and we saw with 7 October 2023, markets are very good at discounting things which they can see ahead, but they can't discount things that happen very suddenly. And that's why you see those jolts. And particularly in a stock market, which is actually quite highly valued by historical levels, the risk is that everybody runs for the door at the same time.

So, I think that geopolitics, whatever that might be, and if it's something that the markets haven't considered, whether it be Israel hitting nuclear sites in Iran or something, or China invading Taiwan, whatever it is, if it's something which isn't currently expected in markets, that is a risk. And clearly we're moving, in a post-Covid world, to a period of higher geopolitical risk than the very benign period, frankly, which we were fortunate to be in prior to Covid and prior to Ukraine. So, that's one thing.

The second thing that I feel that's fairly obvious is a recession. A recession was expected to happen in early 2023. It didn't happen. And so it's sort of gone away now and people aren't expecting it. People are expecting a soft landing. Central banks are talking about a soft landing. Engineering a soft landing.

Soft landings are very rare. They do happen, but they're extremely rare, particularly when you've seen the level of interest rate rises that we've seen. And don't forget, although people are talking about the interest rate cuts that we've seen in the last few months, interest rate effects aren't felt for at least 12 or 24 months. So, actually, what we're feeling today in October 2024 is the interest rate decisions that were made back in the first half of 2023, i.e. that period of going from 0% to 5%. That's what we're feeling today.

The feeling of the cuts won't really be felt probably for another 12 to 24 months. So, there is this long and variable lag which people talk about. I think that the risk is that the Federal Reserve is behind the curve, the Bank of England is behind the curve, and they're cutting too late and that actually we're already heading towards some sort of recession. That's perfectly possible, and it's certainly not discounted in markets. Markets are not looking for any sort of hard-landing prospects.

So, I think those two risks are the biggest for the next, say, call it the next 18 to 24 months.

Kyle Caldwell: One thing, though, that we can immediately see with those interest rate rises is that bonds are now offering a decent level of income, which has not been the case for many years. Given that you can get around 5% on money market funds, which invest in very low-risk bonds, does this change your mentality at all in terms of the investment returns you're seeking to achieve?

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Sebastian Lyon: It's a really good question and it's one we've thought about a lot in that we were in this remarkable era, which we always said wouldn't last forever, but certainly lasted longer than we were expecting, but from the financial crisis to 2022, we lived in an area of effectively zero interest rates and quantitative easing (QE) as well. So, what we call an unorthodox interest rate environment. Almost unprecedented in 6,000 years of monetary history. I mean, remarkable really.

And today we've seen a normalisation, we've seen it back to where we started prior to the financial crisis, when interest rates were sort of between 4% or 5%. And here we are, back to normal rates of interest.

Over the life of the fund, we've generated about 7% net of fees. So, a sort of equity-type return with less than bond-type volatility. That's what we would seek to do over the long term. Over the shorter-term periods, it varies, naturally. It depends on what markets are doing, it depends on how we are invested. But that's what we've generated in the past.

We were happy with those sorts of returns, perhaps slightly higher than that during the interest rate environment prior to the financial crisis. Since the financial crisis, probably a slightly lower rate, but still mid-to-high single digits. And today we recognise that there is a cost of capital. Frankly, I think that's a good thing.

But I think we recognise that we need to be generating high single-digit returns over the medium term to justify the probably 4% that people can generate either in the bank or from short-dated bonds. So, I think we recognise that there has been a change, a dramatic change. I think you've seen that in markets. A lot of alternatives have actually fallen in value due to the fact that yields have risen.

One of the things that we were very careful to do in recognition of this change that was always likely to happen, which is that we revert back to a normal interest rate world, is we didn't have very high-duration bonds within the portfolio. We recognised that the world which we had been in of bonds and equities being this wonderful yin and yang, sort of cheek-by-jowl portfolio construction of a balanced portfolio of bonds doing well when equities do badly and vice versa. 2022 was a real wake-up call for investors that actually bonds and equities can fall at the same time if you [are] in a higher inflationary environment and a rising yield environment.

We knew that was a risk and managed the portfolio accordingly and did pretty well in 2022. As a result of that, we didn't lose too much when other, perhaps less-liquid and more fixed-yielding, assets generally fell in value because yields rose.

So, we're aware of this change in dynamic and we recognise we need to target higher longer-term returns, but we're not going to be seeking to take risks to generate double-digit returns. Unless we really see there's double-digit returns that are there that are obvious within asset classes, within equities, for example.

One of the times we saw that was in 2009. Equity markets collapsed in 2007, 2008, they fell by almost 50%. The prospective returns from there were very high. They were double digits, and we moved up the allocation to equities to 75%. Today, our equity allocation is only 30% because the prospective returns are somewhat lower.

If markets fell for recession reasons or a geopolitical reason, then the prospective returns would be higher and we'd be very happy to increase our risk and therefore our prospective returns.

Kyle Caldwell: Sebastian, thank you for your time today.

Sebastian Lyon: It's a pleasure, Kyle. Thank you.

Kyle Caldwell: That's it for our latest Insider Interview. Hope you've enjoyed it. You can let us know what you think. You can comment, you can like and do hit that subscribe button. Hopefully I'll see you again next time.