Lyon (pictured), who manages the five crown-rated Trojan fund, says that equity income valuations are at risk of becoming overly stretched, which could trigger a huge sell-off in the market.
Bonds are usually charged with being the next asset bubble, but Lyon believes the equity income sector could be one of the most volatile areas of the market in the coming year, and says cautious investors should steer clear.
"We would caution those investing in the [Trojan] Income fund to be prepared to accept a higher degree of volatility," he warned. "If you are unable to entertain the idea of an increased risk to your capital, then equity income may not be right for you."
"Has the yield bubble shifted to equity markets? Certainly the demand for UK and global income funds has been strong in recent years."
"Investment Management Association [IMA] data confirms that, of the £3.4bn of net UK fund sales in 2012, £2.3bn was directed into the two income sectors."
"The yield on the FTSE All Share index at the time of writing is 3.3 per cent. This yield has been lower in the past but it is near the bottom quartile of its long-term range of between 5 per cent and 3 per cent. Another 10 per cent rise in the stock market would diminish the yield to 3 per cent and alarm bells would start ringing."
"This level would, by coincidence, be the old high on the FTSE 100 index of 6,950 – and in a world where a 3 per cent yield looks mouth-watering – at least compared with bonds – the over-valuation could always stretch even further."
Lyon’s concerns echo those of Ruffer’s Steve Russell, who told FE Trustnet in August last year that fears of inflation would result in a bubble in the popular sector.
FE Alpha Manager Martin Gray has also voiced concerns over this issue.
Lyon has headed up the £2.3bn Trojan fund since its launch in May 2001.
It has been one of the top performers in the IMA Flexible Investment sector over that time, with returns of 172.4 per cent.
Performance of fund vs sector since launch
Source: FE Analytics
These returns are more than treble those of the IMA Flexible Investment sector average over the period. The Trojan fund has been considerably less volatile than its peers as well.
Lyon says it is understandable why investors are turning to equities given the historically low yields on offer in government and corporate bonds.
However, he thinks the recent uptick in sentiment is extremely fragile and is concerned that investors are moving higher up the risk spectrum than they think.
"In recent months, anecdotal evidence of investor capitulation has been building," he said. "There is a whiff of panic to invest cash at any price."
"Investor surveys point to the highest level of bullishness since 2007. Stock market volatility, as defined by the VIX, is at its lowest since 2007. Even sceptics of the rally have thrown in the towel and joined in."
"With bond yields having collapsed, equities are the final game in town for those scrabbling feverishly around for income. Yet bond investors make very nervous equity investors as they are not used to big losses."
"Since 1970, the most that global equity investors have lost in a year is 48 per cent, while the most that bond investors have lost is 16 per cent."
"In the topsy-turvy markets of today, the most cautious, with the most to lose, are taking ever more risk."
"We appear to have entered a bizarre phase of reluctant speculation in which tomorrow’s income is being converted into today’s – perhaps temporary – capital gain."
FE data shows Trojan's largest asset weighting is in fixed interest, at 37 per cent. Lyon can hold up to 100 per cent in equities, but at present he only has 19 per cent in them.
The fund has a relatively high cash weighting of 17 per cent. Lyon says he will only spend this when he sees better risk-adjusted opportunities in the market.
"Markets have a tendency to climb the stairs and go down the lift," he said. "We are not market-timers but we are value investors. If and when we cannot find value, we will bide our time."
"This may be a long and nerve-wracking process, but at least we aim to protect capital."
Trojan is soft-closed to new investors; however it can be accessed through fund platforms such as Hargreaves Lansdown. The fund has a total expense ratio (TER) of 1.03 per cent.
The fund will be featured in an FE Trustnet study later today, which will highlight defensively focused funds that can help investors sleep at night.