I’ve recently written a series of articles highlighting which funds do the best when their chosen market performs well. Finding such funds is a tactic used by FE Alpha Manager Martin Gray, who likes to maximise his asset-allocation calls with funds that stand the best chance of making a lot of money in an upswing.
This way of investing makes a lot of sense, but it doesn’t sit comfortably with me when it comes to my own money.
Gray – one of the highest-rated fund of fund managers out there, who has a proven track record of calling market crises – has far more knowledge than I do when it comes to timing the market.
I personally don’t have the conviction to go for a shoot-the-lights-out fund every time I believe a certain area of investment will do well. Looking back at fund managers’ market outlooks for 2011, the majority were very bullish and only a few even mentioned the eurozone crisis, let alone anticipated a swift market sell-off that saw the MSCI AC World index fall almost 20 per cent in the summer months.
Being naturally cautious, I’m of the opinion that slow and steady wins the race. I personally would much prefer to invest in a fund that protects effectively against the downside and that underperforms during the inevitable rebound, rather than one that does the opposite.
After all, if a fund loses 50 per cent one year it has to deliver 100 per cent the next to get back to even. There are a number of aggressive funds, such as Ed Legget’s Standard Life UK Equity Unconstrained portfolio, which more than makes up for poor periods during market sell-offs, but I personally don’t have the stomach for them. Past performance is, of course, not a guide to future performance, but the risk and volatility of a fund is far easier to predict.
Performance of fund versus sector and index over 6yrs
Source: FE Analytics
Whether it’s the long-term core funds that make up the bulk of my portfolio or the shorter-term plays I use to try and take advantage of a particularly strong conviction, I go for those that the industry would call “defensive”.
In my mind, if my asset-allocation decision is wrong and the market falls, my fund shouldn’t fall as much as its rivals, and will give me some protection on the downside. Yes, it may well not make as much as other funds in a market upswing and it may even underperform the market, but as long as it captures a portion of the gains I’m happy.
Take something like Francis Brooke's Trojan Income fund for example, which I’ve held since 2010. During the market sell-off in 2011, it held up very well indeed, and ended the year as one of the best-performing funds in the IMA UK Equity Income sector.
FE data shows it made gains of 6.28 per cent over the 12-month period, compared with losses of around 4 per cent for the sector average. The worst performer – EFA OPM Equity High Income – lost 11.53 per cent.
In 2012 Brooke lagged the market, with returns of 9.88 per cent, but who cares? I managed close to a double-digit return over the period, which is good by anyone’s standards, and the fund was well up relative to the sector and FTSE All Share index over the 24-month period.
Performance of fund vs sector and index 2011 to 2012
Source: FE Analytics
It is the same story with some of my other core holdings, such as First State Asia Pacific Leaders, Aberdeen Emerging Markets and M&G Global Dividend. I also hold two multi-asset funds – Personal Assets Trust and CF Ruffer Equity & General – which prioritise capital preservation above all else.
Even my two riskiest funds – Aberdeen New Thai IT and Smith & Williamson Global Gold & Resources – are less volatile than their benchmark and tend to do better when the market falls. This is only a slight consolation for the latter given the terrible run for gold equities, but hey, it could have been worse…
Performance of funds vs index over 1yr
Source: FE Analytics
Funds with these characteristics have outperformed on a cumulative basis in recent years, as there have been a number of severe market sell-offs: namely the dotcom crash in the early 2000s, the 2008 global financial crisis and the 2011 summer sell-off.
Of course, the next 10 years could be a lot rosier than the last, but given that global growth remains so low and government debt so high, it would take a very, very bullish investor to say we are out of the woods. Sebastian Lyon’s recent interview with FE Trustnet was a welcome reminder of the various headwinds facing markets at the moment, at a time when most fund managers are very optimistic.
Besides, if he is wrong and the markets do go up in a straight line, I’m a happy man – even if my funds do underperform, they’re still going to have made me a lot of money.
Hargreaves Lansdown’s Richard Troue is a big fan of my investment style, and uses it himself.
"I think this is a very sensible way of investing," he said. "It is a bit of an old-man style, but it’s a strategy I follow myself."
"These managers tend to buy quality companies when they are cheap, and hold them until they’re expensive. It’s very simple, but very effective."
"Companies with strong cash-flow and balance sheets tend to hold up much better than those that are heavily geared, but of course the opposite is true when the markets turn."
"If you’re successful at finding the funds that do protect against the downside, you’re likely to be successful, because they don’t have to work as hard to make the money back. You’ll find that over the last 10 years, these are the funds that have done the best."
Personally, I think I have a much better chance of judging a manager’s style and likelihood to do well in certain market environments rather than what direction the market is going to go, so I’m happy with the risk of getting my manager selection wrong.
Troue agrees, but does offer a word of warning. Typically defensive sectors have had a very strong run post financial crisis, and particularly those that have a yield.
Echoing the view of Cazenove’s Robin McDonald in an interview with FE Trustnet last year, Troue points out that sectors such as healthcare and tobacco could fall heavily if sentiment towards them or equities in general switches, as many of the companies are so expensive. In this instance, "defensives would no longer defend".
To counteract this risk, Troue says it is important to invest in a manager with a flexible mandate, and expertise across different sectors and markets.
"The key here is pragmatism – the manager needs to have the flexibility to move in and out of different types of stocks," he said.
"If, for example, a manager is in consumer stocks which have had a very good run and defended well during risk-off periods, he or she needs to have the freedom to reduce their exposure in favour of something cheaper and maybe more cyclical."
"Cyclical companies aren’t necessarily risky – you can still find those with strong and attractive balance sheets."
Troue points to FE Alpha Manager Julie Dean, who manages the Cazenove UK Opportunities fund, as a good example of such a manager.
"She moves in and out of stocks depending on where she thinks the UK’s business cycle is, so may move out of defensives and into more economically sensitive areas," he explained.
"However, she’s still all about finding quality companies. She doesn’t just move into junk because she thinks the markets will go up."
I’m pretty confident that the likes of Troy’s Brooke, who has said on numerous occasions that he would increase his exposure to risk when UK equities hit the right price, and Aberdeen’s Hugh Young, who is one of the most experienced managers in the Asia Pacific space, have the knowledge and flexibility to move in and out of expensive stocks.
Young has recently been increasing his exposure to the out-of-favour mining sector, illustrating this point.
So there you have it – this is why I’m content to consciously look for funds that underperform when the market is rallying around them. Please let me know what you think of this tactic in the comments section below, or email us at editorial@financialexpress.net
