Nevado (pictured), who heads up the €480m M&G Dynamic Allocation fund, says that the vast majority of forecasts are proven to be inaccurate anyway, insisting that focusing on valuation is a much better way of helping investors to outperform. “Economists’ jobs are to make forecasts on GDP and inflation, but there’s one big problem: they aren’t very good at it,” he said.
“On average, the Bank of England and Federal Reserve are no better at making predictions than average. It’s very hard to have an edge when you are forecasting.”
“So what is the alternative? What we look at instead is behavioural finance. History shows us that investors are either over-confident or over-optimistic.”
Nevado argues that the irrational nature of the market presents opportunities for investors, pointing to mass sell-offs such as 2008 and 1987 as good examples. FE data shows that the average UK All Companies fund has returned more than 100 per cent since the FTSE All Share bottomed in March 2009.
“Markets are four times more volatile than they should be,” he argued. “What I mean by that is, markets are essentially a forecast of future profits and dividends.”
The green line in the graph below shows what the performance of the S&P 500 would have been if you knew in advance exactly what profits and dividends of companies were since 1990, Nevado says. The blue line is actually how markets have performed.
Performance of S&P 500 since 1990
Source: M&G Investments
Nevado says that market performance tends to reflect the profits and dividends of companies over time, but in the meantime big spikes in investor confidence and pessimism breeds opportunities.
“Markets are driven by volatility, which is driven by emotion. To succeed, you have to understand the psychology of the market,” he said.
“Throw the IMF outlook in the bin, and look for assets classes that look cheap. That is the key.”
With this method of investing in mind, Nevado explains that he remains more optimistic about equities than bonds, and particularly optimistic about European equities; however, he views the US as an area to be more wary of.
He commented: “Equities are still cheap, because real yields are ahead of earnings. Why are investors accepting cash and bonds with no real yield? The gap between real yield in bonds and equities – the equity risk premium – is still attractive.”
“Investors remain volatility-averse because of what happened in 2008. The world economy is improving, and there is no inflation anywhere.”
Nevado accepts that the risk-premium between equity and bond yields has closed, citing the German market as a good example of this.
Source: FE Analytics
However, he says equities are still more attractive than bonds and especially cash on the whole.
“US equities are the exception,” he said. “We have sold the S&P, but we’ve kept Japan, the UK and Europe. We also like UK miners and some emerging markets for valuation reasons. We’ve been adding to them because the real yields are now much higher.”
“People are worried about deflation in Europe, but this is a bull case for equities because it ensures that central banks will keep interest rates low and monetary easing high. This is not Japan, as the banks have shown themselves to be active. This is good news for cheap markets.”
While Nevado and his team and wary of bonds on the whole, he says the significant sell-off in long duration bonds in light of news of QE tapering announcement has presented him and his colleagues with a much-needed diversifier.
“Thirty year US government bond yields were up 100 basis points on the comments. It’s great news for bonds because they are now cheaper in relation to inflation. Not only did yields rise, but inflation fell as well,” he explained.
“The best way to protect our equity exposure is to buy cheap bonds, and we can now do that.”
Murray International IT manager Bruce Stout agrees that identifying psychology trends is one of the best ways to either make money or avoid pitfalls, pointing to the recent sell-off in emerging Asia as a big opportunity.
“The best opportunities arise when emotions get involved,” he said. “I’ve been in the industry for 28 years, and can remember being a deputy manager on Murray International trust in 1999. The world was dominated by tech, and all we were ever asked was how much we had in it.”
M&G Dynamic Allocation has 50 per cent of its portfolio in equities. Nevado points out the price-to-eanings [P/E] ratio of his equity content is 12, compared to 15 from the S&P.
The fund doesn’t have a benchmark and sits in the IMA Unclassified sector, but has a number of objectives. As well as looking to deliver a positive return over a rolling three year period, it also aims for a return of between 5-10 per cent over five years with an annualised volatility of between 5 and 12 per cent.
FE data shows the fund has returned 11.25 since April 2011, with an annualised volatility of 9.48 per cent.
Performance of fund and index over 3yrs
Source: FE Analytics
Nevado has run the fund with co-managers Tony Finding and Craig Moran since January 2011.