Equities are at risk of a drawdown comparable to the dot com bubble and 2008 financial crisis, according to RWC’s Ian Lance, who is holding more cash than at any time in his career. The manager of the £308m RWC Enhanced Income fund, who has been in fund management since 1989, is currently maxing out his money market exposure at 20 per cent. His £255m RWC UK Opportunities fund has even more in cash, at 25 per cent.
While Lance isn’t a market timer, he says that expensive valuations have prompted him to take his profits and hide in cash, allowing him to wait for a more attractive time to snap up companies.
“We are struggling to find ideas that fit our criteria,” he said. “Yields across all assets classes have come right in, which is why funds such as mine have become more popular.”
“This is QE [quantitative easing] at work; you’re not able to find attractive yields anywhere. Current valuation metrics suggest that annualised returns over the next 10 years will be 3 per cent nominal – a figure we’ve come up independently, though other firms such as GMO have come up with a similar estimate.”
“This equates to a real return of close to zero. In the past when this has been the case, the biggest drawdowns have come, and that’s what I’m worried about.”
“You’re finding more and more people say that they are finding returns and yield harder to come by and are going up the risk curve as a result, but I’m uncomfortable about this.”
The biggest drawdowns in recent memory have occurred in 2000-2003 and 2008, when predicted annualised returns over 10 years were similar to what they are now.
Performance of MSCI World since 1998
Source: RWC
“Exactly when [a market correction] happens? My guess is as good as anyone’s, but if you look at the historical data, it is very possible,” he added.
Lance joins a growing number of funds managers who have increased their cash weighting in recent months. FE Alpha Manager Stewart Cowley has upped his exposure to 28 per cent in his Old Mutual Managed fund from 4.7 per only a year ago, with FE Alpha Managers Marcus Brookes and Alex Grispos also making a move.
Troy’s Sebastian Lyon and Miton’s Martin Gray have long been sitting on the side-lines in cash, but until now have not been rewarded for doing so.
Lance claims that the need to protect yourself is even more important now than it was in 2000, as there are so few cheap areas in the market. In the midst of the dot com bubble he says areas such as healthcare and tobacco were attractive, but that such pockets of value do not currently exist.
The graph below shows that value dispersion – in other words, the difference between the cheapest and most expensive stocks – is at one of the lowest it’s been over the past 25 years or so.
Developed markets composite valuation dispersion since 1988
Source: RWC
Gavin Haynes, managing director of Whitechurch Securities, thinks that it can be healthy to take a tactical cash weighting as a portfolio manager, but for everyday private investors and advisers he thinks trying to be too clever can do more harm than good.
“On the whole, investors and advisers who take a long-term approach should be in a portfolio with its own risk/reward profile,” he explained.
“Short-term market timing is notoriously very difficult to do, and very often even if you get it right many miss the right time to put money back in.”
“We have taken some money off the table in our portfolios, which is more a product of selling some funds and not reinvesting that money immediately. On the whole we wouldn’t have more than 10 per cent in cash though.”
Haynes says the fact that many high profile managers are sitting on cash is a good thing, as market corrections usually happen when the vast majority are bullish.
“Speaking to fund managers the consensus seems to agree that the market has gotten ahead of itself in the short-term,” he said. “We need to see corporate earnings come through.”
“Personally, I think the fact there is a lot of cash on the side-lines is a good thing, as it means it’s ready to come back in once there is a pull back. In the past where there has been something bigger it’s been at a time that institutional investors are fully invested and everyone is positive.”
“There’s a healthy amount of caution out there, so we’re not too concerned.”
As its name suggests, RWC Enhanced Income targets an above average yield by investing in predominantly UK equities. It is currently yielding 7 per cent.
Lance (pictured) formerly ran the highly successful Schroder Income and Income Maximiser funds, which have since been taken over by Kevin Murphy, Nick Kirrage and Thomas See. Like the incoming managers, Lance had a deep value bias, but has since changed his style to suit more cautious investors. This goes some way in explaining his high cash position, he says.
“We’re still sensitive to valuation, but in the past I was buying up battered banks and smashed up retailers post financial crisis. This proved to be the right thing to do, but I have a different focus now,” he said.
“We’re trying to find decent returns but with less volatility and drawdown. The message from investors when we launched the fund [in October 2010] was for something that delivered a stable stream of income and not loads of volatility.”
“Valuation is still important but we are not inclined to take on a lot of risk.”
As well as holding cash, Lance looks to minimise risk by targeting quality companies with a good return on capital and strong balance sheets and using put options on equity markets.
The call options that the manager uses to enhance his yield give his portfolio an extra element of downside protection. Selling the potential for capital growth gives Lance a 1 per cent premium, which helps to mitigate falls in stock prices.
Among the biggest rivals to RWC Enhanced Income include Schroder Income Maximiser, Fidelity Enhanced Income and Insight Equity Income Booster, which all sit in the IMA UK Equity Income sector.
Performance of funds and index over 3yrs
Source: FE Analytics
Over three years, RWC has fallen short of its rivals as well as the FTSE All Share with returns of 16.86 per cent. Along with the Fidelity fund it has been the least volatile over the period, though.
Lance says he has little interest in relative performance, insisting that a high and growing income and capital protection is his priority. He points out that the portfolio is popular with fund of funds managers such as Marcus Brookes at Schroders and Daniel Lockyer at Hawksmoor, as they understand exactly what it is he is trying to achieve.
He claims many managers are fearful of holding cash because they don’t want to deviate too far away from the benchmark. Lance says that those who argue investors should be managing their own cash weighting are simply making excuses.
RWC’s desire for maximum flexibility prompted RWC to put the Enhanced Income and Income Opportunities funds in the IMA Specialist sector rather than the more marketable IMA UK Equity Income sector.
The manager acknowledges that this may have cost him some inflows, but says building diversified portfolios is more important to him than selling units.
“[UK Equity Income] funds have to hold 80 per cent in UK equities. We want the flexibility to hold some international equities, and cash,” he explained.
RWC Enhanced Income has 18 per cent in the US and 5 per cent in Europe, meaning that its UK exposure is a little under 60 per cent.
Lance says that the cash weighting is unlikely to go any higher than 20 per cent as it would make it very difficult for RWC Enhanced Income to hit its 7 per cent yield target.