The manager of the £1.4bn Schroder MM Diversity fund is continuing to increase his cash weighting in the fund to almost a third of its assets, having recently sold down more of his fixed income exposure. Schroder MM Diversity now carries its lowest weighting to bonds since it was launched, with Brookes holding just three fixed interest portfolios which make up less than 10 per cent of his fund.
While he says the market has already priced in some of the risks surrounding the Fed’s tapering of quantitative easing [QE], investors are still not fully anticipating the potential impact it could have on their portfolios.
“Tapering is here and everyone knows it is here but its effect on financial markets is pretty sketchy,” he said.
“Any asset class that has had its price driven up by QE will have its price driven down by the removal of it and anything that is currently looking expensive is about to have a moment of shock.”
“It is not going to mean a massive bear market but things that are looking overvalued will only stay overvalued with QE in place. [That is now being taken away].”
“We would normally be buying very well-positioned hedge funds in the this type of market but even those are pretty bullish at the moment, so maybe currency is the way to play things at the moment.”
Tapering of the Fed’s monthly stimulus program was first hinted in May 2013, causing knock on affects effects across market, most notably in emerging markets where a sell-off began.
When the tapering began in January 2014 the sell-off in emerging markets was further exacerbated.
However prices on US government bonds have risen in recent months whilst US equities have also continued to rise, contrary to expectations.
Performance of indices since May 2013
Source: FE Analytics
Brookes says his response to these concerns has been to build up cash. He says he is doing this for two reasons: one, because there is a lack of attractively valued fixed income assets; and two, it will allow him to buy back into the market after a correction.
“If you look at price to earnings ratios things appear to look fairly valued; however if you look at the Shiller ratio it looks pretty expensive,” he said.
“Equities and bonds are looking very expensive, especially in the US. Our response to this has been to heavily build up our cash level which now way over 30 per cent.”
“Government debt and corporate debt are also too expensive.”
“We are at a difficult time of the business cycle where property prices have been tremendous and valuations have been high so it is time to take some money off the table.”
He says investors need to think about QE as a fountain of money cascading down different tiers of debt, with the water supply slowly being turned off.
“The US Federal Reserve has printed $4.5trn of new money,” he continued. "They have been effectively going around pension funds and large holders of treasury bonds and offering to buy their bonds from them.”
“The first impact of this was that the asset prices went up. This is because the Fed wanted to encourage investors to sell those bonds, so they offered more than market value.”
“The pension funds then ended up with cash and have become increasingly tempted to buy low grade government debt.”
“Finally the money has ended up in junk bonds, low grade emerging market debt and high beta equities.”
“However, now the money going into the top level is being reduced, so the money trickling down is moving at a much slower rate and a much less powerful rate.”
“Another way to think about it is a hot air balloon that keeps on requiring extra gas to replace the hot air that is being lost in order to keep it in the air. The Fed is reducing the extra gas to bring it back down to earth.”
While Brookes doesn’t expect the withdrawal of QE to cause default rates to spike, he warns that bonds will remain an unattractive asset class because yields will continue to trend higher as monetary policy normalises.
According to FE Analytics, Brookes’ Schroder MM Diversity fund has returned 21.34 per cent over three years, beating its IMA Mixed Investment 20%-60% sector average by almost 5 percentage points .
Performance of fund, sector and benchmark over 3 yrs
Source: FE Analytics
However this outperformance has ebbed away over the past year, with returns lower than both the fund’s sector average and the general rise in inflation, measured by the Consumer Price index, which is also its benchmark.
Performance of fund, sector and benchmark over 1yr
Source: FE Analytics
The fund’s high weighting to cash has contributed to this underperformance, but Brookes says he will only put his money back to work when valuations become more attractive.