Low-risk, uncorrelated investments that prioritise downside protection will continue to be key to investors over the next decade, according to FE Alpha rated Manager Iain Stewart, who believes those expecting a smooth ride are kidding themselves.Stewart (pictured) marked 10 years as manager of the £9bn Newton Real Return fund1 earlier this year. He launched the vehicle in anticipation of a tough decade for financial assets.
The fund has thrived, delivering positive returns in every calendar year since inception except in 2011 when it made a minor loss of 0.4 per cent, according to FE data. While risk-assets have performed very strongly over the last two-and-a-half years or so, Stewart thinks the next decade will too be very challenging.
“If we are in a world where returns are going to be solid and risks low, the need for strategies such as ours are reduced, and we would look to adjust how we do things,” he said. “However, I just don’t think that’s the case.”
“When you hear people talking again about the lack of need for absolute return, it’s often been the case that this is the time you should be doing the opposite. Investors tend to work in herds.”
Stewart thinks that high valuations combined with record corporate margins and various structural headwinds to economic growth means that equities are unlikely to perform as well as they have done over the past three to five years.
“Financial assets are looked upon in a very different way to everything else,” he explained. “If a price of potatoes goes up, you’re more likely to look elsewhere to find something cheaper, but in investment quite often it’s the opposite. If the price goes up, more people want to buy.”
Performance of fund, sector and indices over 5yrs
Source: FE Analytics Past performance is not a guide to future performance.
He believes a significant market correction in the foreseeable future is very possible, which would put the focus once again on funds that protect effectively against the downside. He says he feels very much like he did in 2006 when volatility was also eerily low and this heralded the onset of the credit crisis.
That said, he believes the credit-fuelled rally could still go on for some time to come because the sheer scale of the stimulus in this cycle dwarfs anything ever seen.
“If you stand back and look at why we’ve had high returns and low volatility more recently, it’s largely because Central Bank stimulus has led to a rerating of financial assets and sustained intervention in the market place has led investors to believe that nothing can possibly go wrong,” he said.
“The problem I have is the unintended consequences of policy, such as widespread misallocation of capital and whether these policies can be reversed. The risk is that intervention begets more intervention and so on”.
“You’ve got capital misallocation [in areas like residential real estate, EU peripheral bond yields and riskier credit] as investors are forced to chase yield and return. Savers are being squeezed as income and wealth disparities widen.”
“I’m not convinced the growth coming through is sustainable, although demand has been brought forward, real disposable incomes are not increasing.”
“People think that because interest rates are low, they should be bullish – end of story. However, Japan showed that keeping interest rates low and policy loose doesn’t necessary lead to growth.”
Stewart says that total debt globally has increased by around 30 per cent since 2007 (according to the Bank of International Settlements). Such an environment will make sustainable growth even harder to come by, he says.
For the bull market to continue he says we’d have to be “in a new paradigm”, which would render current valuation levels irrelevant.
“We don’t believe that we are at the beginning of a major expansion of financial assets,” he continued.
”It’s not 1982 [when the last great bull market started]; back then, we had high inflation and bond yields which had lots of scope to fall, and really low valuations and margins. We also had US demographics supportive of growth.”
“Wind forward to 2014 and interest rates have never been lower and valuations at the high end of the historic average. Profits are going to have to do something extraordinary, and I don’t think they will.”
This is not to say Stewart is constantly bearish however; Newton Real Return was more aggressively positioned in the mid-2000s, which allowed it to participate in much of the equity rally between 2003 and 2007.
Performance of fund, sector and indices since launch
Source: FE Analytics Past performance is not a guide to future performance.
He also upped his equity and credit exposure in the aftermath of the Lehman crisis, helping the fund to partake in the 2009 rebound.
The Newton Real Return fund is up 123.91 per cent since its launch in March 2004. The FTSE has returned marginally more, though has been significantly more volatile.
While the Newton Real Return Fund has achieved a positive return every year apart from 2011, Stewart admits performance over the past 18 months or so has been disappointing.
His significant weighting to gold and gold equities cost his fund 450 basis points of performance in 2013, though he still managed returns of 6.69 per cent over the 12 month period.
In spite of its poor time, Stewart continues to back gold as a diversification tool in his portfolio – particularly against the possible threat of inflation.
Performance of fund, sector and indices since Jan 2013
Source: FE Analytics Past performance is not a guide to future performance.
Stewart has recently been taking down his high yield exposure, which he says is now expensive and the least liquid in the bond market, and has increased his equity, government bond and cash exposure.
Equities currently have a 57 per cent weighting in the fund, though this is offset with a 16.4 per cent put option. Bonds have a 27 per cent weighting, predominantly in government bonds.
FE data shows that it has been the sixth bestselling fund in the entire IMA Universe over the past 12 months, with inflows of more than £1.2bn.*
As well as a low-risk option for an ISA or a pension, Stewart says Newton Real Return is a popular choice for investors as part of more diversified institutional portfolios.
This article is sponsored by BNY Mellon Investment Management. For a guide to absolute return investing, click here.
1As at 30 April 2014. Past performance is not a guide to future performance.
*The value of investments and the income from them is not guaranteed and can fall as well as rise due to stock market and currency movements. When you sell your investment you may get back less than you originally invested.