Lonergan, who runs the £972m fund with Jenny Rodgers and deputy Craig Moran, held a hefty portion in fixed interest earlier in the year, but has since sold down his position.
He views bonds and other asset classes that are deemed to be “low-risk” as expensive, with much more potential for downside losses than many think.
“The main reason [for the cash weighting] is that when I look across asset classes, what’s most striking is the relative valuation of equities,” he said.
“The level of cash reflects my view that outside equities I can find very little that is attractive at all. In the equity market there is plenty that’s attractive so I’m happy there.”
Episode Growth sits in the IMA Mixed Investment 40-85% sector, meaning it can hold 85 per cent in equities at the very most. Lonergan’s exposure currently stands at close to 70 per cent.
To enable him to have such a punchy position, he has to dampen volatility and permanent capital loss with cash – even though it has delivers a negative real return – because there is a severe lack of alternatives.
“My cash holding reflects my bearishness towards bonds to a certain extent, which I do think are very risky at the moment,” he said.
“At the beginning of the year we had 25 per cent in longer-dated, 30-year Treasuries. They sold off significantly in the second half of last year, with the yield getting close to 4 per cent at the end of the year. The level implied that rates would go back to their average of 4.5 per cent on a medium-term view, which we didn’t agree with.”
Performance of index since Jan 2013
Source: FE Analytics
“This year, we’ve had a big flattening of the yield curve. We’ve had 75 basis points of yield compression this year in 30-year Treasuries while at the shorter end, which is a play on interest rate expectation, yields have risen quite significantly.”
“In light of this, we have sold down our bond exposure and put most of that into cash. I think we are back into a situation now when bond markets are quite dangerous. There is now quite a significant chance of capital loss.”
M&G Episode Growth’s bond exposure now stands at only 10.8 per cent, with 7.5 per cent of this in long-dated Treasuries.
Bonds aren’t the only asset class that multi-asset investors use to diversify equity risk. There are a number of alternative assets available to managers, such as property, infrastructure, preference shares, convertible bonds, gold, derivatives, private equity and so on.
Lonergan says that there are few and far opportunities in these areas as well.
“I don’t see a huge amount of value in alternatives either,” he said, noting that the asset class has less than 5 per cent weighting in the portfolio.
“Yield-based assets have all been distorted by where cash rates are, and so the absolute real return is not very attractive. Property is neutrally priced in my view. I have some exposure in Episode Growth which I think is defendable, but while it gives a portfolio some diversification, it will still lose money in a recession.”
“The holy grail is to find investments that give you returns with no volatility. The holy grail is not only unattainable but is very expensive.”
While there is always the potential for high levels of volatility and loss, Lonergan says the valuation gap means a portfolio of equities and differing levels of cash is the best bet for investors – depending on their risk tolerance.
He sees some of the riskier areas of the equity market as the most attractive.
“Often the way to make the best returns to go for the areas that were hardest hit from the last crisis,” he said.
“If we look at the legacy of risk aversion since the aftermath of the crisis, the obvious areas of value are still peripheral Europe and banks.”
M&G Episode Growth has 21.3 per cent of his portfolio in Europe – much of it in Spain, Italy and Portugal – and 20 per cent in the US, with a strong bias towards banks.
Both areas have rebounded strongly since the depths of 2011, but Lonergan thinks there is still much further to go.
“A lot of the equity exposure we like has done very well,” he said. “Only a forward price-to-earnings basis, Italy and Spain are still at extreme lows.”
Performance of indices over 3yrs
Source: FE Analytics
“The absolute earnings in Italy and Spain have been very depressed, so if there is any sustained cyclical improvement there could be a huge amount of upside. The outlook is broadly encouraging, with some green shoots starting to appear.”
“The probability of earnings upgrades of 50 per cent over two years in the US is very low. The likelihood is that they will be between -10 per cent and 15 per cent. There’s perhaps a 95 per cent chance of that.”
“Looking at Italy, for example, the likelihood of a 50 per cent upgrade over two years is much greater – perhaps 40 or 50 per cent.”
Lonergan points out that in Europe, central bank policy is still “quite radical”, as it attempts to get the exchange rate up and get inflation closer to target.
“The backdrop is still pro-risk, even though investors are becoming more risk averse, which is something of a sweet spot,” he said.
The manager has little invested in emerging markets, though he thinks concerns over a full-scale crisis are over-the-top.
He views Korea as one of the few standout areas of value, making up most of his 8 per cent position in Asia ex Japan.
According to FE Analytics data, 18 funds have more than 20 per cent in Korea, including Hermes Asia ex Japan Equity, Baillie Gifford Emerging Markets Growth, Fidelity FAST Asian Special Situations.
Jonathan Pines, portfolio manager of the Hermes Asia ex Japan Equity fund, agrees this is a place investors should be paying more attention to.
“Current valuations for Korean stocks are as cheap as they have been at any point over the past decade and are much more appealing than expensive ASEAN markets,” Pines said.
“The country is now the fund’s largest absolute country weight, at 32.7 per cent, as well as the largest relative country overweight position at 12.9 per cent.”
UK equities have a 13 per cent weighting in M&G Episode Growth.
While he’s not as optimistic as he is for peripheral Europe and US banks, Lonergan says the potential for returns are still very positive.
“The FTSE 100 is certainly attractive compared to cash and bonds. I think investors can expect an annual real return of between 5 and 8 per cent which, on a time horizon of 10-15 years, is very attractive.”
The fund has returned 22 per since the trio of Lonergan, Rodgers and Moran took over in January 2011, beating the IMA Mixed Investment 40-85% sector average by 2.74 percentage points.
M&G Episode Growth has ongoing charges of 0.96 per cent.
