Funds that target a quantitative measure of risk – most typically volatility – have become increasingly popular with advisers post-RDR, thanks to stricter regulatory pressures. In many cases managers are far more concerned about hitting their risk target than generating returns for clients, which Fishwick believes can lead investors down a dangerous path.
He says valuation should be at the forefront of all investment decisions, rather than volatility. He points out that some stable assets – namely cash – guarantee a permanent loss, while others with a higher volatility-profile are much more likely to generate positive returns.
Fishwick and colleagues Eric Lonergan and Steven Andrew are also currently wary of fixed interest, following the strong run in recent months, despite the fact it makes up the biggest bulk of most defensive managers’ portfolios.
“My issue is that most people have a corrupted view of risk. Long-term investors need to rethink what their attitude to volatility is. I think there is confusion between volatility and true risk,” he said.
“There’s the general idea that bonds are more defensive than equities, and then cash is even more defensive than that. We look at things a little differently,” he said.
“Korean equities at the height of the SARS crisis in 2003 were virtually a riskless equity market. There were incredibly bad expectations. Five to six years later, it was very optimistically priced. The point here is that risk changes.”
Fishwick points out that since just before the Lehman crash, the FTSE All Share has been significantly more volatile than gilts and especially cash, but investors have crucially been rewarded for taking on risk.
Source: FE Analytics
Being able to find assets that reward you for risk is absolutely key, Fishwick says, which means that sometimes even the most cautious investors need to look up the volatility scale.
“There are some points in the bond yield curve at the moment where you aren’t being rewarded for the risks you are taking at all,” said Fishwick.
“The cost of avoiding volatility at all costs is a negative real return. The enemy of the past few years has been the ‘sleep well at night’ asset class, especially cash.”
“The problem with cash is that you don’t notice you are losing money. It’s a sinister force eating away at your spending power. While it makes you feel good that you don’t lose out when the market falls, it’s still losing you money.”
“Maybe cash rates will rise, but for us we have much more appreciation for an equity basket and to a lesser extent a fixed interest basket than cash. Cash is still the enemy. “
Brian Dennehy, managing director of Dennehy Weller & Co, agrees. Speaking in reference to funds that have a volatility target, he said:
“The concept is complete cobblers. These funds aren’t targeting risk but volatility. The problem is that a lot of these managers don’t seem to know what risk is,” he said.
Fishwick defines the range – consisting of M&G Episode Allocation, Macro, Income, Defensive and Growth – as being multi-asset with a rigorous valuation bias.
He admits that the obsession with valuation often leads to worrying times, but that it’s vital to keep your head and look at the fundamentals.
“I didn’t sleep well during October and September, but you’ve got to be able to deal with it – especially when you’re doing the opposite to what you want to be doing in that moment. During the sell-off I was buying equity and high yield, and that didn’t feel all that good,” he said.
Fishwick has radically altered his $114m M&G Episode Macro fund in recent months, removing all of his investment grade bond exposure in favour of riskier assets. He bought heavily into the asset class following last year’s taper tantrum, and at the beginning of 2014 had 75 per cent in 30-year US and German government bonds. However, as of today he has a 10 per cent short position.
He hiked his equity exposure as a result of the autumn sell-off to 72.5 per cent of the portfolio, and US high yield to as high as 30 per cent. M&G Episode Macro’s equity exposure is now around 55 per cent, while high yield has a 20 per cent exposure. Lonergan (pictured) has also overhauled his M&G Macro Defensive fund, bringing US long-dated bonds down from 26 per cent to 10 per cent.
Why have the team been so active this year? Simple – because bonds are much more expensive than they were, while equities are cheaper.
“The genuine risks are those that have a high probability of capital loss that isn’t recognised in the price,” said Lonergan. “In other words, it’s an asset that is discounting something that is very possible.”
“At the moment there is more risk in interest rates and bonds than growth and equities.”
Performance of indices in 2014
Source: FE Analytics
Fishwick added: “People fret about things, but when the asset they’re invested in does well, those worries go away. Now no-one is worried about bonds – even though QE is still going to be tapered and interest rates are going to rise. The person who was worried is now prepared to own them when they are yielding 1 per cent less.”
“There was a very obvious change in risk characteristics. It’s all been driven by valuations and pricing. Having initially been optimistic I think the juice in the long-dated bond trade has gone. Will it outperform cash? It may do, but there will be volatility almost certainly.”
The M&G Episode team are particularly wary of risk-targeted funds with set allocations to asset classes, such as bonds and equities. This, Fishwick says, could lead investors into expensive areas with the potential to lose investors significant sums.
“I’ve been doing this since the 1980s, and the problem is that everyone follows what’s just been the best area for risk/return,” he said.
“In recent years, bonds have provided investors with equity-style returns without the volatility. However, I promise you that in five years’ time people will have moved onto the next story. People’s sense of risk in equities could be not having enough of them.”
“In 1999, a professional fund manager once said that the biggest risk to investors was not having enough cash to buy Cisco Systems. It’s safe to say a few years later that he was saying something different!”
Cisco Systems’ share price rose over 500 per cent between 1 January 1998 and 1 February 2000, but then suffered almost 70 per cent losses over the next 18 months.
“I think you’ve always got to be careful of anything that makes something easier for you to understand. In reality, you’ve got to turn up everyday and look at everything case by case,” he added.
Fishwick confirms the reason why Lonergan’s Defensive fund sits in the IMA Specialist sector rather than IMA Mixed Investment 0-35% is because the team doesn’t want to be constrained by sector definitions.
“Bonds could right now consign investors to losses,” he said.
FE Trustnet will present a defence of risk-targeted funds in an upcoming article.