There have been a number of instances in the past when this has been the case, such as in property prior to the 2007/2008 financial crisis and gold before the price of the precious metal collapsed in 2011.
FE Trustnet highlighted that certain investors may have been guilty of buying into small cap funds’ strong past performance this time last year, as the AUMs of smaller companies-orientated portfolios surged following their strong gains in 2013. While they haven’t delivered catastrophic losses since, they have materially underperformed large-caps.
Performance of sector versus index over 1yr
Source: FE Analytics
Clearly, the chances of timing any market cycle correctly is nigh on impossible and, as we mentioned in the article, the major problem is private investors simply don’t get access to information or data that the professionals are privy to and if they do, they find out too late.
Therefore, to lend a helping hand, in this article FE Trustnet asks the experts which funds or sectors they think – either due to fund flows or valuations – investors really should be avoiding before they finalise their 2015/16 ISA.
Government bonds
Government bonds such as gilts have usually been seen as safe havens and a form of protection against turmoil in equities, but as a result of economic woes, ultra-low interest rates and quantitative easing, funds with high exposure to sovereign debt have delivered stellar returns over recent years.
In truth, experts have been warning investors against buying into the asset class for a number of years but – given that the average IA UK Gilts fund has returned close to 20 percentage points since January 2014 – they have clearly been wrong.
Performance of sector versus index since Jan 2014
Source: FE Analytics
However, with 10-year gilts yielding just 1.5 per cent, the chances of higher interest rates and an election on the horizon, Equilibrium’s Mike Deverell says investors are making a big mistake by holding the asset class.
“Many people have made the point that gilt yields look too low given the next move in interest rates is likely to be upwards. A 10-year gilt yields 1.5 per cent, only 1 per cent above base rate. Just a couple of moves in rates could see this yield rise dramatically, meaning capital falls,” Deverell (pictured) said.
There are many who believe that gilt yields could remain low for some time to come, given that inflation is at 0 per cent, economic growth remains subdued and there is a still huge amount of debt in the system.
However, Deverell says investors really need to consider the risks of holding government bonds, especially if they have a long-term view.
“Whilst rate rises may not happen this year, there’s a good chance it will be in the next 18 months. It is certainly unlikely that they will barely move over the next decade as the 10-year gilt implies. As a result, we think it’s worth avoiding long dated gilts now.”
“However, the main reason for avoiding them is not the lack of value. In a portfolio they are also meant to diversify away your equity risk – they tend to go up and down at different times to equities. Therefore it is usually worth holding both.”
“However, both equities and gilts have gone up together and in recent months they have tended to do so at the same time. The two assets have become more and more correlated. As they move closer together the diversification argument for holding gilts reduces.”
Property
Rob Morgan, pensions and investment analyst at Charles Stanley Direct, says investors should be very wary of direct property funds at this point in time.
Partly as a result of the low bond yields now on offer and as economic conditions in the UK have improved, funds which hold direct commercial property have delivered very strong gains over recent years.
According to FE Analytics, thanks to the alternative nature of the asset class and attractive yields on offer, the average ‘bricks and mortar’ UK property fund has returned 26.04 per cent over just two years – considerably beating the IA UK All Companies and IA UK Gilts sectors in the process.
Performance of sectors over 2yrs
Source: FE Analytics
Data also shows that investors have been piling into property.
The likes of Henderson UK Property, M&G Property Portfolio, Standard Life UK Property and L&G UK Property have all been among the funds which have attracted the most money over the past 12 months, according to FE data.
On top of that, data from the Investment Association shows the IA Property sector has seen net inflows in each of the last 12 months, meaning a combined £4.1bn has gone into the peer group since February 2014.
It was also the best-selling open-ended sector last month, according to the Investment Association.
Given that surge in interest and as strong capital gains have forced yields lower, Morgan says investors need to reconsider their exposure.
“Yields have been driven lower across the commercial property sector precisely because of the search for yield in my view,” Morgan (pictured) said.
“A lot of money has gone into funds in a short space of time and some funds have high cash drag as a result. The time to be buying was a couple of years ago but now I fear that returns will be lacklustre – but by no means disastrous and I still appreciate the merits of diversification of the asset class.”
High yield bonds
The final asset class on the list is high yield bonds, which as a result of quantitative easing and ultra-low interest rates have delivered phenomenal returns over recent years as investors have been reaching for greater levels of income.
According to FE Analytics, the average fund in the IA Sterling High Yield sector has returned close to 110 per cent over the last six years and has a maximum drawdown, which measures the most an investor would have lost if they had bought and sold at the worst possible times, of just 13.19 per cent.
Performance of sector over 6yrs
Source: FE Analytics
However, due to those strong returns, the yield on the sector has fallen to just 5 per cent.
Nevertheless, given that default rates are so low as companies have been able to refinance at very low levels of interest and high yielding credit tends to be less sensitive to rate rises, some managers have said there is still value in the asset class.
John Anderson, manager of the Smith & Williamson Fixed Interest fund, warns that lowly-rated bonds are now dangerously overvalued, though.
“I don’t have any exposure to high yield bonds – they are totally mispriced, in my opinion,” Anderson said.
The manager finds it very worrying that certain experts are recommending high yield bonds at the moment as expectations of an imminent interest rate rise have dissipated thanks to lower levels of inflation, which he says is disturbingly short-term.
“This is a little like the chicken and the egg situation. People think that the bad news out there is good because news because people think, ‘ah yes, interest rates aren’t going up’”.
However, the manager says one of the major reasons why rates would stay low is because inflation remains subdued or because deflation kicks and he says both are events which mean high yield issuers could struggle.
He added: “You only have to see how high yield oil issuers have come a cropper recently, and that is because of deflation in their industry.”