The performance of equity funds in 2015 has been “scary”, according to Chris Metcalfe, investment director at iBoss, who is now focusing heavily on downside protection to shield himself from what he calls an inevitable recalibration of financial markets. 
Although many of the headwinds that plagued the market last year haven’t dissipated, equities around the world have had a very strong start so far in 2015.
According to FE Analytics, for example, every sector within the Investment Association universe is up more than 6 per cent year-to-date while Japan funds and various emerging markets have delivered double-digit returns.
On top of that, although the UK election is just under a month away and the US market has already posted positive returns in each of the last six calendar years, both the IA UK All Companies and IA North American sectors have gained close to 10 per cent.
Performance of sectors in 2015
Source: FE Analytics
The lower oil price, large-scale quantitative easing (QE) programmes in Europe and Japan and the chance of looser monetary policy in China have all been given as reasons for the rally and also as reasons for why it may continue.
However, Metcalfe is very worried about the immediate outlook for equities.
“Returns so far in 2015 have been scary. The economic data hasn’t been particularly good, but the stock market has absolutely torn it up,” Metcalfe (pictured) said.
“The market keeps going up without any apparent justification, but long-only managers always come up with expressions such as finding pockets of value – that concerns us because when there are only pockets left, it means the rest of the value has gone.
“Nevertheless, equity markets keep going up, but while the economy and corporate earnings aren’t improving, P/E ratios will become more and more stretched.”
It is not uncommon for equities to start a year strongly, of course, but Metcalfe warns it is all part of a more worrying longer-term trend. He is concerned that there hasn’t been a meaningful correction in equities since the asset class troughed after the financial crisis.
FE data shows, for example, that the FTSE All Share has returned more than 160 per cent since it bottomed out in March 2009 but has had a maximum drawdown, which shows the most an investor could have possibly lost over that time, of just 15 per cent.
Performance of indices since March 2009
Source: FE Analytics
The major reason for those returns, according to Metcalfe, is the huge level of central bank intervention, and as the likes of the US Federal Reserve are looking to tighten monetary policy, he expects equity funds to have a difficult period.
His thoughts are echoed by star manager Bruce Stout, who heads up the ever-popular Murray International Investment Trust.
“In the current hostile and unforgiving environment for corporate profitability, financial markets appear oblivious to problematic fundamental distortions as they are hypnotically hoisted higher by central bank manipulation,” Stout said in his latest note to investors.
He added: “Against such a complacent backdrop, the portfolio remains widely diversified and focused on capital preservation.”
However, while Metcalfe notes it should be a concern for all investors that stock markets have performed so well for such a long time, he says their performance is particularly problematic for fund buyers – because it has never been harder to assess a fund manager’s ability.
“You’ve got to dig deeper into everything,” Metcalfe said.
“Our starting point is that everything has been QE-fuelled, from one degree or another. The question now is what will happen when QE is turned off? When looking at funds, you can’t use three or five year data to see what will happen in the future.”
“In fact, everything post-crisis is largely irrelevant. The problem is, the longer this goes on, the harder it gets to judge how well a manager has actually done.
A case in point is the Sharpe ratio, a metric often used by industry experts and FE Trustnet, which Metcalfe says is almost useless over the short term.
The funds that have topped the UK equity sectors since the market bottomed have tended to be those that have had a higher weighting to small and mid caps, such as GVO UK Focus and MFM Slater Growth in the UK All Companies sector and Unicorn UK Income and PFS Chelverton UK Equity Income in the UK Equity Income sector.
This is understandable, given that smaller companies tend to be the main beneficiaries of bull markets.
However, when looking at Sharpe ratios – which calculate risk adjusted returns – over that time frame, those same funds feature at the top of their respective sector tables.
“We have not had a big sell-off for a number of years, so ratios like Sharpe are now far less reliable. Since the crash, the more risk you have taken, the better you have performed. We need markets to recalibrate because it is very, very difficult to see what risks managers are actually taking.”
While Metcalfe is concerned about markets in general, he says unprecedented levels of central bank liquidity have left bonds in a very dangerous situation.
“In regards to fixed income, though, we are in completely unchartered territory.”
Thanks to deflation concerns, QE in Europe and Japan plus other more general macroeconomic risks, bond yields have fallen to very low levels over recent years. Ten-year gilts currently yield 1.7 per cent, while their US, Japanese and German equivalents yield 1.97 per cent, 0.32 per cent and 0.14 per cent, respectively.
Many experts have argued that yields could remain at these levels as inflation is flat, there is over-capacity in the economy and debt levels are still very high.
However, Metcalfe says fixed income is now hugely distorted and mispriced. He says that as inflation will inevitably trend higher over the medium term, the outlook for bonds is now particularly poor.
Performance of sectors in 2013
Source: FE Analytics
He therefore says investors need to prepare for an event like the May/June 2013 sell-off when the US Federal Reserve warned the market that it was going to “taper” its QE programme, which caused yields to rise across the board. This time, however, he says it is going to be on a much larger scale.
In an article next week, FE Trustnet will take a closer look at the fixed income funds Metcalfe is using to protect his investors. 
Bill Eigen, manager of the £4.2bn JPM Income Opportunity fund, has a similar view to Metcalfe on the current bond market.
“It is news to no one that central bank action has broken the interest rate market,” Eigen (pictured) said.
“Rates do not respond to traditional factors like economic growth or inflation fundamentals; instead they react to statements from the US Federal Reserve and the ECB. And with central banks showing no sign of easing off the accelerator, the race to zero rates continues.”
“Under a zero-rate scenario, it has become almost mathematically impossible to make money in traditional fixed income.”
The manager therefore advocates holding much higher levels of cash, as he does in his fund (it makes up 40 per cent of AUM).
“Investors cannot afford to be complacent in this environment. They have to grasp that traditional fixed income can’t do what it was supposed to do anymore.”
“Fixed income was meant to do three things: provide income, preserve capital and offer diversification benefits compared with other commonly held asset classes like equities. Clearly when rates are at nearly zero, there’s no provision of income in fixed ‘income’.”
“Correspondingly, capital preservation is no longer assured when bonds carry such high interest rate and duration sensitivity. Even the diversification benefit has faded away as asset classes move in lock-step thanks to central bank stimulus.”