Funds with high exposure to bond-like equities are due a period of underperformance as monetary policy starts to tighten and fixed income yields begin to rise, according to Margetts’ Toby Ricketts, who has recently sold some of his stake in the five crown-rated Fundsmith Equity fund as a result. 
Ricketts, who heads up the fund of funds range at the group, has long been concerned that the rally in developed market assets over recent years has largely been due to quantitative easing programmes from the world’s central banks.
However, now the US Federal Reserve has shut off its liquidity tap and is expected to increase interest rates in the not-so-distant future, Ricketts says investors need to rotate their portfolios away from funds that have been some of the major beneficiaries from the stimulus.
As a result, he has reduced his exposure to star manager Terry Smith’s £3.5bn Fundsmith Equity fund due to his concern that the portfolio’s bias towards high quality, defensive stocks – which have been lapped up by “tourist” fixed income investors who have been forced up the risk scale – will mean it goes through a period of underperformance as bond yields continue to rise.
“QE has created bubbles so we have been reining things back and we have been selling the Fundsmith fund, for example,” Ricketts (pictured) said.
Fundsmith Equity has performed very strongly since its launch November 2010, thanks to FE Alpha Manager Smith’s focus on high quality businesses which have advantages that are difficult to replicate, do not need significant leverage to generate returns, have reliable earnings and are resilient to change.
According to FE Analytics, the fund has been a top decile performer in the IA Global sector since inception with returns of 105.58 per cent, beating its benchmark – the MSCI World index – by 35 percentage points in the process.
Performance of fund versus sector and index since Nov 2010
Source: FE Analytics
Those returns have been consistent as well, given that Fundsmith Equity has beaten both its sector and index in each full calendar year since launch.
Smith’s focus on quality means the fund has been a great choice for investors who want capital preservation as well.
Our data shows it has been top decile for its risk-adjusted returns, annualised volatility and maximum drawdown, which measures the most an investor would have lost if they had bought and sold at the worst possible times, since launch.
Given that the fund has performed so strongly, is a largely unchanged portfolio due to Smith’s low-turnover approach and as monetary policy is tightening in the US, Margetts says now is a good time to sell and look for other opportunities.
“[The decision to sell] is purely based on performance,” Ricketts explained.
“The fund has performed very well against its benchmark and the global sector. If a fund were to significantly underperform over that period of time you would ask questions, so when it performs so well you have to do the same – especially as it is very concentrated and has low turnover.”
“Smith holds a lot of stocks which have come in vogue recently with QE in the background. The team at Fundsmith are also first to admit that they have been in the right place at the right time as they have been hit by a lightning strike of liquidity.”
“I think the fund has delivered a huge amount of returns too early so we have taken some money out. Our verdict on the manager hasn’t changed and we will probably allocate to the fund again in the future, but we were concerned about the level of its significant outperformance.”
Ricketts started selling the fund in February, over which time Fundsmith Equity has underperformed against both the sector and index with returns of 0.82 per cent. That underperformance coincides with a period where yields on government bonds such as UK gilts, German bunds, US treasuries and Japanese government bonds have all risen.
Ricketts expects this trend to continue and says it won’t be just be Fundsmith Equity that will struggle, warning that other top-performing funds with a focus on defensive equities may also be adversely affected.
“‘Bondification’ of certain equities has helped the likes of Neil Woodford and Nick Train to scream ahead recently and I think we could start to see a reversal of that,” Ricketts said.
Following a long and successful career at Invesco Perpetual, FE Alpha Manager Neil Woodford launched his own equity income fund in June last year.
CF Woodford Equity Income has thrived over that time thanks to the manager’s focus on quality large-caps and is currently the second best performing fund in the IA UK Equity Income sector with returns of 16.7 per cent.
Performance of fund versus sector and index since June 2014
Source: FE Analytics
FE Alpha Manager Nick Train has a very similar low-turnover approach to Smith, such as an attention to highly cash generative businesses with strong franchises along with his highly concentrated style to portfolio construction.
Thanks largely to Train’s high weighting to consumer staples such as Unilever, Diageo and Heineken, his five crown-rated CF Lindsell Train UK Equity fund has been the only IA UK All Companies portfolio to have been top quartile and beat the FTSE All Share in each of the last seven calendar years.
Source: FE Analytics
Ricketts is not the first to warn over the outlook for core equity funds as FE Alpha Manager Steve Russell, who heads up the Ruffer Investment Company, told FE Trustnet that a crash in defensive income stocks could be on the horizon.
“We are as fearful as ever,” Russell said. “We are acutely aware that the hunt for yield across all markets has driven prices higher, but it won’t last forever. We don’t know when it will come, but it will.”
“Equity income is an especially dangerous area as it has an aura of safety, but in our opinion in some cases high yield stocks are just as dangerous as a biotech stock given the prices they’ve been bid up to.”
“We have been increasingly moving out of high income stocks which we now view as extremely dangerous, because it seems that many owners of them see them as risk free. It will all end in tears.”
FE Alpha Manager Francis Brooke sympathised with Russell’s argument but said a sell-off in defensive equities was by no-means a foregone conclusion.
“There’s no doubt that utilities and other bond sensitive companies would be more vulnerable if there was a steep rise in bond yields,” Brooke said.
“We saw a little of that in February when bond yields rose quite sharply and utilities were among the hardest hit. They’ve recovered since then, but it was certainly a warning of what could happen.”
“If there is a normalisation of interest rates because the world has entered a more sustainable growth phase, then I do sympathise with the point being made. However, if a market fall was as a result of a broader risk-off event, would there be an exodus from quality companies? I don’t think so.”
Nevertheless Ricketts, who has beaten his peer group composite by more than 25 percentage points over 10 years with returns of 119.77 per cent, says investors should now be focusing on value managers who can pick out pockets of opportunities from the wider index.
Performance of manager versus peers over 10yrs
Source: FE Analytics
For UK equity income investors, he says Jeremy Lang’s Ardevora UK Income is a good option.
Lang takes a relatively unique value approach as his process revolves around cognitive psychology and the belief that people in financial markets – be it company management teams, analysts or investors – are prone to making predictable mistakes, errors of judgement or biases.
He then tries to exploit those mistakes to create opportunities and invests across the FTSE All Share’s market cap spectrum.
According to FE Analytics, it has been the fifth best performing portfolio in the IA UK Equity Income sector with returns of 71.4 per cent, beating its FTSE All Share benchmark by more than 30 percentage points in the process.
Ardevora UK Income has a yield of 3.6 per cent and a clean ongoing charges figure (OCF) of 0.94 per cent.
