Now could be a good time for investors to ditch their momentum-based funds and hunt for value instead, according to BlackRock’s Russ Koesterich (pictured). 
The global chief investment strategist believes the struggle that markets endured for most of last week shows how equities and bonds have been dented by a rise in volatility.
He also points out that markets have rebounded somewhat after a difficult week as the Dow Jones Industrial Average index rose 0.93 per cent to close the week at 18,191, the S&P 500 index rose 0.38 per cent to 2,116 and the NASDAQ Composite index essentially flat-lined, slipping 0.03 per cent to 5,003.
However, he doesn’t expect markets to rise exponentially and sees last week’s volatility as a warning sign.
“The week demonstrates how both equities and bonds have been mired in a meaningful rise in volatility, a shift partly driven by the recent tick higher in bond yields,” Koesterich explained.
“We don’t expect more than a modest increase in rates, but even that may be enough to push volatility higher, which is likely to be a headwind for many of the most popular so-called momentum stocks.”
Sectors such as biotech and healthcare in particular have rallied over recent years, with the NASDAQ Biotechnology index returning a hefty 194.77 per cent over three years. This is more than double the performance of the FTSE All Share, the S&P 500 and the MSCI World indices.
Performance of indices over 3yrs
Source: FE Analytics
However, Koesterich says this sector is perhaps one to steer clear from as the first quarter earnings season winds down and investors focus their attentions on the next steps of the Federal Reserve.
He adds that data continues to appear mixed from the world’s largest economy, but a report released by the Institute for Supply Management (ISM) was better than expected.
“A poor trade report suggests that the first quarter’s growth in gross domestic product [GDP] may ultimately be revised down from a nominal gain to a slight contraction,” he said.
“On the jobs front, the US unemployment rate dropped to a post-crisis low of 5.4 per cent and job growth rebounded in April. However, the rest of the report was less than stellar. The US created 223,000 new jobs in April, in line with expectations, but March’s reading was revised lower by roughly 40,000 and hourly earnings were up a scant 0.1 per cent, less than expected.”
Following the release of the data on Friday, bond prices rallied and yields pulled back as investors grew less concerned that the Federal Reserve would hike rates any time soon.
However, Koesterich believes that the Fed is likely to hike rates later this year, which will continue to pile pressure on bonds.
He urges that this macroeconomic backdrop will not only feed anxiety in the market but will affect which investment styles are most efficient, which is why he believes that a focus on value is important.
“The rise in volatility has important implications for investors. Not only does it make for more anxiety, but the level and direction of volatility also affects which investment styles work best,” he explained.
“As volatility is still below the long-term average, and we are still in the early stages of the market adjusting to a more normal interest rate regime, this process is likely to continue. This suggests investors may want to reduce their exposure to momentum strategies and increase their position in more value-oriented parts of the equity market.”
There are some investors who have always believed that value funds are superior investment vehicles, regardless of the recent volatility spike in the market.
Simon Evan-Cook, senior investment manager at Premier, believes it’s always a good time to be buying into value funds and not just now that the market has changed.
He said: “If they’re genuinely active funds then they should be able to find stocks that are completely separate from the market and display attractive characteristics in terms of potential upside versus potential downside.”
“We think that it’s a very sensible idea to focus on value-led funds because style cycles, particularly in the US, seem to last a long time. When they’re in favour then they reverse for a long time as well, and the growth cycle has been running for an awfully long time now so when it reverses, I expect value funds to outperform for quite some time.”
In his weekly report, Koesterich says that integrated oil companies could be a good value area for investors to increase their positions in at the moment, following the shock fall in the oil price last year.
However, Evan-Cook believes that more value can be found elsewhere in the market.
“The impression we got from talking to a lot of our managers is that a lot of the big oil stocks never really got to the point where they were pricing in $40 oil – they stopped at the point where they were pricing in $70 oil, which is where the price has got back to now,” he said.
“We never really saw big value or distress appear specifically in energy companies and that’s backed up by our fund managers, so while we would hold oil stocks through funds that we own, we never added any specific oil exposure through a dedicated ETF or funds ourselves.”
Instead, the fund manager sees value in regional funds such as Investec UK Special Situations, run by Alastair Mundy, and GLG Undervalued Assets, run by FE Alpha Manager Henry Dixon.
“They’re active funds and the managers have what it takes to be decent value managers, which is a willingness to go against the crowds and have an understanding that there might be times when their investors think they’re crazy,” he explained.
“But they have that ability and that strength to be able to ride through that, which is necessary for value investing. Sometimes you have to buy stocks that are deeply out of favour and disliked by the market.”
Investec UK Special Situations aims to grow value over the long term through a contrarian approach, outperforming both its benchmark and peer average by approximately 25 per cent over 10 years through total returns of 147.05 per cent.
Performance of fund vs benchmark and sector over 10yrs
Source: FE Analytics
GLG Undervalued Assets has a similar aim and investment approach and looks to invest in stocks considered to be undervalued relative to their asset base.
The £311m fund, which was launched less than two years ago, has achieved total returns of 22 per cent since its inception which is 9.71 percentage points higher than its benchmark and 8.27 percentage points more than its sector average.
Performance of funds benchmark since launch
Source: FE Analytics
Investec UK Special Situations has a clean ongoing charges figure (OCF) of 0.85 per cent and yields 2.69 per cent. GLG Undervalued Assets has a clean OCF of 0.98 per cent and yields 1.78 per cent.