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Sebastian Lyon: Investors are in for a “particularly unpleasant” ride

14 May 2015

The star manager warns FE Trustnet why investors cannot rely on a traditional investment portfolio anymore and why they can expect an extended period of very low returns and high volatility.

By Alex Paget,

Senior Reporter, FE Trustnet

Investors should now expect the “particularly unpleasant combination” of very low returns and high volatility due to the huge levels of central bank intervention since the financial crisis, according to star manager Sebastian Lyon, who says traditional balanced portfolios are most at risk as bond and equity markets are now highly correlated and likely to fall.

Lyon, chief executive of Troy Asset Management, is one of the biggest names in the fund management industry and has been bearish on financial markets for a number of years as he been wary of the economic recovery and believes that valuations have been manipulated by central bank policies such as ultra-low interest rates and quantitative easing (QE) programmes.

This view has weighed on his performance, however, as his defensive positioning has been at odds to the ‘risk-on’ sentiment which has characterised markets since the period after the financial crisis of 2008.

While Lyon has considerably outperformed over the longer term, his Personal Assets Trust has returned half the amount of its IT Global sector and its FTSE All Share benchmark since he took charge in March 2009.

Performance of trust versus sector and index since Mar 2009

 

Source: FE Analytics

While he has been accused of being too dogmatic in his bearish views, speaking at Cantor Fitzgerald’s recent Opportunities in Multi-Asset Investing seminar, the manager warned a focus on capital preservation is now more important than ever given that the outlook for nearly all asset classes is bleak.

“Looking forward, we have the prospect of very low returns and high volatility – not a particularly pleasant combination for a private investor,” Lyon (pictured) said.

“Since the crisis, we have lived in a rather bizarre and phoney world of zero interest rates and QE. Savers have effectively become handcuffed volunteers, moving into the bond market and also into equites in order to make a return.”

He added: “These policies have distorted markets.”

Lyon, who has the ability to invest across various financial markets in his trust and open-ended Troy Trojan fund, says that while many were expecting a period of normalisation, central banks in Europe and Japan have compounded the problem and set investors up for an even greater fall.

“Suffice to say, rates cannot go much lower otherwise we will start to get bank runs. One thing about negative nominal rates is that people will ultimately take their money out of the bank if they don’t think they will get a reasonable return on the money they have saved.”

“Unorthodox monetary policy is beginning to reach an extreme. Clearly, we are seeing extremes in monetary policy but also in longer term rates.”


 

All told, the manager says that private investors are likely to be the worst hit as they can no longer rely on traditional asset allocation models.

The likes of Psigma’s Tom Becket and Hawksmoor’s Ben Conway have argued a similar point in recent months. They have warned that after years of extraordinary monetary policy, it has never been harder to build a truly diversified portfolio as asset classes are expensive in historic terms and more correlated than ever.

“You cannot lose sight of fact that the current environment is unprecedented. These are ridiculous times, absolutely ridiculous,” Conway said. “It’s never, ever been harder to build a diversified and cautious portfolio.”

Lyon agrees, but warns that most investors have not realised the risks they are taking at the moment.

“When I first started work in finance in 1989 you could have quite happily invested in a balanced portfolio of 50 per cent in equities, 40 per cent in bonds, 5 per cent in corporate bonds and 5 per cent in cash and you would have seen a 6 per cent return and that was when inflation was at 5 per cent.”

“Today, yields are down to, for all intents and purposes, record lows and they have halved since the crisis of 2008.”

“This has changed over the last five or six years and is a very major dynamic that people who believe they have protection in a traditional balanced portfolio – which has served so well since the early 1980s – haven’t realised.”

The manager points out how the correlation between bonds and equities was around -0.6 between the market peak in 2000 up to the financial crisis in 2008. FE data shows how the FTSE All Share and Barclays Sterling Gilts Index were negatively correlated for much of that period.

Performance of indices between 2000 and 2008

 

Source: FE Analytics

Lyon added: “The threat is that you no longer have that protection of negative correlation between bonds and equities which you have had in the past. In fact, as we have seen in the past few days, when an asset class falls they all will.”

As the graph below shows, the recent trend of rising government bond yields has contributed to falls in global equity markets as well.

Performance of indices over 1 month

 

Source: FE Analytics

Lyon says it is hard to call whether the recent fall in bond prices is the bursting of a bubble in the asset class, but says investors should avoid traditional fixed income.

“Fixed income has asymmetric risk. It offers an awful lot of downside for a very small amount of upside.”


 

However, the manager is also becoming increasingly concerned about equity markets. While he says he is unlikely to reduce his exposure, he points out that some of his core defensive holdings such as Unilever, Colgate-Palmolive, Philip Morris and Nestle are in a dangerous territory.

“Those core holdings, with exception of Philip Morris, are all on valuations in of excess of their valuations they had back in 2007 at the peak prior to the last crisis,” he said.

“Of course, that doesn’t mean they can’t go higher. I’m often asked, with cash yielding zero and bonds yields obviously very low, where else does one go for a return? One can see an argument for an ongoing increase in valuations on high quality equity so we do bear that in mind.”

“However, we are also mindful that we are viewing equities on an absolute basis rather than a relative basis.”

He says there is a major problem in the equity market as all valuations have been pushed up by stimulus from central banks.

“If you are a bottom-up stockpicker, there is a lot less to go for in terms of filtering out opportunities,” he said.

“The tide of liquidity over the last five or six years has risen all boats and so it is very difficult to discern between various stocks as, effectively, they are all pretty expensive. In 2000 when the stock market peaked, the dispersion [in valuations] was a lot greater as you could find high quality but lowly valued stocks.”

“However, that is not the case today.”

To try and protect his investors, Lyon currently holds 44.5 per cent of Personal Assets in equities, 22.1 per cent in index-linked bonds and 22.2 per cent in cash and cash equivalents. The manager also has 11 per cent in gold bullion and he will explain that positioning in an FE Trustnet article next week.

While his trust has largely struggled since he has been at the helm, Lyon has an impressive long-term track of both outperformance and capital preservation.

According to FE Analytics, his £2.5bn Trojan fund is the second best performer in the IA Flexible Investment sector since its launch in May 2001 with returns of 180.04 per cent, beating the FTSE All Share by 66.04 percentage points in the process.

Performance of fund versus sector and index since May 2001

 

Source: FE Analytics

While it too has struggled over recent years, Trojan has had the lowest maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – since launch at just 9.81 per cent, which is around five times lower than that of its benchmark.

That performance profile stems from its slight 1 per cent gain in 2008 when the index fell 30 per cent and returns of 8 per cent in 2011 when the FTSE All Share lost 3.46 per cent.

Trojan has an ongoing charges figure of 1.06 per cent while Personal Assets, which operates a zero discount policy, isn’t geared and has ongoing charges of 0.91 per cent. 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.