Investors should now turn to value and recovery-orientated UK equity funds if they want to protect their portfolios, according to Peter Lowman at Investment Quorum, who says the likes of CF Miton UK Values Opportunities and Schroder Recovery are likely to be the best performers in the event of a correction in both bond and equity markets.
Thanks largely to an extended period of ultra-low interest rates and huge helpings of quantitative easing (QE) from the world’s central banks, both bonds and equities have performed strongly since the market bottomed after the global financial crisis in March 2009.
Performance of indices since Mar 2009
Source: FE Analytics
However, many experts are now concerned that a bubble in bonds is bursting as improving economic data has brought expectations forward about a possible rise in interest rates in the US. Some of this pain has already been felt as over the past few months yields on US, UK, eurozone and Japanese government bonds have all risen substantially.
While rising bond yields have usually been a positive signal for equity investors, the distorting effect of QE in forcing investors up the risk scale means traditional defensive areas of the stock market are also at risk as the added stimulus has pushed up valuations to very high levels.
As a result, Lowman – chief investment officer at Investment Quorum – says investors need to avoid funds which have a high weighting to bond proxy stocks such as utilities, tobacco and consumer staples, which are likely to be negatively affected if bond prices continue to fall.
Instead, he says they need to focus on stock-picking managers who look for out of favour stocks.
“Basically, we are looking for funds that won’t get as hammered if we do see a nasty correction in equities,” Lowman said.
“We are now at a crossroads as we are in the seventh year of a bull market which, on average, usually last around 96 months. We are at the long end now so people are talking more and more about valuations.”
Lowman says it is much harder for investors to build portfolios as in the “old world” they could focus on the relative value between bonds and equities. However, he says that has disappeared as QE has pushed up valuations across nearly all asset classes.
Therefore, he says investors need to be far more selective.
“Interest rates will start to go up and inflation will also pick up and bonds will get crushed. We have already started to see that trend over recent weeks.”
Performance of indices over 3months
Source: FE Analytics
“You’ve got to stay in equities but the question is do you want broad equity exposure or should you start to cherry-pick opportunities? We think you need to start fishing around for sectors and stocks that still look cheap.”
“We hold the likes of CF Miton UK Value Opportunities and Schroder Recovery which are already looking at valuations. We think that if we did get a knock in equity markets, they won’t do as bad because they are avoiding the areas that are expensive.”
Lowman says that while investors may think now is the right time to focus on large-cap dividend paying stocks which have reliable earnings, he thinks it is a very bad idea.
“The thing about ‘defensives’ is that it leads to places like utilities, tobacco and consumer goods,” he said.
“The trouble is, while they offer you a good yield, they are now open to the elements. They are not cheap anymore because since the stock market was last obliterated, investors have piled into those areas.”
Lowman’s argument is similar to that of FE Alpha Manager Martin Walker, who recently told FE Trustnet that if investors were to pile into “defensive” equities now it would be the biggest mistake they can make.
“Fund managers’ Pavlovian reaction to a market that he or she is getting twitchy about is to run to defensive shares, that’s the instinct in all of us. However, I think that is the worst thing you can now do – in fact I think it is a trap,” the Invesco Perpetual manager said.
“It has been defensive shares which have been driving the market valuation up. Investors, in my view, should look to take shelter from any kind of bond market rotation by looking at value areas of the market – now more so than ever.”
Margetts’ Toby Ricketts also recently told FE Trustnet that he was selling his stake in the highly-popular Fundsmith Equity fund due to concerns about rising bond yields. He also warned that the likes of Neil Woodford and Nick Train could struggle over the coming years as bond prices fall.
Two of the fund’s Lowman and his team are now backing are Georgina Hamilton and FE Alpha Manager George Godber’s CF Miton UK Value Opportunities and Schroder Recovery, which is headed up by the FE Alpha Manager duo of Nick Kirrage and Kevin Murphy.
The Miton fund, which currently stands at £240m and primarily focuses on out of favour companies, has been a top decile performer in the IA UK All Companies sector since its launch in March 2013, meaning it has more than doubled the returns of the FTSE All Share over that time.
Performance of fund versus sector and index since March 2013
Source: FE Analytics
It was a top-quartile performer in the remaining months of 2013, in 2014 and is so far top quartile in 2015. CF Miton UK Value Opportunities is a multi-cap portfolio, but currently holds close to 90 per cent of its assets outside of the FTSE 100.
The £695m Schroder Recovery fund has a longer track record than the Miton vehicle and has therefore witnessed differing market conditions. It has been managed by Kirrage and Murphy since July 2006.
While the managers have a deep value approach, the fund has outperformed over the longer term thanks largely to their ability to protect on the downside. FE data shows it has been a top-decile performer in the sector and has beaten the FTSE All Share by 70 percentage points since Kirrage and Murphy took charge with returns of 145.99 per cent.
As the fund was already owning stocks with bombed-out valuations, it was top quartile in the crash year of 2008 and then fully participated in the rebound market of 2009 with returns of more than 40 per cent.
Performance of fund versus sector and index between Jan 2008 and Dec 2009
Source: FE Analytics
Schroder Recovery’s list of top 10 holdings includes the likes of Tesco, RBS, BP, Morrisons and ICAP.
Ben Willis, head of research at Whitechurch, has recently been raising cash within his clients’ portfolios as he has been taking profits from bond-like equities.
“We have been taking profits from ‘bond proxies’, like infrastructure, which have done really well. However, how are they going to be affected if the market starts pricing in an interest rate rise? It’s not a crowded trade, so to speak, but its gaining traction.”
However, while he says focusing on value now is a good long-term strategy, he says it is by no means fool-proof in the current environment.
“The problem you’ve got at the moment is that the market isn’t being driven by fundamentals. If we continue to see volatility and market falls then those areas can sell-off just as quickly.”
Willis therefore says that investors shouldn’t be afraid to hold higher levels of cash in the current environment of rising bond yields so they can keep their powder dry over the summer months. He is also considering gaining more esoteric equity exposure via financials, which he says are not only cheap but should perform well as interest rates start to increase.
