The poor performance of the five crown-rated Schroder Recovery and Schroder Income funds is due to their ‘deep value’ styles falling out of favour, according to FE Alpha Manager Kevin Murphy, who says 2015 is an example of short-term pain in pursuit of long-term gain. 
Murphy (pictured), who heads up the two top-rated portfolios with fellow FE Alpha Manager Nick Kirrage, has a long-term track record of outperformance compared to both his peers and the wider UK equity thanks to his ability to find out-of-favour companies that are set for a reversal in fortunes.
FE Analytics shows that the £685m Recovery fund has been a top decile performer in the highly-competitive IA UK All Companies sector since the duo took charge in July 2006 with returns of 132.46 per cent, meaning it has beaten the FTSE All Share by 60 percentage points.
Performance of fund versus sector and index under Murphy & Kirrage
Source: FE Analytics
They took charge of the £1.6bn Income fund in May 2010 and it has comfortably outperformed the index over that time with gains of 69.76 per cent. The fund was forced to move from the IA UK Equity Income sector earlier this year due to its failure to meet the yield target, but has outperformed both peer groups over the period in question.
However, investors in the two funds may have noticed that the past eight months or so have been more challenging.
FE data shows that Schroder Income has been the fourth worst performer, while Recovery is currently sitting bottom of the 272-strong sector year to date with losses of 1.03 per cent. The peer group average and index are up 8 per cent and 5 per cent, respectively.
Performance of funds versus sector and index in 2015
Source: FE Analytics
While this may alarm some investors, Murphy says he isn’t overly concerned as it is largely as a result of his and Kirrage’s style. He says he will be making no drastic changes in either funds as long-term outperformance is his priority.
“This market environment has not been conducive to a value strategy,” Murphy told FE Trustnet.
“We very much have value philosophy and it has delivered extremely good results over the longer term. However, on a year of six month basis, the fund can underperform because it looks very different to the benchmark.”
“If you look like the benchmark, you are not going to outperform and so do to so you have to make active decisions.”
Murphy says the principle driver of his funds’ underperformance has been investors' shift towards ‘bond proxies’: the name given to defensive mega-cap equities which have reliable earnings and dependable dividend-growth.
These stocks have become increasingly popular over recent years as extraordinary monetary policies, such as quantitative easing (QE) and ultra-low interests, have forced investors to take higher levels of risk to find an acceptable level of yield.
“QE has impacted all asset classes,” Murphy said. “Government bond yields have been depressed, which has meant investors have turned to corporate bonds, then high yield and now equities with bond-like characteristics.”
He says the likes of REITs, utilities and consumer goods companies fall into this bracket. As the graph below shows, all three of those sectors have comfortably outperformed the wider UK equity market over the past five years.
Performance of indices over 5yrs
Source: FE Analytics
While those areas have rallied, some of Murphy’s largest sector bets have had a tough time of it. Banks, for example, have been hit by pressures this year thanks to further fines. He holds HSBC, Barclays and RBS across his two portfolios.
Their style has also led the two managers to the oil & gas sector, with BP featuring in both funds’ list of top-10 holdings. However, the company is having another poor year due to a further fall in the oil price on the back of the recent agreement with Iran.
Another area which has underperformed so far this year is large-cap pharma, with AstraZeneca and GlaxoSmithKline experiencing double-digit falls since April due to a variety of concerns. Both companies are major positions in Schroder Income and Schroder Recovery.
Murphy hasn’t changed his philosophy, though, and has even run high levels of cash (9.21 per cent in Recovery and 4.56 per cent in Income) as he says very few opportunities have met their strict valuation discipline. This too has contributed to some of the relative underperformance.
Kirrage and Murphy are very highly regarded within the industry and Square Mile, the investment research and consultancy firm, says investors in the fund should be able stomach periods of underperformance.
In fact, in reference to their Income fund, Square Mile say when their strategy has gone through a period of underperformance likes this, it often presents a buying opportunity.
In the falling market of 2011, for example, both funds were bottom quartile as investors ran to defensive equities to protect themselves against the worsening European sovereign debt crisis. In 2012 and 2013, though, Schroder Income and Recovery were back-to-back top quartile performers.
“The equity income strategy deployed by Kirrage and Murphy is a credible one which should add value over the longer term,” Square Mile said.
“Investors should note that a contrarian approach such as this does tend to be more volatile than other equity income strategies. The central tenet of their philosophy is that share prices move more than the changes in companies’ fundamentals justify.”
“When markets are low and falling, the managers are likely to be more aggressively positioned as they see such short term volatility as an opportunity. This may be painful in the short term for investors but these times may mark the periods when the strategy has the greatest opportunities ahead of it.”
FE data shows that while Kirrage and Murphy have a long-track record of outperformance, they have given their investors a rougher time than most.
Schroder Recovery is a good example, given it has had a higher maximum drawdown than the sector index and has been bottom quartile for its downside risk and annualised volatility since they took charge.
Nevertheless, one of the major reasons why Murphy and Kirrage are becoming more and more popular with professional fund buyers (despite their recent underperformance) is because their value style looks set to benefit from rising interest rates.
There have already been signs that certain ‘bond proxies’ will struggle in the event of a rate hike – which looks likely to happen in the US and UK over the next 12 months – given their high correlation to government bond markets during this year’s spike in fixed income yields.
Performance of indices since April 2015
Source: FE Analytics
While Murphy says he doesn’t build his portfolio for potential rate increase, he agrees many of the companies he currently own would do well in such an environment as it would suggest a strengthening economy.
“I don’t have a view on exactly when interest rates will rise, but at some stage over the next three years I would expect them to be higher than they are now. We don’t spend too much time thinking about it as we tend to focus on individual stocks.”
“However, we do try to assess which companies would be helped or hindered by higher interest rates and there have only been a couple of sectors which have consistently performed poorly as rates have been falling – and one of those is financials and in particular banks.”
He added: “It therefore makes sense that they would perform well in a rising rate environment.”
Schroder Recovery has a clean ongoing charges figure (OCF) of 0.91 per cent while Schroder Income (which yields 3.61 per cent and has increased its dividend in each year since Kirrage and Murphy have been at the helm) also has an OCF of 0.91 per cent.
