Investors should consider upping their exposure to absolute return and risk-diversified funds in the current choppy environment, according to City Financial’s Peter Toogood, although those with a more aggressive mindset could consider riskier, cheap areas of the market.
Very few investors could have missed the general ramp-up in volatility that has been seen over 2015 so far, despite the promising start to the year when after global growth looked to be healthy and the European Central Bank finally embarked on quantitative easing.
As the graph below shows, many indices are in negative territory over the year to date. Emerging markets have suffered the most with a near 15 per cent fall, while the FTSE All Share has shed 5.06 per cent in total return terms.
Performance of indices over 2015
Source: FE Analytics
As can also be seen, the falls accelerated in August as investors became increasingly nervous about the health of the Chinese economy – which the world’s second largest – and the timing of the first interest rate hike by the US Federal Reserve.
Toogood, investment director in City Financial’s multi-asset team, said: “We believe that August marked a significant turning point for risk assets. We entered this year in a nervous state of mind, reasoning that either growth would accelerate, exacting a response from the Federal Reserve, or growth would disappoint, thereby disappointing investors.”
“In August, growth worries re-emerged and the Federal Reserve recently reinforced that negative message. Investors are now nervous and volatility is back with a vengeance.”
He argues that this means there are too possible ways this scenario could play out.
Toogood says global monetary authorities could launch “even more stimulus” if there is any further market weakness. However, August’s events seem to have eroded investors’ confidence in central bankers’ ability to influence the markets and there is a likelihood that conditions will remain tough.
But there is an alternative scenario that he thinks would be a “much more rapid affair” and carries the risk of greater market falls being experienced.
Toogood notes that much of the selling pressure has come from the futures market rather than investors genuinely liquidating their portfolios. As the low interest rate environment means a proportion of investors’ are “forced participants” in risk assets, there is a risk that they will lose confidence more quickly than long-term investors and spark “an abrupt and potentially imminent adjustment in asset prices”.
Both possibilities suggest a continued period of weakness for markets so how does Toogood think investors should be positioned from here?
“In terms of strategy, and at the risk of sounding like a broken record, we reinforce our view that any buying at this point favours absolute and risk-diversified strategies,” he said.
“Volatility will remain elevated, as will the potential for further capital losses. These funds particularly suit novice investors who are forced into risk assets because of paltry returns in the bank and will be less than keen to nurse substantial losses.”
City Financial has six IA Targeted Absolute Return funds holding a ‘recommended’ rating in its Adviser Centre. Two of these take a multi-asset approach to investing, three are long/short equity portfolios and one looks at bonds.
The two multi-asset offerings are Invesco Perpetual Global Targeted Returns and Newton Real Return. Both have outperformed the FTSE All Share over 2015 so far but have lagged the rise in the Barclays Sterling Gilts index.
Performance of funds vs indices over 2015
Source: FE Analytics
Both funds have also offered investors a smoother ride than either index this year. Invesco Perpetual Global Targeted Returns’ annualised volatility has been 2.77 per cent while Newton Real Return’s was 4.41 per cent; this compares with 8.22 per cent from gilts and 13.71 per cent from the FTSE All Share.
When it comes to the long/short equity absolute return funds, Henderson UK Absolute Return and Kames UK Equity Absolute Return concentrate on the domestic market while Henderson European Absolute Return looks at opportunities on the continent. Absolute Insight Emerging Market Debt, as it name indicates, focuses on emerging market bonds.
FE Trustnet recently asked why low returns have been posted by a large part of the absolute return sector over recent years as well as hearing from Argonaut’s Barry Norris that too many funds simply look to reduce volatility rather than achieve competitive returns.
Toogood continued: “Incremental buying of emerging markets may also suit those with a long-term horizon, although we acknowledge that gradual buying makes more sense here, as they are not immune from further weakness in developed markets.”
There are currently three funds on the FE Invest Approved list, which indicates the favourite funds of the FE Research team.
These are Fidelity Emerging Markets, which has a benchmark-unconstrained approach to the asset class; PFS Somerset Emerging Markets Dividend Growth, which looks at firms that can maintain or grow their dividend; and Vanguard Emerging Markets Stock Index, which uses a passive approach.
Performance of funds vs indices over 2015
Source: FE Analytics
Both of the active funds have outperformed the MSCI Emerging Markets index over 2015 so far and sit in the sector’s first or second decile over one, three and five years. The Vanguard tracker has underperformed the index, as would be expected, but has managed to track it very closely.
“Finally, for those looking for interesting stock-picking credentials, we would definitely be favouring the value managers at this point in the cycle,” Toogood said.
“For example, in the UK, the likes of Investec UK Special Situations, JOHCM UK Dynamic, Jupiter UK Special Situations and Schroder Recovery all have significant exposure to the unloved sectors and above average weightings in the mega-caps. An all-cap, value-orientated exposure can be achieved through the Man GLG Undervalued Assets fund.”
We also recently looked at five UK value funds that have been topping the performance tables in recent years, after Miton’s George Godber argued that there were a number of compelling reasons why investors should be considering this style at the moment.
Jason Stather-Lodge, chief executive of OCM Asset and Wealth Management, argues that markets are likely to remain volatile in the near term owing to concerns such as falling commodity prices, the Volkswagen emissions issue and looming rate rises.
However, events such as the Fed deciding to lift rates, fiscal easing in China to stimulate growth and extensions of quantitative easing in Europe and Japan would be able to shake the market out of its negative trading range.
“Whilst ‘sideways’ markets are not good for absolute return, what they typically do is make their mind up pretty quickly,” Stather-Lodge said.
“We see some key events become binary decisions that allow many who are currently sitting on the side lines to reinvest for the fear of missing the opportunity. It is this position we and many others are trying to avoid, something alike to running after a speeding train leaving the platform.”