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Richard Woolnough: Why there’s no value left in equities

28 January 2016

The star manager, who runs the £16bn M&G Optimal Income fund, explains why he no longer has any exposure to equities, and is finding greater investment opportunities in the UK and US bond markets.

By Lauren Mason,

Reporter, FE Trustnet

Expensive valuations mean that equities are no longer beneficial for the M&G Optimal Income fund, according to Richard Woolnough (pictured).

The FE Alpha Manager, who runs the £16bn fund alongside deputy manager Stefan Isaacs, has decided to sell out of equities completely despite being permitted to hold up to 20 per cent of the fund in the asset class.

Market indices have been in decline since the start of the year due to nerves surrounding China’s growth slowdown and the continuing drop in oil and commodity prices.

Performance of indices in 2016
 

Source: FE Analytics

While this will have made some investors cautious, many others including Rathbone’s James Thomson are seeing this as a good opportunity to buy the dips.

“I can rarely think of a time in my entire career where I’ve had so many good ideas waiting for a place. We have a very exciting watch list of companies, many of which are ready to go now. We’re just waiting for space to open up in the fund,” he told FE Trustnet in an article published this morning.

“It’s also interesting because while these waves of bearishness are sweeping over the whole market, we’re now saying this is the best time in our career for buying ideas. We’re not short of ideas, we don’t think we’re about to fall off a cliff. Our operational tempo is the highest it’s ever been.”

In contrast, Woolnough is instead increasing his focus on the search for high quality fixed income assets. The manager began to reduce his position in equities in 2014 and held a 0.5 per cent weighting in the asset class for most of 2015. Since November last year however, M&G Optimal Income has had zero exposure to equities.

“The equity market is currently too expensive and the recent decline is a necessary pullback for the market,” the manager said.

“The Optimal Income fund currently has a 0 per cent exposure to equities, from as high as 12.3 per cent in 2013. We will not look to increase our allocation until the risk reward premium is greater.”

When taking a look at the fund’s performance on an annualised basis in 2013, the fund was in the top quartile for its return in relation to its peers in the IA Sterling Strategic Bond sector thanks in part to that equity weighting.

Woolnough says that the 20 per cent allowance for holding equities is available for when he believes equities offer better values than bonds, but for the time being, he says that this simply isn’t the case.

“The M&G Optimal Income fund is a bond fund and any equity exposure is an off-index position, so we only buy them when they are very cheap. We look at the relative value of a stock against that company’s bonds. Credit has also sold off over the past year, but if credit performed very well going forward and equities continued to decline significantly, then we would take another look,” the manager said.


The three crown-rated fund then found itself in the third quartile in 2014, and in the bottom quartile in 2015 and since the start of this year.

This has come at a time when the fund has seen significant outflows, possibly as a result surrounding monetary policy, which scared many investors out of bond markets.

Over the last year in fact, the fund by shrank by £8.3bn in size from its previous AUM of £24.4bn.

Martin Bamford, managing director of Informed Choice and chartered financial planner, points out that despite these large outflows, Woolnough has maintained an above-average performance over the past three and five years.

“It remains a highly rated £16bn fund, offering the manager a lot of flexibility to invest in those market areas offering the best opportunities,” he said.

“We expect rising interest rates to have some impact on the bond market, although with an average credit rating of BBB, the Optimal Income fund should not feel rising interest rates as much as many funds composed entirely of gilts or investment grade bonds.”

“Using a strategic bond fund when there is the prospect of rising rates is a sensible strategy for an investor, as the fund manager can make judgement calls around the timing of a move to sub-investment grade bonds, or shortening duration to reduce interest rate sensitivity.”

Out of its peers in the IA Sterling Strategic Bond sector, the fund has managed to achieve a top-quartile annualised volatility over the last year as well as a top-quartile downside risk ratio, which focuses on negative returns and estimates an asset’s potential to decline in price during negative market conditions.

While Woolnough is cautious on equities at the moment, he argues that markets aren’t any more volatile than they have been over the past few years, and says that despite falls in indices, investors must remember that what is bad for Wall Street isn’t necessarily bad for “Main Street”.

However, the manager is currently seeing opportunities in investment grade credits as a result of the market “unfairly” punishing many assets in the sector.

Performance of indices over 1yr

 

Source: FE Analytics

Currently, M&G Optimal Income has a 22.29 per cent weighting in the telecom, media & technology sector, a 12.37 per cent weighting in banks, 4.78 per cent in consumer products and 4.22 per cent in industrials. It also has a 23.55 per cent weighting in government bonds and has a 3.14 per cent cash weighting.


“Exports to China are less than 1 per cent of US GDP and this is largely dominated by food exports, something which is unlikely to significantly slow down,” Woolnough said.

“Commodity demand from China will decline, but investors can position portfolios accordingly. If Chinese growth is 5 or 7 per cent, it is still growing. We do not just say China weak: world weak.”

He adds that the falling oil price, which has sparked fear in many investors, is a positive for economic growth and says that the concept of falling prices killing jobs growth is unfounded.

“Volatility in the oil market is likely to continue but investors should not be focusing on it day to day,” Woolnough continued.

“Instead, we look at the long term and have increased credit risk in the portfolio.”

While the fund holds 15 per cent of its credit rating weighting in AAA bonds, its largest weighting at the moment is in BBB assets, which account for more than 40 per cent of its holdings.

Over the last five years, M&G Optimal Income has provided a total return of 29.53 per cent, outperforming its peer average by 3.68 percentage points.

Performance of fund vs sector over 5yrs

 

Source: FE Analytics

The fund has a clean ongoing charges figure of 0.91 per cent and yields 3.32 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.