Complacency surrounding unusual monetary policy means investors seeking comfort in expensive ‘bond proxies’ could have the rug pulled from under their feet over the coming year, according to Jacob de Tusch-Lec (pictured). 
The manager, who heads up the £3.2bn Artemis Global Income fund, says out-of-favour and underperforming value stocks could give investors protection, given the market cycle can only last for so long before rolling over.
He admits he was early in selling out of defensive holdings for valuation reasons but says prices of bond proxies have risen to extreme levels and, all the while, investors don’t seem to be worried by this.
“There must be a possibility that a bubble is forming in some consumer staples stocks (although we appreciate that the definition of a bubble is when ‘stocks that I don’t own keep going up…’),” the manager said in the fund’s latest annual report.
“While the fund no longer has much exposure to tobacco stocks, we can see their performance being okay until such time as the market starts worrying more about inflation than deflation, when risk-free rates move higher and when ‘growth’ gives way to ‘value’.
“History tells us that no trend lasts forever: every market cycle comes to an end. Yet as the last year showed, pointing out that valuations have become stretched is one thing but predicting precisely when that will change is another.
“We acknowledge that current trends may persist and that expensive assets could become even more expensive. But the threat of what will happen when those trends go into reverse means we are unwilling to risk unitholders’ capital on their continuation.”
Since the financial crisis, equity markets have risen substantially as central banks have continued to implement ultra-loose monetary policy in a bid to keep the economy stable.
Performance of indices since 2009
Source: FE Analytics
However, the use of quantitative easing and the lowering of interest rates means the hunt for income has become more pronounced than ever. Combined with geopolitical uncertainty and a global growth slowdown, many investors piled into bonds to receive a steady stream of income and stable returns.
This has subsequently led to fixed income yields plummeting to historic lows and bonds becoming increasingly volatile and, as such, dividend-paying ‘stalwart’ stocks or ‘bond proxies’ have become popular among investors.
De Tusch-Lec warns this has pushed valuations in the space to extreme levels and, despite the fact it has bruised his performance over the last 12 months, believes it is safer to stay put in value-focused holdings.
“Clearly, the principal reason for the gains in defensive growth stocks and low volatility bond proxies has been that yields on government bonds have fallen,” he explained.
“Because treasuries are the world’s benchmark ‘risk-free’ asset, their mispricing causes other assets to be mispriced in turn. If that were to go into reverse, the price movements in the equity market could be severe. Might that happen?
“If we look at unemployment data and economic growth in the US, treasury bonds do appear mispriced. Their yields are far lower than they ought to be. However, a long period of QE and zero or negative interest rates, both in the US as well as in Europe and Japan means the old rules no longer work and, in relative terms, US treasuries have been turned into high yielding assets.”
The manager adds that the increasing popularity of smart beta strategies – ETFs that are weighted via analysis-based screens as opposed to market cap weightings – have also added to risks facing markets.
Because of their focus on low beta and low volatility specifications, he warns they have increased the popularity of dividend-paying ‘expensive defensives’ even further.
“Their success in attracting assets has played an important role in driving up the price of high quality, defensive equities to their current exalted multiples,” he continued.
“They may also have had the perverse effect of artificially creating one of the attributes that they invest in: the illusion of low volatility. The flows into these types of funds have been such that those equities that meet their criteria have a queue of investors willing to buy them almost irrespective of price. In the short term, that demand appears to have smoothed out volatility.”
One of de Tusch-Lec’s main concerns about buying into defensive assets is that, if these low volatility ETFs were to fall out of favour and start selling rather than buying the same group of expensive equities, any suppressed volatility could suddenly come to the fore.
If bond proxies then start to behave more like typical stocks as a result, he says this could cause a further sell-off in expensive defensives.
“Our hunch is that low volatility stocks have been bought by yield-hungry investors since the financial crisis, which has made them into even lower volatility investments,” the manager reasoned.
“This positive feedback may carry on for a while – but not in perpetuity. So while the fund has some exposure to low volatility bond proxies, it has far less invested in some of the most fashionable areas of the market than its peers.
“That balanced approach has meant holding stocks in those areas that have been less sought-after. We have, for instance, bought some bond proxies that offer higher yields but whose shares are sufficiently volatile to disqualify them being owned by a low volatility ETF.
“These stocks have not been on investors’ radar this year but they could begin to appear on it were conditions to change.”
In terms of his outlook over the next 12 months, de Tusch Lec warns there could be a significant turning point on the horizon, given that a range of asset classes aside from equities – such as real estate, government bonds and corporates – are also expensive in both absolute and historic terms.
He says markets have borrowed cheaply to acquire financial assets, which is what central bankers have been encouraging over the cycle.
“This cannot last forever. We are by no means forecasting an imminent sell-off and so are not running a particularly high cash balance, but we are avoiding companies that trade on historically high multiples of earnings,” the manager explained.
“We do think market volatility is likely to increase over the next year with potential for violent rotations between different sectors irrespective of the market’s overall direction. A market in which miners outperform tobacco and where the US underperforms Europe would leave many investors unhappy. We try to be prepared for such an outcome.
“At the most basic level, we think there is some protection to be had in buying value. Our portfolio tends to perform well when yields rise, when value outperforms growth, when financials outperform consumer staples and when Europe outperforms the US. Those conditions have been largely absent over the last year, but this could change.”
Since de Tusch-Lec launched Artemis Global Growth in 2010, it has returned 150.69 per cent, outperforming its sector average and benchmark by 55.4 and 42.37 percentage points respectively.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
However, it is in the bottom quartile for its annualised volatility and downside risk (which predicts the fund’s likelihood to fall during negative market conditions) over the same time frame, suggesting it may not be well suited to more cautious investors.
Artemis Global Growth has a clean ongoing charges figure of 0.81 per cent and yields 3.1 per cent.