Investors need to be wary of their portfolios seeming resilient and should buy funds that are able to absorb any future market shocks, according to FE Alpha Manager Mark Martin.
The Neptune IM manager argues that there are three types of portfolio, the fragile, resilient and ‘anti-fragile’ among investors. However, with uncertainty expected to remain for some time, Martin says investors should concentrate on an anti-fragility approach – one that gets better the more uncertainty there is.
Despite a number of market shocks, including the results of the Brexit referendum in June and the US presidential election last month, the market has remained fairly robust.
As the below graph shows, the MSCI World has returned 24.56 per cent this year, while the embattled UK market has risen 11.18 per cent.
Performance of indices in 2016
Source: FE Analytics
Although markets have largely shrugged off the shocks of 2016, plenty more remain in the year ahead. Upcoming elections in France and Germany, the commencement of Brexit and Donald Trump’s accession to the White House in January could make the next 12 months challenging for investors.
“It’s very important in this type of market environment, where we are relatively late-cycle, that portfolios are able to absorb shocks,” Martin said.
He worries that investors whose portfolios have a seemingly resilient position could actually be more fragile than they expect.
The first area to avoid, he says, is a home country bias to the UK, with many people already heavily invested in the economy through property, bank accounts as well as investments.
Indeed, many UK pension providers are more correlated to the UK than the wider market, doubling down on the home market bias, according to Martin.
He said: “You may or may not know that a disproportionately large proportion of final salary scheme assets are invested in UK equities relative to the global market – 29 per cent versus 7 per cent.”
The manger adds that property owners are at risk, with arguably their biggest liability already twinned to the UK economy. 
“People are already geared to the UK economy,” he said. “You may think that appropriate given the fact that they have asset liability matching but that is a source of seeming resilience because if something were to happen to the UK housing market - which I’m not predicting - but if it were to happen, that seeming resilience would suddenly start to disappear.”
The second source of portfolios seeming resilient to the market is ‘fund manager herding’, or ‘benchmark hugging’, says Martin (pictured).
If many UK investors are already too highly dependent on the UK economy, then using fund managers that are closely linked to the market can also put investors in a fragile position.
Focusing on mid-cap stocks, Martin said: “If you want low correlation to the UK cycle, particularly in the mid-cap index, you need to have a high active share and vary significantly from your benchmark – no benchmark hugging.”
“We all know that managers have a tendency to hug the benchmark and I think [that] particularly at the moment because we’ve seen this active-to-passive theme which has caused managers to be even more concerned about their jobs.”
“There has been pressures and if you are a fund manager worried about your job the worst thing you can do in terms of career preservation is to diverge significantly from the benchmark: even though that could well be a good strategy for your clients.”
“Career risk, which I think is particularly high right now can lead to herding and fragility, which is not in your clients’ interests.”
The important question then is how to make sure a portfolio is actually resilient - and preferably anti-fragile - than seemingly resilient?
“The good news is that within a UK equities fund it’s actually pretty easy to limit further UK exposure because the broad UK market is a very open one with significant exposure to assets outside the UK,” he said.
While this rings true for the wider market, the mid-cap index tends to be dominated by domestically-focused stocks, but Martin says it is possible to limit exposure in the middle part of the market.
“I would argue that in a UK mid-cap fund it’s particularly desirable to limit that exposure to the UK economy because the index is more exposed to those domestic cyclical stocks - so in order to reduce this correlation it’s better to reduce exposure to the UK economy,” he explained.
Martin says stock picking will become more important in the coming years, with the likely winners being those that position away from the UK economy.
As such, he has positioned his Neptune UK Mid Cap fund away from the more domestic-focused areas of the market.
The fund has been a top quartile performer over three and five years, returning 129.60 per cent over the past half-decade, but has struggled over the last year, returning 0.41 per cent, placing it in the bottom quartile, having positioned for uncertainty that has not yet materialised in 2016.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
He said: “What we’ve seen is a significant uptick in consumer confidence and indeed in house prices and retail sales, and this isn’t really a great surprise given that we’ve had a lot of upside from Brexit in terms of monetary policy but none of the downside from uncertainty that will come through next year.”
The Neptune manager says he is looking at strategic winners in 2017, with money printing firm De La Rue among one of the fund’s more recent purchases.
“Companies like De La Rue, which have significant cost bases in the UK – so their cost bases are almost entirely in depreciated sterling which is obviously good – but almost all of their revenues are obtained from overseas currencies.”
“So you get a double benefit of a margin up from lower costs and also the translation benefit of repatriating those overseas revenues back to the UK.”
Conversely, parts of the market he argues are very risky are those that are cross-correlated with the UK economy.
“Companies like Britvic, which we recently sold from the fund. This is the polar opposite to companies like De La Rue,” he said.
“The company has almost all of its revenues in the UK but significant costs outside the UK in terms of having to use aluminium, plastics, fruit juices, sugars and other commodities that are priced in dollars so they have the negative double whammy.”