Investors who had made the bulk of their returns from bonds, bond-proxy stocks and mid-caps over the last few years are set to see an end to their “free lunch”, according to Neptune Investment Management’s Robin Geffen.
Since the financial crisis in 2008, the world has been in a period of low interest rates, low inflation and strong sterling, all coupled with high consumer and business confidence, giving fund managers an easy time of it, Geffen says, but all this is about to change in the coming years.
“This is one of those signal moments where I want to let off a massive firework to let people know that the game has very substantially changed. Relative to history we are in a very strange place and this is not something that is going to persist,” the manager said.
Geffen says expectations have been high for years that central banks would begin to raise interest rates, particularly in the US, where the Fed fund futures index has priced in a lift off in US rates dating back to 2008.
Fed fund futures expectations vs reality
Source: Neptune IM
“None of those lift-offs have happened and that has built an awful lot of complacency into the market and it means that people don’t think things are going to change – and that’s when things change and bad things happen to those that fall asleep,” he said.
The Neptune chief executive and fund manager adds that the biggest risks are to investors in two asset classes, bonds and mid-cap equities, which have both performed extraordinarily well since the financial crisis.
Performance of UK gilts and mid-caps over 7yrs
Source: FE Analytics
As the above graph shows, the mid-cap index has gained 137.90 per cent over the last seven years, while UK government bonds have risen 50.37 per cent.
Geffen says bonds will particularly be affected in the coming years, as central banks look to begin raising interest rates and governments move from using monetary to fiscal policies to stimulate economies. 
The manager said: “People have built into their forward expectations what’s happened for the last five or six years and that’s very dangerous. We think as we move from monetary to fiscal stimulus this is going to put further pressure on bond prices.”
He argues that valuations for equities are slightly below their long-term price-to-book average of 2.4 times, while bonds look extremely expensive on a 10-year price-to-earnings ratio.
“Now is the time to take that step back. We believe that equities are attractive on a price to book ratio and at a slight discount to their long run average,” Geffen said.
“However, bonds look extremely expensive relative to their long run average. At the end of 2015 the 10-year Treasury bond was at its most expensive level in 226 years.
“There are an awful lot of people that think it is going to get more expensive. It’s more expensive than it was in the Second World War. This is not a normal or sustainable position particularly relative to equities but also on an absolute basis.
“It’s very clear we need to re-examine asset allocation. We think that the expectation of rate rises – in the US in particular – are far too low; there’s complacency there.”
This extends to bond-proxy stocks, such as tobacco and consumer staples, which have also been on an excellent run over the last few years.
Geffen said: “We don’t think that investors appreciate the risks not only in bonds but in equities that have had a high correlation with bonds – those bonds proxies.
“Bond proxies over the last few years have performed very strongly but the last five or six years are an anomaly, they’re not something to go to sleep in or to get used to.”
His concern for the sector is that prices have soared despite (in some cases) earnings downgrades and very limited sales growth, with dividends unable to catch-up to the inflating prices.
“Quality growth is trading at a 45 per cent premium to the wider market – that is another free lunch that is over, dead, buried.”
Turning to mid- and small-caps, 116 out of 121 UK small- and mid-cap funds have outperformed the FTSE 100 since 2009, he says.
As the below graph shows, the IA Smaller Companies sector has returned more than double (254.22 per cent) the FTSE All Share’s gain (121.69 per cent) since the start of 2009
Performance of sector vs index since January 2009
Source: FE Analytics
Indeed, there is only one fund in the sector – the SF Webb Capital Smaller Companies – from the 130 with a long enough track record that has underperformed the FTSE All Share over the period.
However, he says this has been another free lunch, with asset allocation less important in the area over the last few years.
“You haven’t had to do any proper stock picking at all. If you’ve done proper stock picking you’ve done incredibly well but how much of that is sustainable by the people that have had the free lunch. I would argue it isn’t,” the manager said.
This combination, he says, has led to a strong performance for many funds in the IA UK Equity Income sector, where many own the bond proxy-type stocks supplemented by mid-caps.
Geffen said: “Well the game has changed big time. Over the last year only seven UK equity income funds have outperformed the FTSE All Share.
“The All Share has substantially outperformed and there is nothing one-off about this – this is going to be a feature going forward.”
Source: Neptune IM
As the above shows, between 2011 and 2015 the share of equity income funds outperforming the All Share rose, peaking at nearly 90 per cent last year.
The manager said: “Because of the herd mentality, because of the free lunch, because of the lack of need to get any kind of stock picking return, it’s no coincidence that this is going to be the first year since 2009 where the vast majority of UK equity income are going to underperform.
“Free lunches do not last forever and this one is over. I officially announce it dead.”
Of the seven funds to outperform this year, Geffen’s £200m Neptune Income fund is among them, returning 10.40 per cent to investors over the period.
Performance of fund vs benchmark and sector over 1yr
Source: FE Analytics
Geffen said: “I have a strong preference for large- and mega-caps that derive earnings from overseas particularly from the US.
“These are fundamentally attractive companies with international exposure who are still growing profits, have strong margins and are very well-run businesses, and they believe in returning capital to shareholders.”