Valuations, politics and herd mentality are some of the biggest risks to investors, according to three of the industry’s top fund managers.
The macroeconomic environment has been one of constant uncertainty over the past 18 months, with political elections in the UK, US and Europe dominating the headlines.
Despite this, markets have risen steadily higher, with the MSCI AC World and Bloomberg Global Aggregates indices up 39.42 and 23.9 per cent respectively.
Performance of indices since the start of 2016
Source: FE Analytics
Oliver Clarke-Williams, portfolio analyst at FE Research, said: “It has been an eventful 12 months both politically and economically, yet the effects of these events have yet to be felt as markets remain at record highs and stock market volatility is at 20-year lows.
“The prediction of market routs after the Brexit referendum, a Trump presidency and a hung parliament in the UK have not come close to realisation. Will voters’ chickens finally come home to roost over the next 12 months?
“We believe markets will continue to be extremely difficult to predict and are therefore looking for managers who are prepared to have the courage of their convictions and will not be spooked by short-term market events – those who are constantly reacting to every Trump tweet or Theresa May speech will likely do more harm than good.”
FE asked some of the winners at its FE Alpha Manager of the Year awards on the challenges and opportunities they foresee in delivering alpha in the next 12 months and how bullishly or bearishly they are positioning their portfolios.
The awards ceremony is held to celebrate managers with consistently strong long-term track records in generating risk-adjusted alpha.
Many of the winning FE Alpha Managers agree that unpredictable macroeconomic shocks will be the biggest risk to alpha generation with FE Alpha Manager of the Year, Alex Wright suggesting “2016 should serve as a reminder to us all that proper diversification is the only defence against the unexpected”.
Below FE Trustnet looks at how some of his peers and fellow award winners Ben Leyland, Richard Woolnough and Gary Greenberg view their respective markets and are positioning for this uncertain time.
We start with global equities manager Ben Leyland, who runs the five crown-rated JOHCM Global Opportunities fund.
The £318m fund, which was launched in 2012, has been a top quartile performer since inception, returning 126.30 per cent, above both the IA Global sector average (93.3 per cent) and MSCI AC World index (103.66 per cent).
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
The manager, who was named the best global equities FE Alpha Manager at this year’s awards, remains cautious in his outlook.
“We have been fairly cautious for some time and our trepidation has increased over the past 12 months,” he said.
“We see a market full of stretched valuations and high levels of corporate leverage. These are two key warning signs, as is the level of complacency in markets, as illustrated by the VIX index.
“In that context we think it is prudent to run lower than average position sizes and maintain a cash balance in the fund, to protect capital and take advantage of a future pick up in volatility.”
The largest holding in the fund is Oracle (4.3 per cent weighting), with 31 holdings in the portfolio making up 81.7 per cent of the fund. The other 18.3 per cent is held in cash.
He added that the rise of passives has forced valuations higher in many markets, something that could continue over the next 12 months.
“By definition these are price-insensitive, indiscriminate buyers and their dominance has made it very difficult for disciplined active managers to distinguish themselves,” he said.
“Active managers have to decide whether to keep chasing a rising market or step away and wait for better opportunities to present themselves.”
However, Leyland said that managers will find it far easier to deliver relative performance when a number of factors come into play, including market volatility picking up, valuations falling and, in particular, the dispersion of valuations across the market rises.
“These will provide opportunities for patient, selective, benchmark-agnostic stock-pickers to thrive. Whether this happens in the next 12 months is unclear.”
Overall, in the current climate he said investors need to look at where companies have economic exposure rather than the market they are listed in, as valuations across the board seem high.
“Equity markets are currently dominated by top-down perspectives expressed through passive vehicles, which is why perceptions of macro-level political risk are the most important factor driving most share prices,” he said.
“It has become fashionable to argue that US equities are significantly more expensive than elsewhere, but we see little evidence of this when looking at comparable stocks listed in different parts of the world.
“Unfortunately, the rally in European and emerging markets equities year to date leaves them looking just as expensive as their US counterparts.”
Global emerging markets (GEM) FE Alpha Manager Gary Greenberg disagrees, however, noting that he is moderately bullish on the prospects for his asset class.
The manager, who won the best emerging markets FE Alpha Manager prize in 2017, said: “Emerging markets are performing well and we don't see severe problems arising in the short term.”
Unlike Leyland, Greenberg said valuations in the emerging markets “remain reasonable” adding that the rally in the sector has yet to reach its peak.
“Valuations remain reasonable, interest rates are not rising, earnings estimates are turning positive. The rally has further to go,” he said.
The biggest issue, however, is that better performance over the last few years and expected returns in the short term may drive ‘fair-weather investors’ into the sector.
“[The main risk is] global investors jumping on the GEM bandwagon could take valuations beyond sustainable levels. Emerging chaos in US politics could spark contagion globally.”
However, there are pockets of excitement within the region, including Taiwanese optoelectronics, Brazilian pulp and paper, Indian cyclicals and Russian consumer plays.
Indeed, Greenberg sees India as a country with much further to run, if the policies of prime minister Narendra Modi continue to have the positive impact seen so far, though only “if earnings estimates reverse course and begin to rise, which we expect to start later in the year”.
There are areas to remain wary of, however, according to Greenberg, who highlighted Brazil, Turkey and China as areas to take caution.
“The future of essential reforms in Brazil has suddenly become very uncertain while Turkey and South Africa also suffer from discouraging economic and civil conditions,” he said.
“China's slowing growth, along with expected central bank moves to reverse quantitative easing (QE), may put pressure on the materials sector over the coming 12 months.
Greenberg manages the five crown-rated Hermes Global Emerging Markets fund, which has been the best performer in the sector over three years and is in the top three over one and five years.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
The $2.1bn fund has returned 96.98 per cent over the last half-decade, beating the MSCI Emerging Market index and IA Global Emerging Markets sector by 45.43 and 47.49 percentage points respectively.
Finally, turning to the world of bonds, the winner of the best strategic bond FE Alpha Manager this year – Richard Woolnough – said he expects a period of normalisation in the market.
“Growth and inflation are back and central banks are adjusting their policies accordingly,” the manager of the M&G Optimal Income fund said.
“We have been positioning the fund for this: short segments that have been distorted by central bank intervention,” he explained.
“I am still positive on credit risk, duration, and cautious on market and increased the fund’s spread duration to 6.4 years in May. Investment grade credit exposure currently stands just short of 60 per cent.”
However, he expects politics to play a large part in the bond market for the rest of the year, with US president Donald Trump and the UK’s Brexit negotiations likely making the headlines.
“I expect US and UK politics to remain key in 2017, while Europe’s heavy political calendar is also continuing to influence markets,” he said.
“The biggest danger is president Trump’s unpredictability – something that markets are still getting used to.
“Trump’s planned tax reforms and policies to encourage corporate repatriation of funds should prove supportive for US corporate bond markets.
“However, as we have seen in recent weeks, the so-called ‘Trump trade’ has been losing momentum, while risky assets have been supported by the newer ‘Macron trade’.”
Overall, Woolnough said he is finding value when looking down the capital structure in his M&G Optimal Income fund, which has been a top decile performer in the IA Sterling Corporate Bond sector over the last decade.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
“In financials, I am particularly finding opportunities further down the capital structure in the lower tier 2 and subordinated debt space,” the manager said.
“I have been selectively adding exposure in recent months, particularly from the US and Europe. French financials in particular have been attractive so far this year, having been impacted by uncertainty in the run-up to presidential elections.”