“If there is going to be a big move in markets it will be on the downside not the upside,” said BMO Global Asset Management’s Peter Hewitt, who has been adding more defensive strategies to his portfolio to reflect this.
Indeed, the veteran multi-manager has been upping exposure in his F&C Managed Portfolio Trust Growth portfolio to what he describes as “portfolio protectors”.
Although there was a scare at the start of this month, as the below chart shows, it seems as though markets may have bottomed out for the time being.
Performance of MSCI AC World over YTD
Source: FE Analytics
“I don’t think it is immediately about to happen, but I think some time in 2019 there is a possibility –and certainly before the middle of 2020 – I think there could well be a significant de-rating downwards,” the manager said.
“The first week or so of October was an inkling as to how the market sentiment. It seems to have stabilised as you have begun in America to get some great corporate earnings results from the big tech companies and others.”
As such, his portfolio remains invested in some of the big growth names that investors might expect a growth-orientated trust-of-trusts portfolio to include, such as Monks, Polar Capital Technology, Allianz Technology, Scottish Mortgage, Worldwide Healthcare and Jupiter European Opportunties to name but a few.
“In the long run that will be what drives performance,” he said, but added that “you could have a year where you really wish you didn’t own them because they will be down 40 per cent”.
As such, he has been upping his exposure to more defensive trusts, with 12 per cent of the portfolio – an all-time high – in so-called ‘portfolio protectors’.
“In the next six months to a year I want to be increasing the defensive portion of the fund because when the market falls the way it did [earlier this month] Scottish Mortgage was down 20 per cent,” Hewitt explained. “It tells you it is a pretty high beta trust and having a bit to offset that seems like a sensible plan.”
To do this he uses five trusts, four of which are run along similar – although not exactly the same – lines.
“All four are more conventionally invested but the one common link is they have all got a low exposure to equity markets,” Hewitt said.
The four trusts include Personal Assets Trust (37.9 per cent in equities), Ruffer Investment Company (42.2 per cent) Capital Gearing Trust (12 per cent) and RIT Capital Partners (36 per cent).
Of these, three – Capital Gearing, Personal Assets and Ruffer – have large weightings to index-linked bonds of 36 per cent, 31 per cent and 32.7 per cent respectively, with the majority held in US Treasuries.
“What they are afraid of – and you see it happening a little bit in America – is wage growth picking up, unemployment very low, the economy galloping ahead and you are beginning to see the insipient signs of inflation. It is not far off,” the F&C Managed Portfolio Trust Growth manager said.
While inflation is unlikely to go from 2 per cent to 6 per cent in the space of two quarters, he noted that the signs are there that it could be about to come through a lot stronger than people expect.
“Typically central banks in the past would have increased interest rates but you have not seen that in Japan or Europe, you have seen two token rises in Britain and you have seen eight in America but I think it needs to get over 3-3.5 per cent before you see it impacting the economy in 2019,” he said.
However, he said that at some point the market will respect the fact that the Federal Reserve will indeed continue to raise rates, something that is not being priced in at the moment.
That is why, he added, there was a sudden correction earlier this month – as Fed chair Jerome Powell discussed the possibility of future rate hikes.
While this would severely impact conventional bonds, the above funds have little in this area. Similarly, equities would be hit quite hard.
What you might therefore find is that the market gets de-rated, Hewitt said, something that has already happened this year.
Although the US market has been okay, up 6 per cent so far this year in sterling terms, in dollar terms it is largely flat, as the below chart shows.
Performance of S&P 500 over YTD
Source: FE Analytics
This is despite corporate earnings continuing to improve. This means that the market has gone from an average price-to-earnings multiple of 19x to 17x.
While this makes stocks cheaper, he said this phenomenon could continue if investors are worried about central bank policy mistakes leading to a recession. In this scenario the valuation would be largely moot.
While the four trusts above will likely hold par – or should certainly fall less than the overall equity markets – the other fund he owns is designed to add value in these conditions.
“I have slightly increased one of the ‘portfolio protectors’ which is BH Macro,” said Hewitt. “It is an investment trust that is fully invested into the Brevan Howard master fund which is a macro style hedge fund.”
During the period from 2010 to 2018, the fund went “nowhere”, returning 43.03 per cent, while global markets soared.
“It has gone sideways for six to eight years and to be honest I probably shouldn’t have held it for that time,” Hewitt said.
Performance of fund vs sector in each calendar year since 2008
Source: FE Analytics
However, so far this year it has returned 28.01 per cent in sterling terms and it also held up well during the global financial crisis of 2008/09 when it returned more than 20 per cent in each calendar year.
The fund is not invested in equities at all but instead looks to make interest rate and foreign exchange trades.
It therefore feeds off volatility, the BMO manager said, meaning that the period of low volatility seen for much of this decade has meant it that the trust has been facing “uphill and into the wind”.
“Suddenly in May there was an Italian election and bonds sold off. They were short of Italian bonds and their NAV [net asset value] went up 9 per cent in a month,” he said.
“If equity markets fall or there is general instability and they have got the right trades on then this lot should actually make you money and that is what intrigues me.”
As such, if the Federal Reserve continues to raise interest rates – leading to instability in currencies – the trust could easily have a year of returns in excess of 15 or 20 per cent, said Hewitt.
This pairs well with high-growth trusts such as Scottish Mortgage, which will do well in the opposite scenario – where rates remain subdued and growth continues to be at a premium.
As well as this, the investment company recently announced they have cut their fees and remains at a discount to NAV of 2.7 per cent, making it reasonably priced, he noted.