McDonald (pictured), who runs several fund of funds portfolios at Cazenove - including the £1.1bn Multi Manager Diversity fund - prefers cheaper cyclical options in the current environment, which he is offsetting with a high weighting to cash.
The manager has been wary of defensives for more than a year, but given the recent rally in sectors such as pharmaceuticals and tobacco, he says valuations are now dangerously stretched.
“Up until the beginning of 2012, we’d had a conventionally defensive portfolio, which worked out well,” he said. “Our observation then was that cyclical stocks were on a discount comparable to March 2009. We saw an opportunity to switch.”
“In the first quarter of 2012 our US exposure worked well, then Europe led the way in the second half, and most recently Japan has done very well.”
“Cyclicals re-rated, but everything did fine. Someone like Sanjeev Shah [who runs Fidelity Special Situations] beat Neil Woodford [who runs Invesco Perpetual High Income] by 20 per cent, but Woodford only just underperformed the market.”
Performance of funds and index in 2012
Source: FE Analytics
“On aggregate the whole market got more expensive in 2012, but in our view defensives are now getting incredibly expensive, especially seeing that they’ve recently led the rally. Cyclicals are still good value in some places.”
McDonald has recently sold out of the JOHCM UK Opportunities fund, which he says was his last remaining defensive portfolio. He replaced it with the more economically sensitive Majedie UK Equity fund.
“We have things like Fidelity Special Sits, Cazenove European Income which is pro-cyclicals at the moment, and GLG Japan Alpha Core. Investec Global Special Sits is probably our most defensive fund, but the manager [Alastair Mundy] does have some big bets.”
“We’ve also got things like JPM Global Consumer Trends and Findlay Park American, which aren’t exactly defensive.”
McDonald is extremely negative on bonds, which he has minimal exposure to. He points out that defensive equity funds display many of the same characteristics as government bonds, which he says illustrates why he’s currently steering clear of them.
“If you look at the 10 year government bond market and relative performance of Neil Woodford, you see something very interesting. When yields fall, Woodford does fantastic,” he explained.
“I think you need to see a US-type recession, but short of that bonds and funds like Woodford’s look incredibly expensive.”
McDonald and co-manager Marcus Brookes split their funds into three buckets: equities, cash & bonds, and alternatives. In general, assets are split equally between them.
They currently have 28 per cent in equities, 28 per cent in alternatives, but the vast majority of their third bucket is in cash, rather than bonds.
“Cash currently has a very large weighting in our fund, at 30 per cent,” he said. “Six weeks we had six bond holdings accounting for 23 per cent, but that is now down to 13 per cent and three holdings.”
“We’re comfortable with the cash-cyclical barbell. We don’t want to be fully invested in higher risk shares, but we don’t like bonds.”
One of the duo’s bond holdings is the F&C Macro Global Bond fund, which McDonald points out is itself an “anti-bond” play.
“This fund has taken the view for the last 18 months that the sovereign bond market is massively overvalued, and has been outright shorting it. Soon this will be the only bond fund worth holding,” he said.
Performance of fund versus sector over 18months
Source: FE Analytics
While some may look at McDonald’s high cyclical and cash exposure as being risky, he sees things in a very different light.
“A lot of people claim to be bearish at the moment, but in spite of all the talk these same people are fully invested. We hold cyclicals and don’t have defensives, which some say might be risky, but we do have 30 per cent in cash,” he explained.
“People keep asking me, is it brave to hold cash? In my opinion, it’s much braver to be fully invested in extremely expensive defensives equities, and expensive credit which is also massively illiquid.”
“The corporate bond sector is red hot. There could be the mother of all runs to the exit at some point when people realise that. We got out early, and was happy to come out with profits.”
Though the managers are “fairly positive”, they acknowledges that valuations aren’t as attractive as they have been in the past three years or so.
“There are some places that are undervalued on a relative basis, but that doesn’t mean things are cheap on an absolute basis,” he said. “We’re in to a four year bull market.”
“We would look to add to our risk exposure if there was a fall in the market, though it would depend on how much it falls and why. I don’t feel massively bearish at the moment. I don’t think we’re on the cusp of a big global recession as we’re already in one in certain places, like Europe.”
“It will probably take something in the US to really hurt us, but while that’s not impossible, it’s certainly improbable.”
“We would hope to be closer to being fully invested in 2014.”
McDonald and Brookes have been very active in changing the focus of their portfolio in recent years from cyclical, to defensive, and back to cyclical. This has resulted in the fund achieving top-quartile returns of 34.37 per cent over five years.
Performance of fund versus sector over 5yrs
Source: FE Analytics
Cazenove Multi Manager Diversity has a minimum investment of £1,000 and an ongoing charges figure (OCF) of 1.8 per cent.
All of FE Trustnet's articles will be focused on Cazenove today. In the next article, we speak to Matthew Hudson about his five-crown rated Cazenove UK Equity Income fund.