The momentum trade has come under greater pressure as the process of central bank policy normalisation led to higher levels of volatility in 2018, according to Merian Global Investors’ Ian Heslop.
After a becalmed 2017, markets have experienced greater levels of volatility this year.
Investors have become more concerned about the withdrawal of liquidity from the financial system as central banks have begun to unwind key policies supporting markets since the global financial crisis.
As the below chart shows, the CBOE SPX Volatility VIX – Wall Street’s so-called ‘fear gauge’, which measures 30-day expected volatility of the US stock market – has trended higher this year than in 2017.
Performance of index over 2yrs
Source: FE Analytics
However, Heslop, who is co-manager of the four FE Crown-rated £1bn Merian Global Equity fund and head of global equities at Merian, said higher volatility was to be expected after the distorting effect on markets of low interest rates and quantitative easing.
However, the return of volatility this year – returning to levels more consistent with longer-term averages – has caught some investors on the back foot.
“Over the past six months we’ve seen a more normal type of volatility for equities of 15-to-20 per cent and that has caused some issues for the equity markets,” said Heslop.
“There have been a number of drivers of equity markets that have been very different from what we saw in 2017.”
One result of higher volatility in markets has been a more challenging environment for the momentum trade, according to the fund manager.
Indeed, many of the stocks that have performed poorly over the past couple of months have been the high-growth, high earnings companies that have dominated markets in recent years, such as the FAANG – Facebook, Amazon, Apple, Netflix and Google-parent Alphabet – group of stocks.
“As volatility comes back you need to be very careful with momentum, at a stock, sector, style and country level,” said Heslop. “Momentum is very dangerous when volatility is high.
“We’ve seen some of that in the past couple of months, but the underlying structural themes are consistent with the idea that momentum will be dangerous for 2019.”
While the global equity manager believes the momentum trade has become particularly difficult given the recent bouts of volatility, some of the better performing momentum names of recent years can be found among the portfolio’s top holdings.
However, this is due to the Merian Global Equity fund’s focus on quality growth stocks, which are able to weather more challenging conditions.
“The last couple of months have been very unpleasant, particularly for structural growth companies, but I think there is more going on in equity markets and you really need to think about what you invest in going forward,” said Heslop.
The manager said higher quality stocks with low debt to equity, higher profitability and stronger balance sheets are likely to be more attractive in the current investment environment, despite having tough recent times.
Another question that investors have been struggling with more recently – particularly given the wide dispersion in markets more recently – is whether now might be the time to back the value trade.
Performance of indices over 10yrs
Source: FE Analytics
Yet, as the above chart shows, the MSCI AC World Value index has only beaten its growth counterpart twice in the past 10 years – in sterling terms – and looks set to underperform again this year.
Indeed, the MSCI AC World Value index has fallen by 4.06 per cent in sterling terms during 2018 compared with a fall of 0.17 per cent for MSCI AC World Growth.
“The real question on some people’s minds is: ‘Is value ever going to work again and are we expecting that to work in a period of low risk appetite?’” said the Merian global equities head. “The simple answer is ‘probably not’.
“I think risk appetite needs to be higher than it is and I don’t expect that to happen in the short-to-medium term, particularly given the uncertainty we see in the current environment.”
However, it can be difficult for investors to know which way to turn in the current environment, the manager acknowledged.
Markets have reacted somewhat strongly to suggestions that the Federal Reserve could hike rates faster to reach the so-called ‘neutral rate’, while the ongoing trade spat between China and the US is causing further nervousness.
“Really the only thing that seems to be performing recently in markets is low volatility,” concluded Heslop. “I think low volatility has been used as a proxy for quality in an environment where quality showed a little bit of momentum.”
The Merian Global Equity fund invests in a diversified portfolio of global equities, with more than 400 holdings. The process behind it is designed to ensure that the portfolio is not reliant on a single investing style.
The fund’s biggest sector exposure is to healthcare, which represents 17.2 per cent of the portfolio. Other top sector exposures include information technology at 16.1 per cent, industrials (13.7 per cent), financials (13.5 per cent) and consumer discretionary (11.6 per cent).
Since Heslop joined the fund in 2007, it has generated a total return of 179.69 per cent, compared with a gain of 147.26 per cent for the MSCI World index benchmark and a 95.01 per cent return for its average IA Global peer.
Performance of fund vs sector & benchmark under Heslop
Source: FE Analytics
Heslop manages Merian Global Equity alongside colleagues Amadeo Alentorn and Mike Servent. It has an ongoing charges figure (OCF) of 1 per cent.