Ten year gilts are currently yielding 2.75 per cent, however that figure was below 2 per cent this time last year.
Newman, who runs the fund with fellow FE Alpha Manager Ben Wallace, says that the current market is similar to the one in 1994 when the Fed pushed up interest rates following better-than-expected economic data.
While Newman says it is difficult to call when interest rates will rise, he says he doesn’t mind being early into financials and is currently net long the sector as he expects yields on government bonds to trend higher over the coming year.
“The biggest theme in our long book is in the financial sector with banks and insurers,” he said.
“We think there are some big opportunities there and history has shown that when the yield curve is steepening and investors are switching out of fixed income, then banks and insurers have performed well.”
“If you were to look back to 1994 and 1995, they were the big winners. If we were to see the US continue tapering QE and a rate rise here in the UK, then we want to be making money from it for our investors,” he added.
Many managers see little point in holding banks.
For example, FE Alpha Manager Leigh Harrison recently told FE Trustnet that the likes of HSBC and Standard Life are safer but offer little capital upside, while Lloyds, RBS and Barclays are far too risky.
Last year JOHCM’s Clive Beagles and Christopher Lees warned investors that the events of 1994, whereby the Fed hiked interest rates and caused a sell-off in both bonds and equities, could happen again in 2014.
Performance of indices in 1994
Source: FE Analytics
They agree with Newman’s positioning and are tipping cyclical stocks, non-life insurance and banks to outperform as they are the types of companies that can make more money in a higher interest rate environment.
While Newman and Wallace try to add value via their long book, they also use their shorts to deliver a decent rate of return.
“Our short book is more than just a hedge, it is a profit centre,” Newman explained.
The managers cannot disclose the companies they are shorting due to compliance reasons, however, like fellow FE Alpha Manager John Warren, Newman is also negative on some of the UK’s largest, more defensive, stocks.
“We are currently short consumer staples and consumer goods companies,” he said.
“They are looking very expensive and over-owned, particularly consumer staples. They ticked a lot of boxes for people as they were seen as a form of defence in an uncertain market and an income provider in the low rate world.”
Consumer staples such as Unilever, Diageo and SAB Miller were some of the worst hit stocks during the January sell-off.
Performance of stocks vs index in 2014
Source: FE Analytics
Long-only equity managers, such as FE Alpha Manager Mark Costar, say that the major reason why those companies have underperformed is because investors wrongly believed they could perform well in all market conditions and were therefore paying over the odds for that perceived safety.
However, Costar also pointed out that their emerging market exposure had also hurt their share prices.
Newman says that he had capitalised on the weakness in emerging market currencies to take profits from his short book.
Newman and Wallace have managed the strategy for more than 10 years, although the fund only joined the IMA universe in April 2009. The fund was added to the FE Select 100 list of elite funds in its latest rebalancing.
During the crash year of 2008, the strategy returned close to 30 per cent which Newman says was purely down to its tactical and core short positions.
It has also performed well since it joined the IMA Targeted Absolute Return sector. The fund has delivered a cumulative return of 37.31 per cent over that time, making money in each calendar year, except 2011 when it lost 0.44 per cent.
“Both 2010 and 2011 were difficult years for us,” Newman said.
“We are bottom-up stockpickers but what we saw in 2011 was a very macro-driven market where there were very tight correlations at a stock level and between asset classes.”
“Because of that, our attention turned to capital preservation and not losing more money for our investors.”
The fund delivered a return of 16.44 per cent in 2013.
Newman is positive that those returns are repeatable because he says the lack of correlation in the current market means that the conditions are very suitable for his and Wallace’s strategy.
“We made good money on our core and tactical book, which is testament to the very good conditions for long/short equity funds,” he said.
“The opportunities are now as good as they have ever been for a long/short equity fund. There has been a change in market conditions. Liquidity is improving as investors are returning and there are now dispersions at a stock level which were non-existent in 2011.”
“On a day of results, good companies now perform well and vice versa,” he added.
The Henderson UK Absolute Return fund has an ongoing charges figure (OCF) of 1.07 per cent and requires a minimum investment of £1,000.
