Now is a “fantastic opportunity” to move portfolios out of sectors that have performed strongly and move towards areas that will outperform in the next phase of the market cycle, according to the managers of the only cautious multi-asset fund to make money in October’s sell-off.
While stock markets have tended to move steadily upwards with little volatility in recent years, 2018 has thrown some more challenging conditions for investors to deal with. This year has witnessed two significant sell-offs, with last month seeing many parts of the equity and bond markets post losses.
Of course, funds were caught in this as well and many portfolios were unable to generate positive returns in October. In the IA Mixed Investment 20-60% Shares sector, only one of its 155 members – the Schroder MM Diversity fund – was in positive territory; the fund made 0.30 per cent over the month compared with a 3.01 per cent loss for its average peer and a 5.31 per cent fall from the worst performing member.
Indeed, only four of the 533 funds in the Investment Association’s four main multi-asset sectors made positive, albeit small, returns in October. The Schroders portfolio is joined by Troy Trojan (up 0.27 per cent), Pimco GIS Strategic Income (up 0.13 per cent) and Investec Diversified Income (up 0.10 per cent).
Performance of fund vs sector in 2018
Source: FE Analytics
Robin McDonald, who runs the £615.6m Schroder MM Diversity fund with Marcus Brookes, is keen to point out that one month is a very short time horizon and that the portfolio has endured its own “tough times” in recent years; while the fund is the sector’s sixth best performer in 2018, it is very much towards the bottom of the peer group over three and five years after returns were pretty much flat over the past 18 months.
This has been down to the portfolio’s defensive positioning – although the managers are bullish on economic growth, the fact that the equity returns have been driven by valuation expansion rather than earnings growth made them cautious on markets. As a result, their multi-manager range has heavy weightings to cash and alternatives (typically long/short funds with a defensive bias) and is light on some parts of the stock market and fixed income.
However, McDonald believes that the market is showing signs of mean reverting and coming around to the positioning taken in the MM Diversity range’s portfolios. He argued that October “could, in all likelihood, be a rehearsal for a very disruptive period ahead”.
“It may well be that investors have got one last opportunity to reposition their portfolios more conservatively for 2019 and our cry would be that they really ought to take that opportunity,” the Schroders manager said.
“You've got a huge amount of capital today concentrated in what have been the very strong leadership assets of this cycle. In the late 90s the market became concentrated in a similar way that it is today: momentum to the market trend is what matters and the price isn't what matters.
“We've got countless examples historically where you've had these markets where momentum has ruled the day to the point where this final phase becomes almost parabolic. But then when it breaks, people are invariably caught offside.”
Recent years have been marked by the dominance of the growth style of investing, which has outperformed value as an environment of ultra-low interest rates and quantitative easing pushed investors into growth names.
Performance of indices over 18 months
Source: FE Analytics
The most extreme example of this is the information technology sector, specifically the FAANG stocks of Facebook, Apple, Amazon, Netflix and (Alphabet subsidiary) Google. Over the past 18 months, the S&P 500’s market cap has grown by $6trn, but half of this came from tech stocks and a further half of that was from the five FAANG stocks.
Many investors are overweight such stocks – recent fund manager surveys by Bank of America Merrill Lynch, for example, have found that long tech is seen as one of the most crowded trades in the market – and they were one of the areas hardest hit in October’s sell-off.
McDonald fully expects the FAANGs and other growth areas to have a bit of a bounce in the coming weeks as investors buy back in after the correction. However, he warned against assuming that this means the bull market in growth stocks is back in force.
“In the short term what we're anticipating is that the market is probably going to have an attempt at rallying but we quite strongly view this is an opportunity for people to reposition for what will be a tough year in 2019,” he explained.
“The bulk of the difficult returns in 2019 are likely to be heavily concentrated in what the market considers the growth style – as best expressed by things like US tech.”
McDonald said that investors should be looking to rotate into areas that have done less well than growth, such as value. Specific sectors that he considers attractive at the moment include telecommunications, retail and gold miners.
As mentioned above, Schroder MM Diversity has exposure to a number of alternatives funds with a preference for those that tend to have a defensive tilt and can short equities as well go long. Examples within the portfolio include Majedie Tortoise, Sanditon European Select and GLG UK Absolute Value.
Given that the manager thinks markets have a good chance of entering a rough patch, does he expect long/short funds such as these to become genuine profit centres rather than just portfolio hedges?
“Big time,” he said. “They've got a window and over the course of the next 12 months, let’s say, there’s a window of opportunity to make fantastic returns. I think the real performance differentiator over the coming months will be in the alternative space.”
Performance of funds over 3yrs
Source: FE Analytics
McDonald noted that many of these funds have only made moderate returns in recent years as the market environment was not conducive to their approach. However, he suggested that some could make returns of more than 20 per cent if markets enter a more volatile 12 months.
In summary, the multi-manager believes that high valuations in growth stocks and a move towards tighter monetary policy will mean 2019 could be a turning point for investors. He warned that traditional 60/40 portfolios and funds full of momentum ideas such as tech will be left behind as the value style comes to the fore and growth sells off.
“The market appears to be very lopsided in how people are positioned and I think there is a fantastic opportunity to lean against the consensus portfolio here and make good returns,” he concluded.
“Not that I should, but I do worry about other people’s portfolios because they are heavily concentrated in areas that, over the next 12 months, they probably won’t want to be. But that’s what makes a market.
“If we are right and people start reallocating towards our positions, then that will be hugely beneficial for us. We are keeping our fingers crossed and hope for better times, having gone through our own tough times over the past 18 months.”