Manager Jeff Atherton explains why investors may have to rethink their strategies of the past decade.
Since the end of the financial crisis of 2009, growth stocks, and in particular technology companies, have enjoyed a whirlwind decade of upward returns with few bumps along the way.
Now it appears that the tide is turning, and his fund has echoed this. A traditional value portfolio, it has made 26% since the start of 2021 while its average peer in the IA Japan sector and its Topix benchmark have lost 13.4% and 10.9% respectively.
Total return of fund vs sector and benchmark since January 2021
Source: FE Analytics
“I hope we are heading back to a more traditional environment, which is exciting to me and is our strong point,” said Atherton.
“If so, a whole generation of fund managers will need to rethink what they’ve been taught for the past 10 years.”
Below, he tells Trustnet about how he won’t buy a stock unless it has lagged the benchmark by at least 40%, why he has recently given more thought to sustainability and how the fund has turned around from the toughest year of his career: 2020.
Can you describe your process for stock selection?
We run a large-cap, contrarian, value-based strategy in Japan. We look to go against the herd by buying assets that are depressed and unfashionable and we want those assets to be cheaper than their history, with the capability to revert back to normality.
It’s a combination of contrarianism and value. We emphasise both of those, but get side-tracked more often than not into talking about value.
We don’t buy anything unless it has underperformed the market, typically by 40%, over four to eight years. Not every investment hits that, but it is a pretty good guide.
That produces a number of candidates to look at from the top 300 names in our large-cap index. From there it is a question of quality and the characteristics that will get them back to a reasonable price. Here we look at classic value metrics such as price to book, price to sales, price to net asset value and EBITDA [earnings before tax, depreciation and amortisation].
Why should investors pick your fund?
There aren’t that many value funds in the Japanese sector, and we’ve been around a long time and are consistent with what we do. We’ve been doing this since 2006, while the process behind it goes back to 1994.
We’ve never changed our process to fit market conditions and hopefully now value is coming back into fashion, as it has been over the past 18 months.
Returns were patchy in 2019/2020, but the fund has soared over the past 18 months. Why is that?
It is down to the fact that we have had a technology boom and bubble, which is hopefully now bursting. That was always going to make life difficult for us and certainly 2019 was quite tough.
Back then the Federal Reserve was cutting interest rates and tech companies were being revalued hugely. Japan was following the States on that.
We came into 2020 with Covid, which was the toughest year in my 35 years in the industry. It was incredibly tough for a value fund like ours because we had autos, energy, chemicals, steel – every industry that ground to a halt when the world did.
We could not have done much about it, but it was the biggest storm in value for many years, comparable to 1999, which was the worst value market in 50 years.
We have got everything and more back since then and to some extent it has just been a recovery from a bad year or two.
Total return of fund vs sector and benchmark over 5yrs
Source: FE Analytics
What have been your best and worst holdings in recent years?
Mitsubishi Heavy Industries was a top-10 holding at the start of the year, worth 3.3% of the fund. It peaked on 8 June with a 110% year-to-date return and has since fallen back a little, but as of today it is still up 83%, against a market that has fallen 7%.
Our worst however is Japan Post Holdings, which was privatised in October 2015 at a price of Y1,400 [£8.50]. Today the price is Y962, nearly seven years later. We finally exited the position this year after losing faith in the management.
A mis-selling insurance scandal and low interest rates undermined the business and we were a little slow in hindsight to recognise that and act on it.
We sold stock at many different levels, but the loss of approximately one-third of the share price since the IPO probably approximates our loss.
Do you incorporate environmental, social and governance (ESG) in your fund?
It is something we have really taken on board in the past 18 months or so as it is incredibly important and the Japanese have really picked this up.
Historically, they have not been that interested in climate change, but that has changed recently and now every Japanese company we talk to is conscious of ESG, which makes our lives a lot easier.
We are increasingly incorporating it, but our basic process doesn’t change. It is a final factor in our determination of quality.
What do you do outside of fund management?
My big interest in life is military history, which is obviously more pertinent now than usual. When I finally retire, I would like to spend more time looking at that.
Editor Jonathan Jones explains why he has moved to cash despite low asset prices and rising inflation.
It was another week of doom and gloom as UK inflation nudged up to 9.1%, exacerbating the cost-of-living crisis that is being felt across the country.
The consumer price index (CPI) is now at a 40-year high, but the Bank of England predicts inflation will get worse before it gets better, peaking at around 11% in October when the energy price cap is removed.
Some analysts believe that this will bring about a recession or leave the country flirting dangerously close to the line at the very least.
Annabelle Williams, personal finance specialist at Nutmeg, said: “It’s too soon to call definitively whether there will be a recession in the UK this year, but the ducks are getting into a row. The economy may begin to teeter on the edge of a recession by the end of the summer.”
The problem for investors is working out how to allocate their money with this in mind. As such, this week we covered a number of high-profile funds.
Analysts at Investec were positive on Monks investment trust, which has dropped 40% since its highs in 2021, saying it remained a “core” option for investors – unlike its stablemate Scottish Mortgage, which they downgraded last week.
Speaking of what was previously the UK’s largest investment trust, Scottish Mortgage was in the news again this week as Brewin Dolphin’s Rob Burgeman said it may have a private equity problem.
I won’t go into detail here, but in short, the trust is up against its self-imposed limit on unlisted companies, so may struggle to pump more money in when the begging bowl is inevitably passed around and these businesses ask for more cash to survive.
Another fund having a tough time of it is Fundsmith Equity – the UK’s largest fund is in danger of failing to beat its average peer for the first time in a calendar year since launching (gasp).
It is down 21.3% so far in 2022, 5.1 percentage points below the IA Global sector. Analysts were unanimous that long-term investors should hold on, pointing out that selling now would mean crystalising losses at these levels.
However, if you think inflation will remain high in the long run, its performance could continue to suffer, according to Darius McDermott, managing director of Chelsea Financial Services.
Conversely, if you’re of the view that these conditions won’t last forever, or that the market is already pricing in the worst, you could even make an argument for buying more.
I will sign this week off by noting that while the suggestions of whether to buy, hold or sell are valid, a lot will come down to personal circumstances, particularly in this difficult time.
I have liquidated more than half of my ISA portfolio, which I have been accruing (incredibly slowly) for more than a decade.
My wife and I are expecting our first born in August, a wonderful – but also horrifically expensive – time. By all accounts, selling now is likely to be one of the worst things an investor can do, but it is also a necessity for me.
I won’t let sequencing risk stop me from being able to afford all the things I need, even if I’ve probably lost out in the long term. Financial theory is great, just don’t forget that sometimes real-world problems require real-world solutions.
So far this year, the trust has been among the top performers of its sector, but it had been suffering since 2020. Is it time to buy, hold or fold?
The year so far has proved challenging for investors and the sea of investment trusts has not been spared a shake-up.
Traditionally strong players like Scottish Mortgage have been suffering, presenting investors with the conundrum of whether they should buy the dip or back out.
Investors can tackle the current discomfort in markets in a variety of different ways, whether it be by taking a cautious approach, trying to ride out the wave of volatility altogether, or by taking advantage of price falls and buying at the lows.
So far, Murray International has emerged as one of the winners in the reassessment, but it has not been smooth sailing.
Looking at its 10, five and three-year performance, the £1.5bn trust had been anchored in the bottom quartile against its Global Equity Income sector. The three-year performance line below shows prolonged periods of underperformance against the reference sector and the benchmark.
Trust’s three-year performance against sector and benchmark
Source: FE Analytics
Ewan Lovett-Turner, head of investment companies research at Numis, blamed the disappointing performance on the little exposure to US tech stocks, while head of research at Chelsea Financial Services Juliet Schooling Latter also noted the trust’s greater weight in Asia and emerging markets than some of its peers.
Additionally, the trust also invests “a reasonable amount” in bonds, which would have been a lag during times of strongly rising equity markets.
“What are the key performance indicators for Murray International? In the past 20 years they haven’t changed: grow the dividend above RPI, have an above-average dividend yield covered by income, and grow the net asset value over the rate of inflation over the long term. Relative performance is destroying our industry,” he said.
“There is no point comparing a trust like ours, which can own bonds and invest in any market in the world, against others that are buying the hot stocks and paying dividends out of capital.”
Stout’s investment philosophy has indeed always been to look for more sustainable, long-term growth opportunities where valuations had yet to reflect widespread popular recognition, which resulted in a rather defensive portfolio where he feels he will be able to retain both earnings and dividends, without paying over the odds.
Schooling Latter: “He’s never one to follow fashionable stocks or pay extravagant prices (and there are the ones that have done well). By his own admission he is of a thriftier disposition.”
This penalised the trust while the market was focused on growth, but in the past year the tide has turned and the company has leapt to the top of the ranking over 12 months, as well as the six, three and one-month results. The chart below clearly shows the turning point in performance.
Trust’s one-year performance against sector and benchmark
Source: FE Analytics
On the back of these results, Stout confirmed in the latest trust factsheet that the current strategy will continue to be maintained.
He wrote: “The portfolio proved relatively resilient under such circumstances, the emphasis on diversification and real assets protecting capital during some extremely volatile trading days.
“With safe havens in short supply, it was encouraging to witness strength in energy, telecoms, insurance, and industrial holdings, plus the focus on quality and yield, holding firm as ‘popular’ sectors such as internet, media, software and new economy services succumbed to intense selling pressure on future growth concerns.”
But how much longer will the trust benefit from the current market conjuncture and should you consider staying the course or abandoning? For fans of the trust, is it time to buy and settle in for the long-run returns, or has that ship sailed?
The trust is currently trading at a -3.1% discount to net asset value (NAV) – a small discount, as it has traded lower in the past, as Schooling Latter noted, but it has also traded significantly higher.
“Certainly, the manager’s style means that returns have been very strong in some years and weaker in others, but he has delivered in the long run. In the past six to 12 months, the positioning of the trust and the style have really come to the fore, and it has outperformed the market and peer group quite considerably,” she said.
“The companies he holds should be better able to weather market volatility and higher inflationary environments.”
She continued to praise the manager for having always been “very clear about the way he invests” and so for her it was “at least a good long-term holding, if not a buy”.
Lovett-Turner reiterated his faith in the manager too, as he was convinced that the trust will continue to be “well-placed for providing defensive exposure in the current uncertain outlook”.
Both analysts provided other options, should investors not feel encouraged by Murray’s current discount.
For defensively minded investors, Lovett-Turner recommends RIT Capital Partners or Personal Assets, while Schooling Latter opted for JP Global Growth & Income or Invesco Select Global Equity Income for those requiring regular dividends, while in the open-ended space she suggested Guinness Global Equity Income and TM Redwheel Global Equity Income.
The broker said it was “shocked by the brutality of the sell-off” in the Baillie Gifford trust, considering most holdings continue to do well at the business level and are financially robust.
Investec Bank has reiterated its ‘buy’ rating on the Monks Investment Trust after it endured a “perfect storm” that has caused its share price to fall by close to 40% since its 2021 high.
Performance of trust over 3yrs
Source: FE Analytics
With Monks being run by growth house Baillie Gifford, it has been hit hard by the spike in inflation and interest rates this year.
In Monks’ annual results, its managers Spencer Adair and Malcolm MacColl said that while they had been reflecting on a period of strong performance just 12 months before, they recognised that “the speed and size of the reversal since then has been jarring for shareholders”.
Investec warned the “macroeconomic storm” that has caused so much pain for growth investors is still some way from passing, and last week downgraded another Baillie Gifford trust, Scottish Mortgage.
However, it said it was “shocked by the brutality of the sell-off” in Monks’ shares, considering the majority of companies in the portfolio continue to perform well operationally and are financially robust.
“Revenue growth is accelerating, with sales forecast to grow at 17% over the next five years versus 10% for the broader market,” said analysts at Investec.
“Meanwhile, the managers’ analysis found that the portfolio is skewed towards businesses with a high degree of flexibility to cope with a surge in inflation.”
Spencer Adair and Malcolm MacColl, the managers of Monks, look for exceptional companies with the potential to deliver attractive earnings growth over the long term.
The portfolio comprises three growth categories: rapid growth at 39.7% of assets, which comprises early-stage businesses with a vast opportunity, or innovators attacking existing profit pools or creating new markets; growth stalwarts at 34%, which are businesses with a durable franchise and competitive advantage that allow them to deliver robust profitability in most macroeconomic environments; and cyclical growth at 26.3%, meaning companies that are subject to macroeconomic and capital cycles but have significant structural growth prospects.
The managers don’t always get it right and some poor stockpicking decisions have also contributed to the trust’s decline in the past year.
For example, they referred to home fitness company Peloton as a “disappointing holding” – it is down by more than 90% since they bought it in August 2021.
Performance of Peloton stock since IPO
Source: Google Finance
“The company has significantly overestimated demand and committed too much capital to the production of its hardware (bikes),” said Adair and MacColl.
“This has undermined the prospect of future profitability. A new CEO in Barry McCarthy, formerly of Netflix and Spotify, is a move in the right direction; however, this stock remains firmly under review.”
Yet they were happy with most of their holdings, saying it is important not to make any rash decisions when the market is moving against you.
“Periods of share price weakness can bring behavioural challenges, not just for investors, but also for management teams, and may be deeply unsettling for employees,” they explained.
“One of the risks in the current portfolio is that management teams react to the signals they are getting from the market, shortening their own time horizons and reining in investment. There would likely be a significant opportunity cost to such actions.”
As a result, they have encouraged management teams of their portfolio holdings to separate operational decision-making from share prices. Where this has not been the case, or where management isn’t investing for the long term, they have sold.
One example of this was the recent sale of ride-sharing app Lyft.
“We felt that the scale of ambition at Lyft – having once been to bring fleets of autonomous vehicles to market – has been curtailed,” they explained.
“This has been coupled with egregious stock-based compensation payouts which, in our view, are not appropriate given underwhelming operational progress, nor aligned with the long-term interests of shareholders.”
Investec said this focus on the long term despite short-term pressure is one of the reasons why it continued to back the trust.
“In the results, the managers reaffirm the philosophy and process, and we agree with the chairman who notes that, at times like these, it is of utmost importance that they stick to their longstanding approach.
“Although the past 16 months have been painful, we continue to regard Monks as a core holding for investors looking to achieve a diversified exposure to Baillie Gifford’s best global ideas.”
Even after its recent problems, Monks’ returns of 201.9% over the past decade are well ahead of the 155.1% made by its IT Global sector. However, it has slipped behind its FTSE World benchmark.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
Meanwhile, its 10% discount is potentially attractive considering it has traded at a premium for most of the past five years.
Investec said: “We have recently expressed frustration when companies adopt an asymmetric approach to share issuance/buybacks. However, in this case, following several years of share issuance, the board has provided additional liquidity to the market through buybacks.
“During the last financial year, it purchased 8.8 million shares at a cost of £98m, and, since the beginning of this calendar year, it has bought 11.7 million shares or 5% of shares in issue.”
With inflation at current levels, nominal bonds will remain under pressure. We explore the more resilient alternatives within the bonds universe as well as property, infrastructure, liquid real assets and targeted absolute return funds.
Rising inflation and rising interest rates mean nominal bonds (such as corporate bonds, UK gilts, and global government bonds) are under pressure and will remain so for the medium-term. For so long as real yields remain negative, bonds are guaranteed to lose capital value in real terms over time. So what are the alternatives to bonds in a portfolio for UK investors?
Exploring alternatives within the bonds sector
So while it may make sense to reposition or tilt the bond part of a portfolio away from nominal bonds, some managers and advisers are looking to go further and eliminate bonds from a portfolio altogether in order to adapt portfolios to an inflationary regime. In this instance, managers and advisers need to consider asset classes outside of bonds as potential alternatives.
Alternatives outside of bonds
In the face of rising rates and inflation, it makes sense to reduce or remove the allocation to bonds and dial down the duration risk within a bond portfolio. For alternatives to bonds, careful risk budgeting is required to make sure that asset classes with “bond-like” income don’t introduce “equity-like” risk.
Henry Cobbe is head of research at Elston Consulting. The views expressed above should not be taken as investment advice.
Private equity can be a “double-edged sword” according to Brewin Dolphin’s Rob Burgeman, who argues that some trusts may face being diluted if they are not able to re-invest.
Investment trusts have a number of differing characteristics from open-ended funds that make them appealing, such as the ability to use gearing (leverage), their liquidity (due to being closed-ended) and their independence (through their board).
However, one that has come to the fore in recent years has been their ability to buy into private companies.
The fallacy that open-ended funds could do this was debunked in 2019 with the collapse of Woodford Investment Management, as investors withdrew their cash more quickly than former manager Neil Woodford could sell the unlisted holdings in his Woodford Equity Income portfolio.
That trusts are listed on the stock market, meaning investors can almost certainly sell – they may not like the price, but at a certain point there should theoretically be buyer – means that the asset class is more liquid.
Yet Rob Burgeman, senior investment manager at wealth manager Brewin Dolphin, said that it remains a complex balance, with the latest news that Scottish Mortgage is being pushed over its limit for unquoted assets “a stark reminder that the policies and rules investment trusts set themselves can make a material difference to how they run”.
“Scottish Mortgage had set itself a 30% limit for exposure to junior companies which, as many of the larger stocks it holds have dropped in value, has been exceeded,” he said.
Total return of trust vs sector and benchmark over 1yr
Source: FE Analytics
The rationale for holding these assets is obvious. They are generally smaller, faster-growing businesses that can make a windfall when they are taken public.
However, they also tend to require more investment to grow and are often lossmaking.
“When times get tough in the quoted market, you can have a rights issue or place some shares to raise funds. Unquoted companies tend to go into a state of denial, as they do not want to raise fresh funds at a lower price than their last fundraising for fear of diluting existing shareholders; that is, until their hand is forced,” said Burgeman.
“If you are a holder, you then either have to put up or shut up. If you do not participate, you are simply diluted to a fraction of your previous holding.”
This is a potential risk for Scottish Mortgage, he argued, which could be at risk if it remains up against its own imposed exposure limits for too long.
One way out is through gearing, he noted, although this “can be a blessing and a curse”, as taking on debt to invest will both amplify losses in downturns as well as gains in rising markets.
“This is doubly true for trusts that invest solely or substantially in unquoted companies,” said Burgeman, pointing to examples from both the 2000 dotcom bubble (Candover, SVG Investments, and Partners Global Opportunities) and 2008 financial crash (Pantheon International).
While the latter has since recovered, he said that there is the potential that the market is only “mid-rout” in the current tech sell-off.
This could affect Scottish Mortgage, he argued, which may be at risk of dilution unless it takes on gearing, which could in turn magnify the effect of any losses.
He also highlighted the Chrysalis investment trust, which invests in a portfolio of later-stage private companies. He argued that these businesses are harder to trade and therefore there can be a considerable delay between the desire to sell and the eventual disposal. “This can, in turn, lead to liquidity crunches,” Burgeman said.
The Brewin Dolphin senior investment manager also highlighted Molten Ventures (formerly Draper Esprit), which is a similar strategy to Chrysalis above, with more of a focus on tech.
“It, too, has similar issues, with the added kicker that it focuses on a sector deeply out of favour at the moment, in which values are particularly affected by higher interest rates,” he said.
Lastly, defensive asset RIT Capital Partners is an example of a trust that may be better positioned in the current environment. The trust holds unquoted companies among other assets, although its allocation to these firms currently stands at 41% through a mixture of private funds and companies.
“Clearly the Rothschilds are no fools and they recognise the superior returns that unquoted or private companies can generate over time, particularly compared with their quoted equivalents. This is not, however, a risk-free trade,” he said.
“These excess returns come at the expense of greater volatility and lower liquidity, making investing in unquoted companies a bit of a white-knuckle ride at times – especially in a worsening economic environment.”
The quality-growth portfolio has dropped 21.3% so far this year and further falls are expected as inflation continues to rise.
A decade of low growth, low rates, and low inflation put Terry Smith’s quality-growth style of investing very much in favour, boosting his Fundsmith Equity portfolio 165.3 percentage points ahead of the IA Global peer group over the past 10 years with a total return of 327.3%.
However, the dramatic shift in markets this year has dragged the £21.8bn fund down 21.3% since the start of 2022, resulting in a 5.1 percentage point lag behind the sector.
If performance continues to decline, this could well be the first year Fundsmith Equity has failed to beat its peers in 10 years.
Total return of fund and sector since the start of the year
Source: FE Analytics
Global funds and their broadly growth strategies have all taken a hit from the current rotation into value funds and Fundsmith has been no exception, with its quality-growth style coming under pressure.
Ben Yearsley, investment director at Shore Financial Planning, said that even if the fund’s performance levels out, “it will be difficult to give the same level of returns” as it has in the past.
He added: “The first decade of the fund fitted perfectly to Smith’s style. The coming decade is likely to be much more nuanced – and don’t forget how big the fund is now.”
For example, the fund’s overweight exposure to consumer staples and discretionary, which accounts for 41.1% of sectoral allocations, may be a significant detractor to performance if inflation continues on its steep rise.
Consumer businesses are likely to have their cash flows reduced as customers limit their spending on non-essential items.
Companies such as Uber, Robinhood and Coinbase have already announced cost cutting measures as consumers wind down spending in the face of the cost-of-living crisis.
Darius McDermott, managing director of Chelsea Financial Services, suggested that investors who anticipate inflation will remain high in the long-run may be better off cutting their losses.
“If you see a scenario where we might actually have higher standard inflation for the next two or three years, then that's a period where you could see Smith’s strategy continue to underperform”, he said.
UK inflation hit the 40-year high of 9.1% yesterday, and the Bank of England has forecast rates to reach 11% by the autumn.
That being said, markets could very easily go the other way – if central banks contain the wrath of inflation and in doing so, cause a recession. In this scenario, Fundsmith Equity could be a beneficial holding, according to McDermott.
In fact, the fund could perform a similar role to bonds in investor’s portfolios if a recession were to occur.
With high interest rates lowering the price of bonds, the compounding, long duration assets held in Fundsmith Equity could offer some security in the long run.
Ben Faulkner, communications director at EQ Investors, agreed that people could be “crystallising losses” by selling the fund now, but cautioned those considering an exit not to take a short-term view.
He told investors: “Market timing is a tricky business – there is a reason that most fund managers invest for the longer term.”
Indeed, McDermott also said that many investors were acting irrationally in this rotation by shedding their growth assets, stating: “I think there's too much short termism in our industry and people need to remember the job that Fundsmith Equity has done in their portfolios if they've held it for 10 years.”
In his fund of funds, McDermott said that he is “very happy to continue holding it” as the fund is behaving exactly as he would expect in this kind of environment and Smith’s skilful stock-picking will likely cause performance to rebound.
Despite Fundsmith Equity’s decline over the past year, none of the experts Trustnet spoke to thought that selling it now was a good idea.
Tom Sparke, investment director at GDIM said: “While I have other concerns about the fund, the performance through a harsh rotation from growth toward value is not a reason to sell in my opinion.”
Likewise, Yearsley said that an investor with a well-diversified portfolio, which spread risk across assets in different styles, sizes and geographies, has no reason to sell.
The manager of the LF Blue Whale Growth fund says many disruptive tech stocks are beginning to get disrupted themselves.
If you ask any quality growth manager about their investment approach, one of the first things they will talk about is the concept of a business's ‘economic moat’. This can take many forms, such as a patent, brand or piece of intellectual property, but every one prevents competitors entering its owner's market and driving prices and margins down.
The benefit of investing in a company with a strong economic moat, also known as a barrier to entry, is evident from their longevity. For example, the average birth year of a company in Fundsmith Equity – the largest quality growth fund in the UK – is 1926.
Yet while some economic moats can last for longer than a century, they can also be created – and destroyed – within a matter of years. The growing power of the internet, cloud computing and mobile technology over the past decade or so has seen some tech companies start up, wipe out entire industries, then get disrupted themselves, in less time than it takes for the economic cycle to turn.
Yiu invested in PayPal when he launched LF Blue Whale Growth in 2017, but he said it has been one of the most controversial stocks in his portfolio, provoking more disagreements among his team than any other holding.
Other quality growth managers continue to rate the company highly – Terry Smith holds it in Fundsmith Equity and it is a top-10 holding in Nick Train’s Lindsell Train IT – and Yiu dramatically increased his position as recently as 2020.
“Before the pandemic, if you wanted to shop online outside the Amazon ecosystem, it was fairly likely that you’d use PayPal, because that's what gives you protection in terms of your credit card details. It had the first-mover advantage at the time,” he said.
“Then during the pandemic, it managed to win a lot of new customers, with many people who had never shopped online before signing up.”
In 2021, chief executive Dan Schulman extrapolated this surge in demand, predicting PayPal’s 377 million users would grow to 700 million by 2025.
However, Yiu disagreed, selling out of the stock early this year and calling it “structurally broken on multiple fronts”.
“We started to notice a few more competitors popping up on small merchants’ websites,” he said.
“Back in the old days, we would only see PayPal as a de facto button at the checkout. But since then, I've seen Amazon Pay in some, even though it's outside of the Amazon porthole, and others like Block, Stripe and Shopify. That made me realise that maybe it wasn’t that dominant.”
Performance of PayPal stock over 5yrs
Source: Google Finance
Yiu also became concerned by PayPal’s foray into new areas, including buy-now-pay-later and crypto trading, with a stock broking option also in the works.
While many tech companies have successfully expanded into new sectors, PayPal’s management doesn’t expect to make a profit from these new services. It is launching them in a bid to make customers more reliant on the app, hoping this will reduce the churn rate.
The final straw for Yiu was a rumoured $45bn acquisition of Pinterest. Although this eventually fell through, he said it suggested management had taken its eye off the ball.
“Of course, Pinterest has about 400 million users and this would quickly increase Paypal's user base from 300 million to 600 or 700 million,” he continued.
“But from our perspective, that is a distraction. Pinterest is a social media company and you definitely don't want to get into that area given all the scrutiny you have in that space.”
Yiu added: “It's not like one single thing was a deal breaker, but if you put them all together, it basically means the technology is not that great and many other companies have managed to replicate it, and even do it better. And the consumer certainly isn’t loyal to a particular payment technology.”
Reservations about social media were also behind Yiu’s decision to dump another holding – Meta, formerly Facebook. He had also held this stock since he launched the fund, and it was a top-10 holding as recently as October. Again though, he completely sold out of his position early this year.
Yiu said Meta’s business looks attractively valued today: he has high hopes for WhatsApp, and pointed out Facebook and Instagram remain dominant players in the digital advertising area.
However, he said founder Mark Zuckerberg’s focus on the metaverse – an immersive virtual world – hinted at fundamental problems for the company.
“The reason Zuckerberg is interested in the metaverse is because of the longevity of the business model,” the manager continued.
“If you think about who really controls our day-to-day activities now, it is basically Google Android and Apple iOS.
“What changed was Apple introducing its iOS 14.5 operating system, which lets the user stop apps from tracking their activity for targeted advertising. Basically, Facebook has got really disrupted and it could have seen this coming.”
In a recent article in The Financial Times, Eric Seufert, an adtech consultant, estimated Meta lost out on $8.3bn of revenue last year as a result of the change to privacy settings.
Performance of Meta stock over 5yrs
Source: Google Finance
Yiu said this change has made Facebook realise it needs to build a new operating system from scratch, which is why it spent $10bn last year on developing the metaverse. However, the manager said he wouldn’t be surprised if this figure rose to between $50bn and $100bn over the next 10 years – and even then, there would be no guarantee of success.
“The problem for us is, who is going to be the ultimate winner? If you start from scratch versus someone like Apple or Google – and even Microsoft is doing something in the metaverse – that might not be Meta.
“I think we can speak for many value managers and say Facebook is actually a value stock now – it is really cheap. But it's just how far do you have to look out and what certainty do you have in terms of what Metaverse is going to bring?”
This recent period of underperformance for cautious portfolios is a wake-up call for the industry to move away from this ‘bonds=low risk’ mentality.
The belief that bonds are low-risk assets permeates through the fund management and financial advice industry, which can mean the decision to buy bonds may not be based on fundamental valuation analysis but flawed historical analysis.
We have long had the view that bonds (generalising I know given there are myriad different bonds) are not as low risk as the investment industry believes.
There are many definitions of risk in the industry with the most common being either the extent of a portfolio’s deviation from a benchmark or the measure of volatility of an asset. Our definition of risk is the probability of a permanent loss of capital after the impact of inflation.
The decline in bond yields to ultra-low levels in recent years significantly increased the risk of a permanent loss of capital after the impact of inflation if you bought and held those bonds to maturity.
As a result, over the past three years we have had very low traditional fixed income exposure across our funds. Yes, yields continued to fall and yes, being too early is the same as being wrong, but that position has been helpful to performance this year.
At the start of 2022 there was one of the biggest drawdowns in history for bond markets, including the third largest drawdown in a century for the US 10-year Treasury bond.
Most, if not all, participants in the investment industry today have been investing or advising during a period of falling bond yields and falling inflation and we have all been taught and conditioned to believe that bonds are low risk and therefore suitable for all low risk or cautious portfolios.
The Oscar-winning 2015 film “The Big Short” begins with a display of the following quote attributed to Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
That belief that bonds are low risk is why so many cautious investors, who have such high allocations to bonds in their portfolios, are the ones most surprised and upset by their recent performance (for reference, the iShares Core UK Gilts ETF is down 16% since its peak in December).
Because bonds for the past 40 years, up until 2021, have acted appropriately for low-risk investors, our industry assumed they would forever and is why everyone’s investment parameters, benchmarks, asset allocation tools, guidelines etc have bonds as the foundation in all low risk portfolios.
The Investment Association, the trade body for UK investment managers, is responsible for setting the definitions of the various sectors in which the thousands of funds registered for sale in the UK reside.
Each sector will have a broad asset allocation intention, such as UK All Companies (every constituent fund will invest in UK equities), but also restrictions to prevent managers drifting beyond their mandate (every fund must have at least 80% invested in UK equities). The intention is to help investors compare similar mandates’ performance easily.
The problem comes in the multi-asset, Mixed Investment Sectors where one of the restrictions for the ‘lowest risk’ sector, the 0-35% Shares Sector, is to have at least 45% invested in investment grade bonds.
This means funds within that sector must have almost half their exposure in the highest quality corporate bonds or government bonds, which had the lowest yields this time last year.
It is no surprise therefore that this sector has underperformed the ‘highest risk’ multi-asset IA Flexible Sector over the past year falling 5.2% compared to Flexible’s -1.6%.
This methodology is enforced across the huge and highly influential fund rating industry on whom the financial adviser community relies for deciding which funds to buy for their clients across the risk spectrum.
Our Hawksmoor Vanbrugh fund, which is the 6th least volatile in its IA Mixed Investment 20-60% Shares Sector (previously called the Cautious Managed Sector) over the course of its 13+ years, is rated by one such agency as a 5 out of 10, in line with other ‘balanced’ funds because of its low bond allocation and preference for alternative assets via investment trusts which they find hard to categorise. This defies logic in our view given our very different definitions of risk.
I fully acknowledge it is a near impossible job to pigeon-hole the many different flavours of funds into sectors and risk rating brackets, but surely this recent period of underperformance for cautious portfolios is a wake-up call for the industry to move away from this ‘bonds=low risk’ mentality.
If interest rates and inflation continue to climb, and central banks remain on their aggressive hiking cycle then there could be more losses to come for those clients who have specifically asked for losses to be minimised.
A lot more thought and words are needed to discuss this properly, but at the very least a more forward-looking process for assessments of risk is required instead of relying on the past patterns of performance.
Daniel Lockyer is a senior fund manager at Hawksmoor Investment Management. The views expressed above should not be taken as investment advice.
Headline inflation increased to 9.1% in May in the UK, but has yet to peak, warn experts.
The Consumer Prices Index (CPI) published this morning has registered an increase in prices year-on-year of 9.1%, up from 9% in April. Despite a smaller rise than the markets had expected, the index has now hit a new 40-year high.
Fuel and raw material prices were up by more than 22% year-on-year, and, driven by the supply crisis from Ukraine, food and non-alcoholic beverages were also among the biggest contributors to the upwards rally.
Analysts are at a loss trying to predict how long this situation will go on for. Les Cameron, technical expert at M&G Wealth: “We now see the inflation peak is going to be higher than earlier predictions. What we don't know is where it will stop and how long these high rates will be around.”
The rate is expected to grow even further later in the autumn, when the energy price cap will expire and energy prices could soar. For the next few months, the Bank of England (BoE) predicts inflation to hover at around 9% before spiking to around 11% in October.
Source: Office for National Statistics
Commenting on May's figures, Daniel Mahoney, UK economist at Handelsbanken, suggested that “we are, indeed, on course for this trajectory, unless an unexpected event occurs at some point this year”.
With such fortuity not yet on the horizon, many analysts see the UK one step closer to a recession.
While the valuation of sterling against the dollar is down to $1.22 compared to $1.23 yesterday, the burden to prevent a recession is on the shoulders for the BoE, according to Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.
“With the economy taking on more of a sweat, the pressure is now on the Bank of England to apply much cooler compresses in the form of successive interest rate rises over the next few months to try and reduce demand and bring down prices”, she said.
Neil Wilson, chief market analyst for Markets.com, feared the BoE is not doing enough to protect the currency: “Better a short, sharp dose of monetary policy medicine now than prolonged stagnation/stagflation”, he said.
But further spikes in interest rates are also dangerous, as Mike Bell, global market strategist at J.P. Morgan Asset Management, warned: “There is the risk that without further rate rises a wage price spiral could develop. The Bank of England are therefore stuck between a rock and a hard place.”
Despite the uncertainty, not everyone was as pessimistic, with some commentators suggesting shy optimism. Some hope for headline inflation to be helped by falling freight costs and ingredient costs in the coming months could improve the picture, for example.
Others drew attention to the better piece of news that came out with this morning’s report, which is that the core inflation has slipped down 0.3 percentage points to 5.9% in May, slightly lower than the 6% predictions.
James Lynch, Fixed Income Manager at Aegon Asset Management, was among them.
“Yes, headline has moved from 9% to 9.1%, but core inflation fell from 6.2% to 5.9% which is a better gauge of underlying domestic inflation. So that is two months in a row that if you squint hard enough, we can see what almost seemed an exponential rise in prices starting to tail off”, he said.
Chris Beauchamp, chief market analyst at IG Group, agreed: “The rise to 9.1% for headline CPI will heap fresh opprobrium on the BoE for its slow hiking moves, but with core CPI a touch softer compared to last month’s figure perhaps there are still signs that the rise in prices is abating.”
But how does the everyday situation in the UK look? Emma Mogford, fund manager at Premier Miton Investors, said that today’s CPI figure is a reminder of the pressure that consumers and businesses are currently facing. Or, as Wilson put it, “consumers don’t pay core, they pay headline”.
While the inflation measure is a ‘one size fits all’, realities may seem wholly different depending on demographics as the increase in prices disproportionately affects some parts of society.
“People spending a lot of time at home, for example pensioners or the new army of people working from home, may well feel they are experiencing much higher inflation with increased energy and food prices and, for many, the dramatic rise in the cost of fuel”, said Cameron.
In an inflationary environment and without any increase in savings rates, more people with cash savings or near cash savings will see the continued erosion of their wealth in real terms.
“Strict budgeting, dipping into capital savings and perhaps even looking to invest cash to try and generate a real return should be on most people’s agendas at present”, he stressed.
Sustainable portfolios have been “technology funds in disguise” and offer little diversification as markets shift towards value.
Sustainability has been a massive theme in the investment world over the past few years and many new environmental, social and governance (ESG) funds have been established to profit from the path to net-zero.
However, green assets are often growth oriented and ESG portfolios have suffered this year from the rotation in markets towards value.
These types of funds performed extremely well in an era of free money and pro-growth, but the ESG bubble may be about to burst, according to James Penny, chief investment officer at TAM Asset Management.
Now that the wave carrying them over the past decade has lost momentum, Penny said that many sustainable funds will struggle to outperform an environment of 9.1% inflation in the UK, while in the US they are having to contend with aggressive 0.75 percentage point interest rate hikes from the Federal Reserve.
Penny added: “It’s this soft underbelly of the ESG space that remains so exposed to this ruthless market.”
Even though the transition towards clean energy and net-zero commitments made by governments around the globe present many investment opportunities, too many funds are competing for a limited space, according to David Coombs, multi-asset fund manager at Rathbones.
He said: “Its’s a very nascent industry so there will be significant losers in that space. Not everyone is going to make money.”
Many existing funds have been quick to introduce ESG mandates, but a lot of them invested into narrow growth sectors such as technology and healthcare rather than considering the environmental impact of their assets, according to James Sym, manager of the River and Mercantile European fund.
Indeed, many contain big US tech names such as Microsoft and Alphabet within their top holdings, which have suffered this year from high inflation and interest rates, which impact the forecasts on their future earnings.
This has led to an ESG market saturated with growth funds that have little protection against this value cycle.
However, Patrick Thomas, Head of ESG Portfolio Management, Canaccord Genuity Wealth Management, pointed out that although “some ESG funds have been technology funds in disguise”, not all sustainable funds have faltered since the start of the year.
In fact, some parts of the market thrived, with portfolios in the IT Renewable Energy Infrastructure sectors making an average return of 12.3% over the past year as the MSCI World dropped 3.4%.
Total return of sector vs index
Source: FE Analytics
Thomas said: “The definition of sustainable is far too broad to be useful – the global clean energy sector has been defensive in an environment where global equity markets have been selling off and the sector is incredibly growth oriented.”
Companies supplying energy have been highly in demand in recent months as governments seek new sources of power to subsidise the lost imports from Russia.
Since the invasion of Ukraine, Europe has lost almost 40% of its energy and gas sources and authorities are encourages the encouraging the construction of new renewable energy sites with attractive tax cuts.
However, Penny said that some European governments may favour coal power as a short-term solution to the gap in energy production, which could set the renewable movement back.
He said: “It’s likely these pressures will show their scars on the growth trajectory of ESG innovation for some time.”
In order to perform well in future, ESG funds will have to stop being so growth heavy and in the meantime, alternatives are likely to be a more popular choice for sustainable investors.
He said: “With the era of quantitative tightening far from over, one can envisage a continuation in outflows from ESG funds into more ESG-agnostic strategies focusing on capital preservation rather than capital innovation.
“This threat to ESG remains an opportunity for innovators to create a new raft of ESG strategies specifically designed to deliver market-uncorrelated outperformance, which so many investors are crying out for in this bear market.”
Analysts highlight four options that investors may be able to turn to if they are worried about high inflation.
Investors that need to find reliable income without the volatility may be best served thinking outside the box, according to experts.
While traditional equity has struggled so far this year, and many open-ended income funds have held up better than expected, income trusts have struggled.
The IT Global Equity Income and IT UK Equity Income sectors are down around 7% each year-to-date, as the below chart shows.
Total return of sectors YTD
Source: FE Analytics
As such, of the four experts asked by Trustnet, none selected a traditional equity trust for income, although David Johnson, an analyst at Kepler Trust Intelligence, suggested investors may want to take a look at Middlefield Canadian Income.
While Canadian equities may not seem like an obvious choice, he said that they “offer an attractive option for income investors to hedge against inflation”.
“The Canadian market, and by extension MCT, is well positioned for today’s environment, thanks to the strong presence of high-quality financial companies as well as energy-related stocks, which are beneficiaries from a rise in global interest rates,” he said.
This should allow the trust to continue to pay a dividend despite the recent market falls, as it has little exposure to the tech giants – these have been among the stocks worst affected by rising rates and inflation as these affect the value that investors put on future growth expectations.
The trust has struggled to keep pace with the IT North America sector over the long term, as it has been hampered by its penchant for dividends and the inability to buy US tech giants.
However, over the past year it has been the second-best performer in its sector, up 22.8%, while its average peer is down 1.6%, as the below chart shows.
Total return of trust vs sector over 1yr
Source: FE Analytics
Johnson noted the trust’s energy allocation (c.15%) is split between cyclical and price-sensitive producers and stable, price-insensitive pipelines, while the financials allocation (c.25%) is particularly attractive.
“Canadian banks are amongst the most attractive, as Canada is home to six of the safest banks in North America. Canadian banks have proven more resilient than their British or American peers, having better weathered past economic crashes in far better shape,” he said.
Away from equities, Matthew Read, senior analyst at QuotedData, suggested there could also be value in bonds, which have had a tough year as central banks have raised interest rates around the world.
CQS New City High Yield was his pick. The trust has had a phenomenal run recently, making the highest return in the IT Debt – Loans & Bonds sector over five and 10 years, while it is flat year-to-date at a time when its average peer has lost 5.1%.
Total return of trust vs sector over 10yrs
Source: FE Analytics
Manager Ian Francis has “long thought that central bankers’ caution was creating a real risk of the inflation genie getting out of the bottle and has been positioning CQS New City High Yield’s portfolio accordingly,” said Read.
Financials – which tend to benefit from rising interest rates – and real assets, account for a large part of NCYF’s portfolio, while Francis also thinks that the UK economy is more vulnerable to inflation than Europe and the US, and so has been increasing the trust’s exposure to overseas assets, while also increasing its exposure to equities.
“CQS New City High Yield tends to be in demand and trades at a premium, but drips stock out once the premium hits 5 to 6%, so this tends not to become excessive. It also offers a yield of 8.3%, so investors are paid to wait,” said Read.
Turning to alternatives, Monica Tepes, head of investment companies research at finnCap, suggested investors should consider the £3.1bn International Public Partnership (INPP) trust.
Here, she said investors get inflation-linked assets. She estimated that for a 1% increase in inflation, its portfolio returns should increase 0.7%.
“Second is the safety of payment receipts. Its cashflows are government backed and it has investments in regulated utilities, energy & transmission, transport, education, health, justice, military housing and digital infrastructure,” she said.
The trust is well diversified, with more than 100 investments in total. While most of its assets are in the UK, it does have projects in Europe, Australia, and North America.
Last up, Emma Bird, research analyst at Winterflood, highlighted the Impact Healthcare REIT as a reliable source of income in an inflationary and rising interest-rate environment.
The property specialist provides well-managed exposure to UK care homes and is comprised of 128 healthcare properties, of which 126 are let on fixed-term leases of 20 to 35 years.
These are then subject to annual upward-only RPI-linked rent reviews, with a floor and cap at 2% per year and 4% per year respectively on 99 leases and at 1% per annum and 5% per annum respectively on nine leases. In addition, the fund owns two healthcare facilities leased to the NHS with annual, uncapped CPI-linked uplifts.
“We believe that the portfolio's long-term, inflation-linked leases with no breaks are appealing, with their fully repairing and insuring nature and the embedded rent cover penalties offering additional security,” she said.
“The inflation linkage should support the fund’s progressive dividend policy and is likely to appeal to a growing number of investors in the current environment of rising inflation expectations.”
|Fund||Sector||Fund size||Yield||OCF||Gearing||Premium/discount||Launch date|
|International Public Prtnrship||IT Infrastructure||£3,154m||4.6%||1.18%||2.1%||11.3%||09/11/2006|
|Impact Healthcare REIT||IT Property - UK Healthcare||£405m||5.7%||1.53%||26.7%||7.5%||07/03/2017|
|Middlefield Canadian Income Trust||IT North America||£135m||4.0%||1.14%||24.4%||-6.7%||06/07/2006|
|CQS New City High Yield Fund||IT Debt - Loans & Bonds||£255m||8.3%||1.25%||9.7%||8.1%||07/03/2007|
The management company’s mid-year outlook is positive towards global credit.
It has been a troublesome six months for credit investors but as we enter the late stages of the economic cycle and volatility soars in what could prove to be a harder landing than expected into bear market territory, government and investment grade corporate bonds should outperform riskier asset classes such as equities.
Indeed analysts, including at JP Morgan, have been approving the acquisition of bonds and in Invesco’s mid-year outlook, senior client portfolio manager Andy Byfield and fund manager Stuart Edwards, said they too were keen, although they highlighted that they are not blind to adversities.
The war in Ukraine and the subsequent rise in prices and interest rates has created a high-inflation, low-growth environment, while a tight US labour market and supply chain disruptions due to China’s anti-Covid measures further aggravate the risk of stagflation.
With tighter monetary policies around the world, the bond market has been aggressively repricing. As a result of more hawkish central banks and fears of further interventions, bonds yields are increasing.
The chart below shows that the yield of the global investment grade credit market is now north of 4%, “higher than the peak yield of the covid shock in March 2020. The last time we saw such high levels of yield was during the 2011 European sovereign debt crisis”, said Byfield.
S&P 500 Investment Grade Corporate Bond Index, yield to maturity performance, year to date
Source: S&P Global
This drags bond prices down overall as investors are taking risk off the table. This will push them into cash and higher-quality assets such as government bonds, forcing the price lower until it reaches a nadir that is too cheap to ignore.
What might be seen as distressing at first consideration, Edwards interpreted as a long-term advantage.
“This is ultimately a healthy development for fixed income markets once that [repricing] journey has been completed. It means that returns on offer could be more commensurate with the underlying credit risks, without the distortions we have seen from the unconventional [quantitative easing] policies of the past decade”, he said.
The managers remained confident at the employment levels, healthy corporate balance sheets, and the unlikeliness of a recession, the latter only being a threat if central banks were to tighten their monetary policies too much or too quickly.
With yields at more attractive levels, credit is offering better opportunities than at the turn of the year, they assured.
Indeed, Edwards said the team was “positioned defensively” at the start of the year, fearing that "inflationary pressure could lead to a significant uptick in yields”.
This proved to be true, but now there is a “divergence of returns” that should only exacerbate as central banks continue their move away from quantitative easing for the foreseeable future and into of quantitative tightening.
“The increase in macro uncertainty and market volatility means that there should be more risk premium embedded in all markets, not just fixed income. We are seeing signs of this already,” Edwards said.
“Going forward, much of the initial phase of the adjustment in central bank interest rate expectations is likely ‘baked in the cake’, meaning there should be more balance in fixed income markets at these levels. We believe that with yields at more attractive levels, the asset class is offering better opportunities than at the turn of the year,” he added.
The opportunities on offer in the Land of the Rising Sun will prove to be more than just another false dawn.
The investment spotlight is beginning to shine on Japan once again, as a plunging yen and continued signs of elusive inflation heighten the appeal of this oft-overlooked economy.
With the Bank of Japan staunchly refusing to raise rates, despite producer prices rising to the highest level in 41 years in April, investors are waiting to determine whether a weaker currency will trigger an influx of foreign investment and reignite Japan’s anaemic economic growth.
However, while the current focus is firmly on the implications of yen weakness, there is a far more compelling wider picture emerging in Japan. The country is undergoing a remarkable turnaround, with improving demographics, widespread corporate governance reforms and ESG awareness all combining to power productivity and corporate earnings. For investors willing to dig deeper into the Japanese dynamics, there is a wealth of untapped potential on offer.
Historically, Japanese corporate culture has been associated with hierarchy and lifetime loyalty. Dominated by a few conglomerates or keiretsu, and revered longstanding entities known as shinise, Japanese corporates have been slow to adopt tech, which has stifled start-up innovation – a polar opposite to the backdrop in the US. With decades of deflation and a feeble economy, it is not surprising investors have looked elsewhere for high-growth stocks.
But the Japan of today is not the Japan of 10 years ago, and the country has undergone quite a revival. Although Japan is well known for its ageing population, the retirement of baby boomers in the past several years has brought with it a welcome change of strategy for management teams. Companies previously felt obligated to maintain high levels of employment – even when productivity was suffering – but there are now signs of flexibility and an emphasis of value over volume.
The advent of the Japan Stewardship Code in 2014, which transformed corporate governance, also delivered a profitability boost. More recently, prime minister Fumio Kishida has been promoting a form of ‘new capitalism’, which focuses on the distribution of wealth – not just the creation. Corporates are now prioritising sustainable growth, and last year we saw Japanese companies boost capex and add jobs.
We recently added Hitachi, one of Japan’s oldest electric machinery and heavy industrial equipment manufacturers, to our portfolio. After recording major losses during the 2008 financial crisis, the company went through numerous restructurings and has since significantly boosted profitability. We see even further improvements ahead, as Hitachi transitions from a manufacturing-driven hardware sales model to a scalable asset-light, solution-based business. Hitachi serves as an example of the changes underpinning many companies across Japan.
Bright future ahead
While it has been decades since Japan was home to the world’s most innovative corporate icons, investors should not discount the strong upside potential as a result of ongoing productivity and sustainability tailwinds. We would not be surprised to see return on equity surpass 10% as Japan catches up to international standards.
Japan is also gaining ground on environmental, social and governance (ESG). Recent revisions to the Stewardship Code now require companies to disclose carbon emissions and reinforce board-level independence and measures of diversity. In April, the Tokyo Stock Exchange also changed its company classifications from first, second and third to prime, standard and growth, with stricter ESG standards for the coveted prime listings.
While the leaders in ESG adoption may not offer much upside after strong share price gains, we see tremendous potential in a range of ESG improvers, and are working closely with management teams to enhance practices.
We recently invested in Horiba, the world’s leading provider of instruments measuring and analysing automobile exhaust gas, which is also developing new business lines related to hydrogen technology. Most companies trialling hydrogen tech are fossil fuel led, so this is a rare opportunity to back a totally clean energy enterprise.
We also took a position in Toyota Motor last year after it ramped up its sustainability activities. Toyota is also active in hydrogen, already selling over 15,000 units of fuel cell vehicle. The car manufacturer has a technological advantage in this space, as it can easily adapt its supply chains away from combustion motors and into clean fuel engines.
For investors willing to renounce preconceived notions on corporate Japan and open their eyes to the ongoing progress on display, the opportunities on offer in the Land of the Rising Sun will prove to be more than just another false dawn.
Yu Shimizu is manager of the SPARX Japan Equity Sustainable All Cap UCITS fund. The views expressed above should not be taken as investment advice.
The Trojan Global Equity manager says that while many investors obsess about macroeconomic shocks, she prefers to focus on companies “beavering away and doing their thing”.
Anyone who has been alarmed by the volatility in equities this year should bear in mind that some of the best times to invest in the past have been when markets have resembled the “Wild West”, according to Gabrielle Boyle, manager of the Trojan Global Equity fund.
Boyle started her career on a European equities desk in September 1990, a year after the fall of the Berlin Wall and a month after Iraq invaded Kuwait. Meanwhile, inflation in the UK stood at 9.5% and the average interest rate on mortgages was 10%. Yet she pointed out that despite this challenging backdrop, it would have been a mistake to take an overly defensive stance.
“Europe in those days was like the Wild West – shareholder rights were not top of the agenda,” she said.
“Governments were privatising assets, there were tonnes of IPOs and it was a crazy time. But despite all the currency devaluations and the ERM [Exchange Rate Mechanism] crisis, it was a golden age to invest in European equities: annualised returns were in the high teens. It's a reminder not to get too carried away.”
Performance of index in 1990s
Source: FE Analytics
The manager also pointed out that the high inflation in the UK in 1990 quickly dissipated, to 5.9% in 1991, then 3.7% in 1992 and 1.6% in 1993.
While Boyle wasn’t making a prediction that price increases today would be brought under control just as quickly as they were back then, she said she has been able to apply the lessons she learnt in the turmoil of the early 1990s to the other shocks she has encountered throughout her career – including a second Gulf War, the Long-Term Capital Management bailout, the dotcom bubble and the financial crisis.
“You've got to remember bad things happen,” she continued. “They are happening at the moment.
“We obsess about these exogenous causes and macroeconomic events, which are obviously so important to our lives and valuations and so on. But one of the fascinating things is that you've always had companies that just beaver away doing their thing, delivering great returns, investing in their business, adapting and growing.”
A key characteristic that Boyle looks for in businesses is resilience, which is one of the reasons why she holds three of the 30 best-performing European stocks of the 1990s in her portfolio today: Roche, Heineken and L'Oréal. Even the 1990s was relatively recent in these companies’ history: Roche and Heineken were founded in the 1800s, and while L'Oréal is a relative youngster, launching in 1909, its enduring appeal is evident from the fact its “because you’re worth it” slogan has been a household phrase for more than 50 years.
However, Boyle warned that a company’s history and longevity are no guarantee of future success. She highlighted accountancy software company Sage as an example of a former holding with an impressive track record that has fallen behind competitors such as Intuit.
“We first invested in Sage in 2006, then bought Intuit in 2013, and they were both very good investments for us,” the manager said.
“But while Intuit was really early in embracing the move to a subscription model, Sage always gave excuses. Intuit invested 18% of revenue in R&D over the past 10 years, whereas Sage’s reinvestment rate was much lower.”
Performance of stock over 5yrs
Source: FE Analytics
Boyle said that when she speaks to Intuit today, its focus always seems to be on solving customers’ problems, whereas Sage always appears to be on the backfoot – she pointed out it increased prices in its core mid-market segment at a time when it was facing aggressive competition from Intuit and Xero, “which didn’t work terribly well”.
She has subsequently sold Sage and increased her position in Intuit.
“Not all companies are created equal, and it's quite easy to fall in love with them and get stuck,” Boyle continued.
“The reality is companies need to adapt. We're living in such dramatic, fascinating times. And if they don't have that willingness to change, adapt and reinvest, and potentially move away from something that they've done very successfully in the past, it can be a problem.
“We as investors obviously also need to adapt and not get too set in our ways. To quote Warren Buffett, you need a lot of curiosity for a long time.”
Other managers take a different view on Sage – the company is a top-10 holding in top-rated funds such as Royal London Sustainable Leaders Trust, TB Evenlode Income and Finsbury Growth & Income Trust.
Nick Train, the manager of the latter vehicle, recently pointed out that Sage trades at an enterprise-value-to-revenue multiple of less than half that of Intuit, and less than a third that of Xero.
“Sage is a business that is making progress – it needed to,” Train said. “Sage is not yet in the same league as Intuit or Xero, but it's actually getting closer to those businesses than the extraordinary valuation disparity implies.”
The firm also introduced a new ESG fund to its range, taking its total number of ETFs to 31.
JP Morgan has today launched two new exchange-traded funds (ETFs) on the London Stock Exchange, including the first ever “actively managed UK equities UCITS ETF”.
The JPMorgan UK Equity Core UCITS ETF (JUKE) will invest in many of the companies contained in the FTSE All-Share index, but position sizes will differ depending on the managers conviction, with small under and overweights taken where appropriate to make returns above those of the benchmark.
At a sector level, however, weightings are expected to be closely aligned to those of the benchmark.
Already, the portfolio contains 155 holdings, with its largest exposure to Shell (7.2% of assets under management (AUM)), AstraZeneca (7.1%) and HSBC (4.8%).
Both managers have already worked with each other on the £1.8bn JPM UK Equity Core fund since Illsley joined as co-manager in 2013.
Returns are up 69% since Illsley came on board, outperforming its peers in the IA UK All Companies index by 11.2 percentage points.
Total return of fund since Illsley joined
Source: FE Analytics
Oliver Paquier, head of ETF distribution in EMEA at JP Morgan, said: “We believe that JUKE will offer investors a unique opportunity to invest in UK equities, which unlike a tracker, aims to deliver incremental excess returns at an attractive fee level.”
Also launched today was the JPMorgan Climate Change Solutions UCITS ETF (T3MP), which will invest in companies finding solutions to climate change, such as businesses creating clean energy and low-carbon technologies.
An artificial intelligence (AI) system called ‘Themebot’ will screen and rank more than 13,000 stocks based on their sustainability credentials, then the managers will analyse the resulting companies and select allocations.
Around 54 assets are held in the portfolio at present, but this may expand to 120 as managers Francesco Conte, Yazann Romahi and Sara Bellenda seek out new opportunities. Investors in T3MP will be charged a slightly higher fee of 0.55%.
The two new launches add to their existing range of 29 UCITS ETF products, which have collective AUM exceeding $8bn (£6.5bn).
Trustnet looks at the IA Sterling Corporate Bond sector to see which funds have paid out a strong income while making good total returns for investors.
There are two parts to a bond’s return: the coupon paid each year and the price of the asset, which changes over time.
Recently, bond prices have been falling as central banks have hiked interest rates aggressively.
Perhaps more so than in any other sector, when it comes to bonds, investors need a fund that can combine the coupon payment with capital appreciation.
In this series, Trustnet looks at the total amount of income paid on an initial £10,000 investment made at the start of 2017 to the end of 2021.
We then looked at the total returns of these funds from January 2017 until the end of May 2022 to show those that have managed to make money from capital returns as well, filtering out those that have failed to land in the top 25% of their sector.
Previously, we have looked at the IA UK Equity Income, IA Global Equity Income, IA Mixed Investment 0-35% Shares, IA Mixed Investment 20-60% Shares and IA Mixed Investment 40-85% Shares sectors, as well as IA Sterling Strategic Bond.
Source: FE Analytics
Top of the pile is the five FE fundinfo Crown-rated Schroder Sterling Corporate Bond fund, managed by Daniel Pearson and Julien Houdain since the start of 2021. Former manager Jonathan Golan left last year.
The fund is 55% weighted to the UK, with the remainder in overseas bonds. It has overweight positions in industrials and financials.
It mainly operates on the cusp of investment grade and high yield, with the majority of the portfolio in BBB-rated bonds.
As such, it has paid out a healthy £2,266.16 in income over the past five years, while making a total return of 28.3%, the highest figure in the 91-fund sector.
Up next is the five-crown rated £2.4bn Rathbone Ethical Bond fund, managed by Bryn Jones, which focuses primarily on income generation. This helps to explain the above-average £2,201.13 paid out on £10,000 over five years.
Analysts at Square Mile Research & Consulting said the fund’s manager uses both positive and negative screens, as well as implementing a high beta approach. This means it should do well when the credit market rises, but poorly when it falls.
For example, in 2019 when markets were more accommodative, the portfolio made a top-quartile return. It also held up well last year, but has made a larger-than-average loss in 2022 so far.
Total return of fund vs sector in each of the past five calendar years
Source: FE Analytics
“This fund is actively managed and we find the investment team credible both on the investment and responsible sides. This is one of the few funds within the sector that holds a long-term track record of running money in a responsible manner whilst outperforming on a consistent basis,” said the analysts at Square Mile.
Another fund with an environmental, social and governance (ESG) angle is the £465m Liontrust Sustainable Future Monthly Income Bond fund, managed by Stuart Steven, Kenny Watson, Aitken Ross and Jack Willis.
It has paid out the most on the list (£2,481.68), while making a 13.7% total return overall in the past five years.
Analysts at Square Mile said that this is a fund “with a conscience”. Focusing on sustainability matters, it invests in the bonds of businesses that produce goods or services that benefit the environment or society.
“This focus on sustainability is not, however, at the expense of sound investment principles. The team are all skilled credit analysts, and bonds will only be included in the portfolio if they stack up on fundamental grounds as well as from a valuation point of view,” said the analysts at Square Mile.
Conspicuous by their absence are the three largest funds in the sector, which are all passives: iShares Corporate Bond Index (£4.7bn), Vanguard UK Investment Grade Bond Index (£3.7bn) and L&G Short Dated Sterling Corporate Bond Index (£2.9bn).
Source: FE Analytics
On average the three have paid out less than the wider sector, while making total returns that placed them in the third or fourth quartile over the period.
The firm also highlighted that hold ups in the global supply chain could mean a move towards onshore production in the US and Europe.
Investors should expect more of the same in the upcoming third quarter of 2022 as they have suffered through in the first half of the year, according to BlackRock.
Nigel Bolton, co-chief investment officer of BlackRock Fundamental Equities, made several predictions about which sectors will thrive and falter in the third quarter but warned that those hoping for a tech bounce may have more pain to come.
He said that the rapidly rising cost of living will have a detrimental effect on technology businesses as consumers reign in the amount they are willing to spend.
Already, companies such as Uber, Robinhood and Coinbase have announced cost-cutting measures to compensate for lower cash flows.
Likewise, the share price of streaming platform, Netflix, dropped 70.4% over the past six months as large swathes of viewers cancelled their subscriptions in order to limit their expenses.
This is the case for many consumer companies, with US retailers such as Walmart, Costco and Target reporting an excess of stock as customers go on budget.
Change in US consumer credit card spending
Source: BlackRock, Adobe Digital Price Index
Bolton said: “Higher rates make it harder to borrow or raise money to support loss-making operations, and there is now a sharper focus on cash generation.”
On the flip side, Bolton expects financials companies will benefit from higher interest rates because they’ll be able to increase their net interest income (NII).
He said that these businesses are in a unique position as their profit margins are likely to expand even if economic growth slows.
Even though financials are forecasting high returns as monetary tightening takes place, many bank stocks are trading below their historical average.
European bank valuations, 2005-2022
Source: BlackRock, Refinitiv DataStream
Additionally, he predicted that energy companies are likely to do well as they fill the 40% gap in European demand left from the severed natural gas supplies from Russia.
The transition towards clean energy and increased use of electric vehicles (EVs) is also likely to boost the need for businesses producing energy.
Industrials is another area that Bolton said is displaying a lot of investment opportunities, especially with the European Union’s €1trn (£858bn) ‘green deal’ and US’ $1trn (£820bn) infrastructure package giving the sector an institutional backing.
Despite the long-term potential from this area, many industrial stocks are selling at an attractively low price, according to Bolton.
One area of interest that he highlighted as an ongoing, long-term trend, is the supply chain hold ups that have driven global inflation over the past few years, which should push governments to invest more heavily in onshore production.
Shortages began when Covid initially struck in 2020 and supply chains are still struggling to catch up with demand, especially as China, the world’s biggest producer, continues to lockdown cities such as Shanghai in its ‘zero-Covid’ stance.
As a result, countries in the West are considering how they can move parts of their production line onshore in order to have more control over domestic supply chains.
Onshore related mentions in earnings calls
Source: Goldman Sachs
Semiconductors are a key asset that the West could increase their production of, according to.
They play a crucial role in manufacturing most electronic devices and demand has been high over recent years, yet nearly half of all chips are produced in Taiwan and South Korea.
The CHIPS of America Act was passed in the US last year, which aims to invest billions into achieving “semiconductor sovereignty”, according to Bolton.
He added: “We expect semiconductor equipment makers – providing the machines for the factories – to be beneficiaries of this long-run trend.”
High labour costs will continue to be a challenge as production moves westward – one of the main reasons that manufacturing moved to Asia in the first place is because it is cheaper to produce there.
However, automation may be a solution to the problem, with the number of industrial robots installed increasing 27% in 2021 to 486,700.
Robots were expensive to install when they first began to be used on a large scale, with only big companies able to invest in the automation of their factories, but alternatives have since arisen.
For example, cheaper robots that are programmed by staff to work alongside humans are used more frequently, and older, proven technologies are sold at a more affordable rate.
Massive delays throughout the pandemic meant “many companies realised they didn’t have total control over their supply chains” and highlighted the efficiency of automation, according to Bolton.
Markets convulse at rising interest rates, but is a recession actually looming?
As Covid and the war in Ukraine hike up prices around the world, central banks are caught in an impossible balancing act between inflationary risk and the risk of a recession.
Last week, the Federal Reserve (Fed) seemed to choose one over the other, as it raised interest rates by 75 basis points (bp) instead of the previously expected 50bp in the hopes of easing inflation. In Europe, the Bank of England (BofE) and other central banks are following suit.
Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown, said there was an initial injection of optimism at these moves, but what followed was a “sinking feeling” that hit the financial markets, as worries rose that countries around the world would not be able to avoid falling into the economic pit of recession.
“The mood soured on Wall Street as concerns mounted that the price spiral was going to be an even harder nut to crack, without fresh aggressive hikes”, she said.
Stephen Innes, managing partner at SPI Asset Management, agreed: “No matter how high the Fed drives interest rates, inflation does not decline. The market does not think the Fed will be able to cut in the face of persistent inflationary pressures.”
In the current scenario, with the Fed “rate hike locomotive on the track” and eroding growth opportunities, investors are looking for safer assets than equities.
Bonds have traditionally been one option and they have lately been the subject of booming interest, with JP Morgan recently backing fixed-income and Trustnet looking at where to find the best credit opportunities.
But they are becoming increasingly volatile.
Since the beginning of the month, the Merrill Lynch Option Volatility Estimate (MOVE) index, which is linked to 1-month US-Treasury options, has increased by 40 points, as shown in the chart below.
MOVE index past month’s performance
Source: Google Finance
Concerns around interest rates are so high, that the MOVE index is higher than it was after the last round of Fed repricing in April and higher than in late February when Russia invaded Ukraine.
In fact, it is only 20 points away from the peak reached during the market dislocations of March 2020, as Innes highlighted.
Analysts and investors therefore seem to be losing hope in a bounce back.
Innes commented: “Bonds are not supposed to trade like meme stocks, which is a primary reason the market is in a constant frenzy. Frankly, I am finding it tough to paint any semblance of a bullish backdrop for the broad market amid this sort of wealth destruction as tighter financial conditions have reduced the global equity.”
Mihir Kapadia, chief executive of Sun Global Investments, said: “The worry now is that a recession is imminent and earnings, which are the denominator in price to earnings (P/E) ratios, may decline quite sharply.”
He also noted how consumer goods, lifestyle and travel stocks faced the brunt of the market falls, which has led to the S&P 500 dropping 13.6% year to date, as shown below.
S&P 500 year to date performance
Source: FE Analytics
But, as much as Innes worried about a hard landing, he remained cautiously prudent regarding predictions of a recession, especially if they are based on market indices.
The S&P 500 turned into a “virtual gambling casino” over Covid, paying 18% in the three days after the March market bottom, and it generally kept going up while the economy was in lockdown. This is a reminder that there is no link between the market's daily moves and the real economy, he said.
He also argued that investors should now watch two things: inflation forwards and short-end interest rate spreads. “There is no respite from interest rates. If the market priced the Fed to back off, there would be a light at the end of the tunnel”.
Time is running out, but investors can help to support the fragile food economy.
Russia’s invasion of Ukraine has highlighted many things, not only our naivety at thinking a war within the confines of Europe would never happen again.
One of the starkest wake-up calls has been the dawning realisation that Ukraine is one of the world’s major breadbaskets and we’re dependent on it for a fifth of high-grade wheat and about 7% of all wheat.
The fact that large swathes of Ukrainian farmland are now inaccessible, littered with landmines or occupied by invading Russian forces means the disruption to the spring planting season is already affecting future supplies.
The whole world operates on a 90-day food supply – if food production stopped today, we would have a 90-day supply of food to feed the world – and we currently have 800 million people on Earth subsisting on less than 1,200 calories per day. The conflict means there is a real risk of a famine in emerging economies – our food security is in danger.
The crisis has created unprecedented calorie deficits, food inflation and widespread shortages in commercial fertiliser supplies. And the effects of the latter will be felt deeply and painfully by some of the most vulnerable regions of the world.
Of course, in the sustainable food stakes, the war in Ukraine is the latest in a long line of disasters. Climate change and extreme weather events have been conspiring for a long time to affect the food supply chain and agricultural production.
With food inflation ratcheting up – and the stomachs of millions at risk of not being filled – the sustainable food challenge is one that needs to be addressed immediately.
The world of investment has a significant role to play in terms of the capital that can be deployed towards solutions. Key to this strategy is the ability to identify the important themes in food sustainability and the sectors that will provide the solutions the world needs.
In our opinion, there are four main areas:
Bio-based fertilisers: The key to reducing dependency on energy and fertilisers from Russia involves a greater shift towards bio-based fertilisers. These optimise the use of nutrient-rich ingredients such as manure and sewage sludge and will reduce Europe’s dependence on imported fertilisers – as such, they will have an increasingly important role in future food production.
Plant breeding and precision farming: Progress in plant breeding and precision farming could produce healthier crops and higher yields. One of the biggest problems in agriculture is that, globally, farmers have concentrated their efforts on too few plant types, ones that are suitable to our current environmental conditions – so any changes in climate, for example, could seriously hamper harvests. Diversifying and increasing the numbers of plants the world farms and eats needs to be a key focus.
Holistic and environmentally sustainable production systems: Production systems such as mixed-farming, agroecology and organic farming also have the potential to optimise nutrient cycles, strengthen the resilience of the agriculture sector and use minimal levels of chemical inputs. They will be key in the move towards sustainable food production.
Alternative protein sector: In recent years there has been a decline in the appeal of the consumption of meat. The rise of veganism and vegetarianism is partly down to people’s personal choice and taste, or for health reasons but also the environmental impact – the carbon footprint created from cattle ranching and animal rearing is widely known. So the rise of synthetic protein will play a key role in providing the world with calories, whilst having a positive impact on carbon production associated with food.
As investors, then, where can we look to find opportunities that play to this theme? There are a ton of options, but investors need to tread carefully. Where there is a green trend, there is a propensity to greenwash – companies or funds that purport they tick sustainability boxes, but when you look under the bonnet, they really don’t.
One fund that authentically follows the sustainable food theme is Pictet Nutrition. Pictet Nutrition invests in companies that ‘secure the world’s future food supply,’ including innovations to improve farming productivity, increase efficiency in food transportation and maximise the nutritional content of food.
The Rize Sustainable Future of Food ETF is another – it says that the security of the world’s food system is one of our most pressing challenges and the need to provide nutritious, affordable food while reducing the environmental impact is increasing. Both these funds are a credible way for investors to access this theme.
The weaknesses in our food system are clear and the Ukraine war has only served to shine a light on these structural vulnerabilities. The investment world knows what it needs to do in terms of channelling money. The question that now remains is whether the world wants to. And time is running out.
Patrick Thomas is head of ESG portfolio management at Canaccord Genuity Wealth Management. The views expressed above should not be taken as investment advice.
Orbis’s Alec Cutler warns that the gap between inflation and treasury yields is at its widest since 1970.
It is likely economists in the future will say today’s central bankers made a bigger mistake with inflation than those working in the 1970s, according to Orbis’s Alec Cutler.
Cutler, manager of the Orbis Global Balanced fund, said there is a trend among modern-day central bankers to criticise the actions of their forerunners working in the 1970s, when the consumer price index (CPI) reached 13.5%.
Yet while today’s economists say they now know what tools to use to keep inflation under control, Cutler said their reluctance to take difficult decisions could see history treat them even more harshly than those they are disparaging.
“If you study economics in the 1970s, you'll find PhD papers from the 1990s written by the people now running the Fed, and they think they know what they're doing,” he said.
“But if you compare how closely the inflation rate has tracked T-bill yields, today it is the biggest gap since 1970.
“What are the odds that five to 10 years from now, people will look back at this period and say, ‘these guys really got it wrong’? It feels to me the risk is actually higher now than it was back in the 1970s.”
While interest rates in the US stand at just 1.5%, around 7 percentage points below CPI, they have already been raised three times by the Federal Reserve this year – most recently last week. Along with the threat of further hikes, this has led to a 7.2% fall in the ICE BofA 1-10 Year US Treasury index so far in 2022.
Performance of index in 2022
Source: FE Analytics
Cutler said the popular media narrative suggested the crash in what is supposedly a safe haven asset class was “striking, exceptional or outrageous”, but what was more outrageous to him was that it was able to make more than 5% in 2019 and 2022.
“When you have nearly 20% of all bonds in the world, government and corporate, yielding less than zero, they make absolutely no sense from a risk/reward standpoint – to the point where we started referring to them as reward-free risk,” he continued.
“It’s the same with gilts. If you bought a gilt in July 2021, you would have received an interest rate of just over 0.5%. With an increase in the yield on the bond to 2% and a nine-year duration, you’ve got an 18% capital loss over nine to 10 months. But you did get 75% of 50bps for that – you got 37bps in return for the risk that got actualised and cost you almost 20%.”
With interest rates set to climb further, Cutler warned there was further pain to come – and not just for investors who hold bonds.
Because valuing growth stocks involves discounting future earnings, a higher risk-free rate means these are worth less. While there has already been a noticeable shift in sentiment in the press, with commentators no longer urging investors to ‘buy the dip’, Cutler said growth investors look completely unprepared for the scale of losses coming their way, with all the signs suggesting the bear market may just be getting started.
For example, while the NASDAQ just had its 20th worst week on record, this is the first entrance by the current bear market in the top 20. In contrast, the dotcom bubble accounted for 11 of the index’s worst weeks.
“If you add up all the weekly falls [after the bursting of the dotcom bubble], you would say, ‘that's impossible. How can you have -25%, -15% and -12%? You’ll get down to a ridiculously low level.’ Yeah, you were down 90%,” added Cutler.
“But if your margin crashed 50% and your multiple crashed 30%, then that seems a lot more reasonable. That's what's happening now.”
Cutler said that back in the early 2000s, he thought he would never again see an environment where the difference in price between value and growth stocks became so extreme.
Yet he said the difference in expected returns of the top and bottom halves of the FTSE World index by duration shows that despite the recent crash in growth stocks, they need to fall another 50% just to get back to par.
“This is a decent way of explaining why we are rotating out of growth shares and into things like BP, Shell, Smurfit Kappa and Bank of Ireland,” he added.
“It was because we had blown through the prior peak of complete weirdness in the market and we felt it was time to rotate into these names that were already extremely cheap.
“You could say we’re almost halfway there. But it's nothing compared with the amplitude needed just to get back to the extremes of 2000, much less to get back to some kind of par. We're nowhere near a period when value is popular. Growth is still actually quite popular. We have a long runway to go.”
The latest edition of Trustnet Magazine finds out what it takes for value managers to get interested in former growth stars.
As the bear market gathers pace and many of the growth darlings of the past decade collapse, bargain hunters are beginning to sift through the wreckage in search of stocks that have been excessively punished. In Trustnet Magazine's cover feature this month, Danielle Levy finds out what it takes for value managers to become interested in former growth stocks. Elsewhere, Cherry Reynard explains why even the best fund managers will buy back into stocks they previously sold out of, while Anthony Luzio names three defensive trusts that have beaten the FTSE All Share over the long term.
This month’s sector focus falls on IA Targeted Absolute Return, as Adam Lewis asks if the bear market will give it a new lease of life after it struggled for relevancy during the bull run of the 2010s.
In the magazine’s regular columns, John Blowers finds out which investment platforms offer the best service in terms of planning and saving for your retirement, Fidelity’s Jonathan Winton names three distributors that are taking market share off their competitors, and Hargreaves Lansdown’s Kate Marshall reveals which small-cap fund she thinks could act as a diversifier in an adventurous portfolio.
As always, Trustnet Magazine is free – you do not even have to enter any details. Simply click here to start reading, then click the arrow pointing down on the left-hand side of the screen if you want to download the PDF.
A selection of experienced investors tell Trustnet how they are using their knowledge of previous crises to see them through the current rotation.
The market environment we are entering looks unlike any other we have seen this millennium.
Tighter monetary policy, high single-digit inflation and a fragmented global supply chain have led to an environment that’s become difficult to predict.
Yet while this is a novel environment for most investors, Malcolm Smith, head of international equities at JP Morgan, said there is a small number of veteran fund managers for whom this is nothing new.
Therefore, Trustnet has asked a handful of managers with a track record of more than 20 years how they are using their experience of previous crises to navigate the current volatility.
With most markets in decline, he said that “the fear is that earnings have yet to retrace”, so he is adopting the same approach he took in 2001 and focusing on valuations.
Stick explained: "Twenty years ago, we did two things – we tried to be realistic as to what businesses may earn, but more importantly, we focused on valuations.
“Owning a business at the right price is the best insurance policy as markets fall; conversely, expensive assets offer nowhere to hide if things go awry.”
Anthony Cross, a manager on Liontrust's Economic Advantage Team, also ran money through 2001 and the financial crash of 2008.
He will approach this rotation the same way he did during both these crises, focusing on the pricing power of companies, which he said will be critical in dealing with cost pressures.
Although Cross was “not overtly indicating that a recession was likely”, he said it was something that he was certainly mindful of in today's environment.
He claimed that “cyclical businesses with low barriers to competition, poor pricing power and weaker balance sheets” will be the worst affected in the coming cycle.
Meanwhile, Alec Cutler, manager of the Orbis Global Balanced fund, said many investors appeared to be reluctant to accept the bear market could last for some time yet, meaning growth would remain out of favour for many years to come.
“If the world's changing and everyone is stuck in the last 12 years, they're going to get hammered,” he said.
In his 40 years of investing, Cutler has noticed symmetry in how markets behave. For example, a short and sharp growth cycle is often followed by a short, sharp value cycle.
He added: "One thing to think about is just how long the next environment could last, and if we're looking at any kind of symmetry, it could last a very long time.
"We're considering what kind of investing era we're going into. I prefer to think of it as an era, because when you've had 14 years of something, that's more of an era than an environment."
The last decade was typified by a desire for companies with high returns on invested capital, which is why the likes of Google, Microsoft and Amazon did so well, according to Cutler.
It is also the reason why commodities and energy companies have largely been overlooked.
Cutler added: "The world just wanted no capital investment and cash flow, which is great, but only a few companies can do that.
"That reluctance to invest is a strong signal that we're going to have a very long cycle."
He likened the current environment to the 1970s, when inflation hit double digits and central banks took an aggressive stance on monetary policy.
Cutler compared current valuations with those in the 1970s to see which asset classes were under or overvalued.
Analysts typically compare prices with their 7-10 year history in order to assess how they’re valued, but this becomes irrelevant when the previous decade only covers one cycle.
Many of the findings were as expected, such as the value in commodity stocks, but the manager was also surprised to see defence assets were also a great place to invest.
He said the ongoing war in Ukraine and growing tensions between the US and China would likely result in increased defence spending in the future.
He pointed out that in the 1970s, the average European country was spending 4.5% of GDP on defence spending, which has now lowered to around 1.6%.
The findings mostly emphasised that many of the best performing stocks of the past decade were extremely overvalued.
Cutler said: "People kept saying that things like Netflix were cheap relative to its historical standpoint, but that's because Netflix used to sell at 400 times earnings and dropped to 40 times earnings – that looks cheap, but it ain't cheap."
Tim Guinness, chief investment officer of Guinness Asset Management, agreed that prices became very high over the past 10 years, and said the recent pullback was just an example of the market correcting itself.
He expected this adjustment to end when the S&P 500 lowers to a third of its peak, at 3,200 from its 4,800 high.
Guinness expects this correction to be completed by the end of the year, at which point global markets can begin to recover.
He said, “this is not something I’ve never seen before”, adding it was not as extreme as some commentators have claimed.
The 2001 and 2008 cycles involved the bursting of a stock market bubble and a banking crisis respectively, neither of which are evident in the current rotation.
Guinness added: “We’re not seeing the end of globalisation – we’re just seeing an adjustment.”
Many argue that active funds come into their own when markets are going through a rough patch, but this does not seem to be the case in 2022’s volatile conditions.
Investors in actively managed funds are being hit harder by the 2022 sell-off than those tracking the index, research by Trustnet reveals, despite arguments that active managers are better to able to protect on the downside.
Fans of passive investment make the argument that the average active fund will underperform over the long run, so investors might as well just track the index. But those in the active camp have long maintained that they have a better chance of protecting investors’ capital during downturns as they can move away from the worst-hit parts of the market or retreat into cash.
However, this claim has come under increasing scrutiny in recent years and with markets currently enduring a broad-based correction because of rising interest rates and other concerns, Trustnet has put the 2022 losses of active and passive funds under the microscope.
Average drawdowns by active and passive funds in 2022
Source: FinXL. Maximum drawdowns in sterling between 1 Jan 2022 and 15 Jun 2022
The chart above shows maximum drawdown in 2022 so far for the average active and passive fund in each Investment Association sector (the handful of peer groups with no passive members have been removed).
There’s a lot of detail in there, but the upshot is that there are only 12 sectors where the average active fund has suffered a smaller maximum drawdown than the average tracker. In the other 40 sectors, active funds lost more than passives.
Among the peer groups where active funds failed to protect capital as well as trackers are some of the most popular in the Investment Association universe, such as IA Global, IA UK All Companies and IA Sterling Corporate Bond.
However, it must be pointed out the above figures don’t differentiate between the various benchmarks that are being used by active and passive funds in each sector: they aren’t really comparing apples with apples.
To address this, we ran the numbers with active and passive funds grouped by benchmark as well as their sector. This resulted in 130 combinations of benchmark and sector and the average active fund had a higher drawdown than passive in 98 of them – or 75%.
The table below concentrates on the most common benchmark in 15 equity peer groups, which is a decent sample size as it covers the maximum drawdowns of 687 active funds and 53 index trackers.
Source: FinXL. Maximum drawdowns in sterling between 1 Jan 2022 and 15 Jun 2022
The results further back up the evidence that active funds have done a worse job than passives during the 2022 sell-off in some of the most popular parts of the market.
Some 13 of these 15 common sector and benchmark combinations above have their average active fund post a higher drawdown than trackers.
The two areas where active funds have done a better job are funds benchmarked against the FTSE All Share in the IA UK Equity Income sectors and IA Global Equity Income funds with an MSCI AC World benchmark This reflects a revival in interest in income investing as investors seek to protect themselves from the impact of higher inflation.
But the 152 active IA Global funds that use the MSCI AC World as their benchmark have suffered an average maximum drawdown of 11.4% this year, some 5.7 percentage points worse than a tracker. Likewise, the drawdown of the 115 active IA UK All Companies funds with the FTSE All Share as their benchmark is, on average, 4.7 percentage points higher than passive’s.
Ending with a look at individual funds, 63% of active funds have a higher maximum drawdown than the average tracker with the same benchmark. The 25 funds that have lagged behind the average tracker with the same benchmark can be seen in the table below.
Source: FinXL. Maximum drawdowns in sterling between 1 Jan 2022 and 15 Jun 2022
But while active funds’ drawdowns of 2022 are nothing to be celebrated, there are of course some funds that have been able to defend investors better than a tracker would have. So to end on a positive note, our final table shows the 25 funds that have the smallest maximum drawdowns compared with the equivalent passive.
Source: FinXL. Maximum drawdowns in sterling between 1 Jan 2022 and 15 Jun 2022