The potential for undervalued mid- and small-caps to lead the UK’s recovery has been widely touted, yet Artemis’ Ed Legget thinks large-caps are a better place to be.

“Today we’ve got more large-caps in the fund than I’ve ever had in my career,” said Legget, an FE fundinfo Alpha Manager who has been running money for 20 years.

“A lot of the very large stocks offer free cash flow yields that – other than at times of extreme stress such as Covid and the great financial crisis – we haven’t seen before in our careers.”

Shell and most of the UK’s large banks are offering distribution yields in the teens, he added, yet their valuations are on “huge” discounts compared to international peers. Shell is worth 40% less than ExxonMobil, depending on the metrics used.

“HSBC is forecast to make broadly the same amount of money as Bank of America this year but it has half the market cap. We’d argue that HSBC’s balance sheet is much stronger in terms of capital ratios. Its dividend yield and cash distribution are much higher because it’s valued at a much lower multiple.”

Around 75% of his £2.6bn Artemis UK Select fund is in large-caps, not least because some of his mid-cap stocks have graduated into the FTSE 100, including Vistry and Weir.

The fund is the top performer in the IA UK All Companies sector over five years to 11 September 2024 and the third-best over 12 months.

Performance of fund vs benchmark over five years

Source: FE Analytics

What is your process?

The portfolio holds 40-50 stocks and we’re 100% focused on compounding long-term returns. In contrast to a few of the funds we get compared to, we are genuinely multi-cap and today we have more large-caps in the fund that I’ve ever had in my career, which reflects where we see the best opportunities from a risk/reward perspective.

We fundamentally believe that, over the long term, our returns are going to correlate very closely with the underlying free cash flow generation of the companies we own. We try to keep a constant three-year time horizon and we are looking for companies whose earnings and free cash flow progression is going to be better than consensus.

We focus a lot on the macroeconomic outlook as well. You can’t look at a company in isolation from what’s going on in the world. You can’t have a view on a housebuilder without having a view on interest rates, the planning regime, mortgage availability, economic growth and unemployment.

What is your current macro outlook?

The savings rate in the UK is currently running at 11% – the historical long-term range is between 5% and 7.5% – and every one percentage point reduction in that savings rate means over £10bn flowing into the UK economy. That’s the prize for the current government if it can get growth going, plug the deficit, meet its spending and tax commitments and build confidence in the economy.

Real wages are growing and the outlook has become clearer following the election and the first rate cut from the Bank of England. As a result, we think there’s scope for the UK consumer to start saving less and spending more. Therefore we like domestic consumer cyclicals such as Next and pub group Mitchells and Butlers.

What is your outlook for the banking sector?

Banks are incredibly undervalued and we own all five large UK banks. Because of the way they hedge their balance sheets, it takes a long time for the interest rate rises we’ve seen to fully earn through into the profit and loss account, so we expect them to continue to see net interest income and top-line growth into 2025 and even 2026. If the economy does pick up, we might start to see some loan growth as well.

HSBC trades on 6x earnings, it yields 7.5% and, on top of that, you get a special dividend because it sold its Canadian business, as well as 6% in buybacks. Meanwhile, NatWest has retired 30% of its equity in two and a half years.

What was your best performing stock in the past year?

The best performer was Rolls-Royce, which was up 123% in the year to 31 August and was the second-largest contributor to the fund’s performance.

It has been a good story over the past 18 months but a tricky story for the past 10 years. Going forward, it has an exciting combination of strong and visible end-market growth across not just civil aerospace but also its defence and power systems businesses. This is a restructuring story led by a board that now has much more industrial experience and we believe there is a lot of potential for growth, profits and cash flow ahead.

NatWest was the largest contributor in percentage terms for the fund because it was a bigger holding.

Performance of stocks vs FTSE 100 over 1yr

Source: FE Analytics

Which stock detracted the most from performance?

The largest detractor was sports betting company Entain, which owns Ladbrokes and Coral and is down 43% for the year to 31 August. It has lost market share in the US where its BetMGM joint venture’s products and technology have fallen behind its larger competitors, Draftkings and FanDuel. There were also regulatory headwinds in the UK and Australia.

Entain now has a new chief executive coming in and a new chair, and there are signs that the operating performance of the business is starting to turn around, so we are hopeful we can claw back some of the value lost there.

What do you enjoy doing outside of work?

Cooking, travel, sailing, golf. I’ve got two sons so I spend a lot of time on touchlines.

It is hard to be upbeat at present, with the US election upcoming, geopolitical tensions on the rise, war in different parts of the world and numerous concerns in markets around the world. Throw in inflation (which is still yet to come down to central banks’ forecasts) and it is easy to be downbeat.

But analysis by Robeco shows that investors and savers alike have a nice problem to solve. For the first time in a long time, everything is forecast to make money and beat inflation. This means portfolio construction comes down to how to get those returns and how much risk someone is willing to take. It’s a question of picking your poison, but for once it is not actually poison investors are taking.

Let me explain. Please bear with me as the chart below is a little confusing, but I will do my best to simplify it. In the left-hand column are the long-term expected returns for different asset classes on average, each year. Next comes three factors that may impact those returns in the medium term.

Then, for UK investors, we can skip all the way to the right-hand side of the chart, where it shows the expected returns for the next five years of each asset class in sterling terms.

Source: Robeco

Okay, perhaps it wasn’t that complicated. However, the more important question is what investors can take away from the results.

The first thing to consider is the bottom row, which suggests UK inflation will hover around 2.75%, so all of the numbers above need to beat this to make a real return.

Luckily for savers and investors alike, all of the asset classes included here are expected to beat inflation, with emerging market equities forecast to be the best-performing asset class over the next five years – with 8% annual returns forecasted in sterling.

This comes at a time when few are likely to be loading up on emerging market stocks, which have perennially disappointed and recently suffered another major setback when the Chinese market tanked late last year.

Is that return worth the risk? The answer, of course, is it depends but, if these predictions are correct, investors may be able to just stick with developed market equities. Here, the return potential is 7.25%. This seems like a strong set of returns for investors, with much less risk than in emerging markets.

Over the past 10 years, the MSCI Emerging Markets index has a volatility of 14.3%, while the developed market index (MSCI World) is at 11.7%. Maximum drawdowns (the most an investor could have lost if buying and selling at the worst time) and the maximum loss (the biggest continuous drop) are also far shallower in developed markets.

Both are high when compared to cash or bonds but for 75 basis points of additional returns, is the extra risk of an emerging markets allocation justified?

Of course, there is also risk in developed markets at present, particularly for those invested in global and US trackers, with many highlighting concerns around the valuations of the ‘Magnificent Seven’, upon which these investors will be highly dependent.

So this begs the question…

Why invest in equities at all? Some investors may decide to eschew the stock market. After all, they can get 4% from cash over the next five years, according to Robeco, and it is fair to argue that there is a lot more than double the risk involved with buying something like emerging market stocks than keeping your savings in a bank account.

Or they could look to bonds. Here the asset class with the most risk attached (emerging market debt) is expected to make 6.75% per year, just 50 basis points behind developed equities.

Don’t be fooled though. These are also quite risky, as are corporate high-yield bonds, which are forecast to make around 6%.

Investment grade bonds might be the best risk-adjusted returns of the lot, paying out 5.75% per year – more than double inflation. This is also more than commodities and just behind property – suggesting that these alternatives may not have the appeal they once did.

I am not suggesting that investors sell out of everything and buy investment-grade bonds in their entirety (sorry to the fund managers that run these strategies).

But as the above table shows, that diversification is much easier to achieve at present than it has been in the past and investors now have a wealth of choices to make money.

In reality, investors may want a bit of all sorts to make up their portfolios. However they choose to do that, these predictions show that the next five years could be prosperous ones.

The ugly duckling is the perfect metaphor for contrarian investments – underappreciated and undervalued, different from the flock, but with the potential to turn into swans.

Joe Bauernfreund, chief investment officer of Asset Value Investors (AVI), said: “The ugly ducklings are the ones that get left behind that nobody cares about, nobody bothers about, but very often they're the ones where there is a much more compelling valuation argument.”

Below, managers outlined their favourite areas that are currently unloved, including Chinese equities, property and commodities.

China

Ruffer fund manager Duncan MacInnes believes China to be “probably the ugliest duckling of all” as “everyone's default reaction” is that China is “uninvestable” due to the geopolitical risk. But he finds that attitude “closed-minded”.

“I think there's no such thing as bad investments. There are just bad prices. And Chinese equities are pricing in a lot of bad news,” he said.

Investors and fund managers are concerned about tariffs imposed by the US, especially if Donald Trump wins the presidency, as well as the risk of a Taiwan invasion, so they have put China in the “too hard pile”.

“You can see how under-owned China is because it didn't sell off in that early August wobble. China was just flat and that's because there were no Western investors involved anymore to panic sell it,” he observed.

For fund managers, there is an element of career risk if China invades Taiwan, which would “basically be the start of World War III”. In this scenario, investors could lose 100% of their money, as those that invested in Russia found out following its invasion of Ukraine.

“Nobody wants to own any, in case that happens, because they'll have to tell their clients and it will, of course, seem like it was entirely foreseeable,” said MacInnes.

However, it is impossible to avoid exposure to China as it accounts for 20% of global GDP and impacts a wide range of companies from luxury conglomerate LVMH to tech stocks such as Nvidia and Tesla.

“So everyone is long China anyway, they're just long it at a much higher valuation via global growth companies than they are if they're long it via Chinese equities directly,” the Ruffer manager said.

He has direct exposure to the country via tech behemoth Alibaba and a Chinese equity ETF.

Family-controlled companies

Family-controlled companies often hold private assets that the market finds hard to value, such as Dow Jones, which is 100% owned by Rupert Murdoch's News Corp.

Bauernfreund said markets can be “quite inefficient in pricing” companies that require a lot of analysis and suggested that, in his view, Dow Jones can be compared with the New York Times, which is listed.

“It trades at 19x EBITDA [earnings before interest, taxes, depreciation, and amortization] and the implied valuation on Dow Jones is around 5x or 6x, so there's a very substantial discount there,” he said. “Yet we would argue that Dow Jones is a better business than the New York Times.”

News Corp share price over 5yrs in dollars

Source: Google Finance

D’Ieteren Group is another under-appreciated, family-controlled company. Wilfrid Craigie, senior investment analyst at AVI, said the Belgian family made its money distributing Volkswagen cars but “the value really lies in a 50% stake they hold in Belron”, the vehicle glass repair and replacement business.

Windscreen repair is becoming much more technical with the move towards driverless cars that have cameras fitted to their windscreens and Belron is the market leader.

“Due to the increased complexity, we've seen margins go from about 5% in 2018 to over 20% today,” Craigie said. “Markets are really mispricing the inherent value in this unlisted business.”

D’Ieteren Group’s share price over 5yrs in euros

Source: Google Finance

UK commercial property

The Covid-induced transition to working from home and shopping online led to the demise of the office sector and the UK high street, and to the ousting of commercial property from many a portfolio, said David Lewis, lead investment manager on the Jupiter Merlin multi-manager team.

In particular, open-ended property funds have been under fire, promising investors daily dealing in an asset class that is tough to sell, which forced many to close when they could not raise enough cash to meet redemptions. As a result, “many [investors] rid themselves of their exposure when they could”, he said.

The Jupiter Merlin team introduced the Mayfair Capital Commercial Property fund to its Merlin Portfolios in 2014 and has stuck with this allocation.

“We were always aware of the danger of being in widely held open-ended funds, unprotected from the vagaries of performance-chasing investors, making the underlying fund managers forced buyers in the good times and forced sellers in the bad. We instead created our own fund managed by Swiss Life Asset Managers, formerly Mayfair Capital Investment Management,” Lewis explained.

“We see this well-selected suite of properties, with reliable tenants with baked in rental uplifts, and yields of around 5%, as an attractive opportunity.”

Commodities

From a strategic perspective, Ruffer believes investors should allocate to commodities alongside equities and bonds because commodities tend to perform well in inflationary environments and times of geopolitical disruption.

Yet because these are cyclical assets that wax and wane with the economy, MacInnes said investors need to be tactical. “Just because you think they're going to be good over a five to 10 year view, that doesn't mean they can't hurt you quite a lot in the in the interim,” he said.

“Commodities are now very ugly. Copper and oil are down 20% since April and May. That's the battle we're fighting here. You want to hold these for multiple years but you also want to sidestep the 20% drops if you can. You don't really want to own copper into a recession.”

The prolonged outperformance of the ‘Magnificent Seven’ has taken many by surprise, but none more so than Richard De Lisle, manager of VT De Lisle America, who had to admit he was “significantly wrong” to underestimate them.

Speaking to Trustnet in November 2023, he declared technology stocks would only go sideways from there on; but nine months later, they are stronger than ever, having made investors a 30% return since the start of the year and just above 40% in the past 12 months, as the chart below shows.

Performance of Magnificent Seven as tracked by Roundhill MAGS ETF over 1yr

Source: FE Analytics

“Last November, I was significantly wrong. I underestimated Nvidia’s surge and how it would drag the rest of the Magnificent Seven higher,” said De Lisle.

“They ran up to a high in July and beat the S&P 500, which was up 19%. They continue to be the only place to be and are even more dominant within the market than they were back then. We're in a very unusual situation.”

The VT De Lisle America fund invests in the opposite end of the US market (small manufacturing companies, community banks and industries benefitting from infrastructure spending), which admittedly, has “not been the place to be”.

The sector was particularly damaged by the August sell-off, a “good old-fashioned panic” that “took away all the year’s gains”. In this “superior crack”, the Russell 2000 lost 11%.

De Lisle America was “back to start-of-the-year levels” and over the past year, it significantly lagged the average peer, coming in in 234^th position out of 244 funds in the IA North America sector.

Performance of fund against sector over 1yr

Source: FE Analytics

Another development that the manager couldn’t have predicted was that the Fed “really achieved what it wanted”, namely “to damp down spirits and stop people enthusiastically spending”.

 “That was a surprise,” De Lisle said. “One year ago I couldn’t have predicted that consumer spending on durable items, such as boats, would be down 40% year-on-year. Most durable items are bought on finance, so people are just waiting for rates to come down.”

Consumer durables wasn’t the only depressed sector either. By splitting consumer cyclicals into retailers, house builders, consumer durables and financials, the manager was able to highlight different trends within the groups.

Retailers have been weak because consumers have run out of their surpluses, with credit defaults rising and retailers reporting bad earnings as a result.

Another value staple, commodities and energy, is “just too stuck” as a sector, and the manager is planning to cut his exposure by 2 or 3 percentage points from a starting point of 15%.

Among the doom and gloom there have been some flickers of hope for some value sectors. One was housing, which remained “relatively strong” and another financials, which is having “a bit of a stealth rally”, up approximately 19% year-to-date.

But the real sweet spot for De Lisle has been another. Almost 20% of the fund is invested in more growth-focused names beyond technology, whose earnings haven’t moved, and yet the stocks have doubled as their potentials were “suddenly recognised”.

Examples include heathcare company Pennant, retailer Build-A-Bear and gasoline stations and convenience stores Murphy USA.

A share in Pennant was priced at $13 at the end of last year and is now closer to $33, with earnings “not much better than we would have expected”. Build-A-Bear was up 45% over the year “for the simple reason that its earnings did not collapse” like other retailers’, although they stopped at “a little more than black”.

The manager said a 20% allocation to this area is “clearly not as much as we should have had”, but many of these names are suffering from the same ailment as the largest growth stocks: they are getting too expensive, so he is wary of adding more.

But neither would he cut down the rest of the portfolio to add more. On the contrary, it would be “risky” to sell value stocks now.

“The difference between the ratings of value stocks and the more expensive stocks is so large that it would be quite risky to sell value hard,” he said.

“Despite recession fears have grown since June, relative valuations have been pushed so hard that it would be difficult for value to continue to underperform.”

In 2023, many investors expected that the Federal Reserve’s (Fed) aggressive monetary policy tightening would lead to a potential recession and a pick-up in defaults in the high yield market.

Given this backdrop, the broad market consensus was for investment grade to outperform high yield and, within high yield, higher quality BBs to outperform lower quality CCCs.

This consensus was wrong. Despite continued volatility in the US treasury market, the high yield market has benefited from a healthy fundamental backdrop and resilient US economy.  US high yield companies have, despite diverging trends across sectors and issuers, performed better than anticipated.

Technical factors have also remained very supportive and, over the past couple of years, the market has seen a wave of rising stars to investment grade. This has surpassed the number of fallen angels. Alongside this, there has been less new issuance in the primary market, creating more demand for new deals when they do come to market.

Looking across the high yield market, lower-rated credit has outperformed higher quality in 2023 and 2024 year-to-date, while short duration has continued to look appealing relative to longer duration due to the inverted yield curve and prolonged rates volatility.

The US high yield market has outperformed investment grade, government bonds and cash over this timeframe.

Is there still room to run from here?

Looking at previous cycles, the high yield market tends to bounce back strongly after a sell-off. This is because, as bond prices recover and coupons reset at higher levels, the level of income that bondholders receive increases.

This is reflected in the all-in yield, which in the US high yield market moved from around 4% in 2021 to 9% at the start of 2023 and is now slightly below 8%.

The sell-off in 2022, however, was unusual as the rise in yields was driven mainly by interest rate increases, not by credit spreads widening. This means that bond prices today remain discounted as the outlook for interest rates has been uncertain.

That could now be all about to change as we expect the Fed to start moderately easing policy. As such, there is still significant upside potential for the high yield market through a combination of higher income and continued bond price recovery.

It is worth bearing in mind that rallies in high yield can happen very quickly: in the fourth quarter of 2023, the US high yield market delivered a 7% total return as the market priced in rate cuts, with the average high yield market dollar price increasing from $88 in September to $93 by year-end, remaining at $94 today.

Timing such market moves can be challenging and the only way to ensure full participation in rallies is by being invested, whilst also benefitting from the higher carry now on offer.

We expect high yield spreads to continue to be supported by broadly healthy corporate fundamentals and any potential spread widening to be met with buyers, providing further technical support.

That said, dispersion is increasing as high yield companies adjust to a higher-rate environment. That is why prudent fundamental analysis is critical to identify companies that are well positioned to pay coupons on a timely basis and pay back, or refinance, principal.

Carry

Over the long term, the high yield asset class has proven its ability to outperform other parts of the fixed income market. This is principally due to the attractive carry component that compounds through time. High yield also has the potential to compete with equities from a return perspective but with less volatility.

US Debt Index Returns

Source: AXA IM. Dara 30th September 2001 – 31st July 2024.

Since the financial crisis 15 years ago, the high yield asset class has matured significantly in terms of the quality and diversity of companies that make up the market. Many of these are household names and global leaders in their lines of business, that feel very comfortable using the high yield market to access capital.

Due to these characteristics and developments, high yield has become much more of a core part of investors’ portfolios.  As well as the high income available relative to other asset classes, high yield also offers diversification qualities within a balanced portfolio.

With a risk/return profile that sits somewhere between the fixed income and equity markets, high yield can be used in a variety of different ways to suit different risk appetites and outlooks. It is an asset class that, even today, can continue to surprise to the upside.

Jack Stephenson is a fixed income investment specialist at AXA IM. The views expressed above should not be taken as investment advice.

The European Central Bank (ECB) has cut interest rates for the second time this year, bringing them down to 3.5% following recent inflation data showing price rises had dropped across the Eurozone to 2.2% in August, down from 2.6% in July.

However, the ECB’s job may not be as straightforward at future meetings, with Des Lawrence, senior investment strategist at State Street Global Investors, noting some signals, such as services inflation rising to 4.2% in August, were more mixed.

Lawrence said: “The concurrent rise in services inflation to 4.2% in August raises a dilemma for the ECB: how to avoid over-promising on policy moderation and yet respond to legitimate concerns around a slowdown in activity that's gathering pace and breadth.”

Janet Mui, head of market analysis at wealth manager RBC Brewin Dolphin, was less concerned, noting that “markets continue to price in close to two more rate cuts by the end of the year and a further four cuts in 2025”.

The move was broadly expected by the market and is in-line with expectations for both the Bank of England and Federal Reserve who are forecast to make similar moves next week.

Lindsey James, investment strategist at Quilter Investors, said: “Given it is faced with an economy in desperate need of some form of stimulus, the ECB will be hoping this second quarter-point rate cut will begin to make easier financial conditions felt.”

“All eyes will now turn to the Federal Reserve and the Bank of England to see if they follow suit with rate cuts of their own next week.”

After more than a decade of domination, US growth funds are starting to cede places at the top of the rankings to their value counterparts.

It has been a tumultuous three years for investors in growth names such as the behemoth US tech and healthcare stocks. Higher interest rates that started climbing towards the end of 2021 and beginning of 2022 threatened to derail their performance before the rise of artificial intelligence (AI) caused names such as the ‘Magnificent Seven’ to flourish.

But this short-term volatility has allowed other, formerly maligned strategies, to leap up the rankings, including value funds, which have spent much of the past decade in the shadow of their growth peers.

Below, Trustnet highlights three US equity funds in the IA North American and IA North American Smaller Companies sectors that have rebounded from a bottom-quartile performance over 10 years to the top 25% of their sector over the past three years.

Across both sectors, three funds fit our criteria, all of which invest with a value tilt. They were: M&G North American Value, Robeco BP US Large Cap Equities and FTF Royce US Smaller Companies.

How bottom quartile funds over 10yrs have performed recently

Source: FE Analytics.

First up is the £280m M&G North American Value fund, co-managed by Daniel White and Richard Halle, which has an FE Fundinfo Crown Rating of four.

It rallied from a bottom 20 performer over 10 years in the 129-strong IA North America sector, but made a first-quartile return of 30.3% over the past three years, enjoying a particularly strong 2022.

It managed to make 5.9% that year during a challenging one for US stocks, which had to contend with high global interest rates causing many of the formerly surging growth stocks to struggle.

Performance of fund vs the sector and benchmark over 3yrs

Source: FE Analytics

Nevertheless, its track record has not been perfect, with 2022’s strong performance followed by a fall to the third and bottom quartile in 2023 and 2024 respectively.

Also from the IA North America peer group is the £1.1bn Robeco BP US Large Cap Equities fund. It is led by a four-strong team, the longest-tenured of which are David Pyle and Mark Donovan, who have been named managers on the fund since 2010.

Over the past three years, it has become one of the top 20 performers in the peer group, up 10.4%, owing to a two-year streak from 2021 to 2022 in which it ranked within the first quartile of its sector with returns for these years of 29.7% and 6.5% respectively.

Performance of fund vs the sector and benchmark over 3yrs

Source: FE Analytics

Once again, however, performance has not been smooth sailing throughout this period and the fund dipped to the bottom quartile in 2023, and in 2024 it sits in the third quartile.  

In the IA North American Smaller Companies sector, only one fund matched this criteria of bottom quartile over 10 years to top 25% over three; the £263.7m FTF Royce US Smaller Companies fund, headed up by Lauren Romeo.

Thanks to consistent first-quartile performances in each year between 2021 and 2023, the portfolio has not only been a top performer over three years, but it has also been one of the top performers over the past five years.

Performance of fund vs the sector and benchmark over 3yrs

Source: FE Analytics

Its record in 2022 is particularly notable because, despite making a loss of 3.72%, the fund was the second-best portfolio in the peer group, in a challenging year for smaller companies across the globe.

High global interest rates and geopolitical conflicts meant investors feared a US recession, and these concerns hit smaller company equity funds particularly hard.

With some funds in the wider North American Smaller Companies’ peer group falling in value by as much as 30% that year, the FTF Royce US Smaller Companies portfolio’s performance was among the best in the sector.

It was flanked by two years of strong gains in 2021 (up 26%) and 2023 (16.12%). However, 2024 has proven particularly challenging for the fund, as it fell to be one of the worst-performing portfolios in the sector, down 4.4% year-to-date.

Previously in this series, we have looked at the Europe Excluding UK, UK Smaller Companies, UK Equity Income, emerging markets, IA Global and Global Equity Income, and the UK All Companies sectors.

Alphabet, Meta and Amazon might not be the stocks that you expect to find in a value fund such as Nedgroup Contrarian Value, and yet they all belong to its top-10 holdings, making up 8.9%, 4.9% and 3.3% of the portfolio, respectively.

This has helped the strategy achieve a maximum FE fundinfo Crown rating of five, which is given on the back of relative three-year performance – a timeframe in which technology stocks, the largest sector exposure in the fund at the moment, soared.

The reason for holding these in a value portfolio is clear, according to manager Mark Landecker. No not be out of business.

“If you were to look at the portfolio and just saw a collection of deep-value names such as auto manufacturers, retailers and telecoms, we probably wouldn't be having this conversation today because we'd be out of business,” he said.

“We're not trying to bottom-fish and find companies that are valued in the lowest decile. We're trying to purchase high-quality companies when they very occasionally trade at a level that allows you to buy them as a price-disciplined investor with a margin of safety”.

So it all goes back to the time at the stocks were purchased. For Alphabet, it was in the 2010s, when the company was navigating regulatory scrutiny, antitrust investigations in the European Union, privacy concerns and market competition. For Meta, it was during the Cambridge Analytica scandal in 2018.

“These are long-held names in the portfolio, not indicative of us trying to jump on the artificial intelligence (AI) bandwagon,” he said. “We are fans of secular growth. Who isn’t? We just don’t like to pay for it.”

Top 10 Holdings as at 31 July 2024

Source: FE Analytics

Other names with a technology element in the portfolio include connector company TE Connectivity and semiconductor company Analog Devices. Microsoft was also a holding from 2010, when everybody “hated it and didn’t think it was going to go anywhere”, until 2020, when the valuation had become “hard to justify”.

Asked whether this was a concern for other names in the fund, Landecker said that he is “comfortable” owning companies as long as there is a “reasonable likelihood” that they can earn “equity-type rates” of return.

The latest example of a name that was cut for valuation concerns is Broadcom, as it has now pushed to a price-to-earnings ratio of 25x to 30x, whereas it was originally bought in 2018, as the manager recalled, at a 10x to 12x level.

According to Landecker, owning companies that investors are used to finding in funds with different styles doesn’t betray the price-disciplined process, but rather it’s “indicative of the strategy, the underwriting and the research working exactly as intended”.

“If we do our job well, we are in the right companies and we buy them at the right times, then the hardest thing is to convince ourselves not to sell them as the value appreciates.”

Another winning decision for the fund was to whittle down its exposure to Chinese companies on the back of geopolitical concerns. This has allowed it to avoid the abysmal returns of the past few years, illustrated in the chart below.

Performance of index over 3yrs

Source: FE Analytics

The manager had higher exposure to China in years past, but then the Chinese economy “moved towards more central-market planning rather than capitalist tendencies”, making it “a more unpredictable environment”.

“Relying on the decisions of a few people at the top, rather than the markets as a whole creates greater uncertainty and can potentially restrict your ability to compound capital over time,” Landecker said.

Admittedly, given the status of China as the world's second-largest economy, it is “almost impossible to escape it completely”, but today the NedGroup Contrarian Value is “virtually” China-free.

“Previously, if you were running a global equity portfolio focused on larger companies, you didn’t have to take geopolitical events into account as much, but unfortunately it looks like geopolitics will be part and parcel with investing in the next couple of decades,” he concluded.

The Fidelity Global Special Situations fund has been popular among investors, reaching £3.3bn of assets under management (AUM) but its failure to beat the MSCI World index and its benchmark, MSCI All Country World, in the past five, three and one years, may leave investors wondering why.

It means those with money in the fund would have been better off with a cheaper index tracker over the medium term.

Fidelity Global Special Situations has lagged the MSCI World index by more than 5 percentage points over the past three years, both singularly and cumulatively, which made it eligible for the Bestinvest doghouse, where it ranked as the second-largest underperforming fund in the whole peer group.

Other worries around the fund were added last year via a manager change, as Jeremy Podger, the FE fundinfo Alpha Manager who ran it, announced his retirement and was replaced by Christine Baalham and Tom Record.

These are just a few of the reasons why investors might be wondering what to do with this fund. Joe Richardson, discretionary investment manager at Dennehy Wealth, found another, namely the extreme valuations in the US and the potential downside risk. If he was holding this fund, he would “certainly be looking elsewhere”.

But not all experts agreed, with some considering it a good play going forward.

About 65% of the portfolio is invested in US equities, including major holdings in Microsoft, Alphabet and Amazon, unusual choices for a value fund which, according to its factsheet, aims to buy “undervalued [companies] whose recovery potential is not recognised by the market”. This is what made it “a concerning hold” for Richardson.

“To reach run-of-the-mill valuations associated with future returns of approximately 10% annually, the S&P500 would need to fall by about 70%,” explained Richardson.

This fund is “too heavily exposed to that risk,” so the manager would sell and move on to other markets that are less correlated to the US and positioned to perform well in a new era of higher interest rates, inflation and volatility – sectors such as commodities, particularly gold, and regions such Japan and parts of Asia, both “better opportunities” at present.

For investors who are still interested in recovery plays, the Ninety One Special Situations is a more attractive option according to Richardson, given its value tilt and the fact this environment offers some “extremely compelling stocks” trading at “incredibly cheap levels” compared to markets and their own history.

“This positions the fund well for strong returns in an otherwise expensive world,” he said. The Ninety One fund, despite a much smaller size, has made higher returns than its Fidelity competitor, as highlighted in the chart below.

Still, 40% of its holdings are again in the US, which made Richardson hesitant. “A significant correction in the S&P would likely drag down most, if not all, of these stocks, regardless of whether they are undervalued or not,” he said.

Performance of funds against sector and indices over 3yrs

Source: FE Analytics

Charles Stanley managing director Rob Morgan had a more nuanced take on the matter. Despite the “special situations” moniker, he considered the fund a core position, as it isn’t particularly tilted to a value style as one would expect form a special situations fund.

“Whether to retain or buy this fund, therefore, will depend on how it sits in the context of a wider portfolio,” he said.

While Fidelity “may not offer enough diversification” for those looking for a more defined value tilt, it represents “a solid option” as a core holding and would be a ‘hold’ for Morgan if that is the intention of the investor.

The Ninety One fund in comparison has “a significantly different portfolio” to the average global fund, which stems from its contrarian and deeper value approach, making it a candidate for a satellite position in a portfolio.

For Darius McDermott, managing director at FundCalibre, Fidelity Special Situations is “an all-weather strategy that integrates both growth and value opportunities”.

After meeting the new managers last quarter, he was “impressed with their differing but complementary skill sets”, which should ensure a “well-rounded” approach.

The fund therefore is suitable for “a variety of market conditions”, including the new growth cycle that we are entering, according to McDermott.

“With global interest rates expected to decline and the market broadening out, we anticipate that growth-oriented stocks may regain prominence,” he said. “This shift could bolster the performance of more balanced funds in this space, Fidelity Global Special Situations included.”

Investors face a “serious dilemma” over how to save for retirement, according to Dzmitry Lipski, head of fund research at interactive investor (ii).

Conventional wisdom suggests moving a pension further down the risk scale the closer one approaches to 65 years of age (or sooner if retiring early), taking on more fixed income and ditching riskier assets such as equities.

But investors with limited assets “may find it difficult to build a portfolio that provides a comfortable retirement without fear of running out of money”, said Lipski.

Part of the problem is we are living longer. Someone retiring at 65 can still expect to live another 20 years or more, suggesting the need to keep growing their retirement pot.

Considering these risks, he noted that there is a place for both equities and bonds in any pension portfolio. Investors should also attempt to marry up income-producing investments with those that can provide capital growth.

Below he highlights the key areas within a pension portfolio and outlines funds that are suitable for each.

Fixed income

At present, investors have a real opportunity to make the most of high yields, with the Bank of England Base rate around 5% while both two and 10-year gilts are yielding 3.8%.

However, bonds have been out of favour recently. The main argument has been that they have tended to trend in the same direction as equities – a reversal of conventional wisdom which dictates bonds and stocks should have an inverse relationship (one falls when the other rises and vice versa).

In 2024 this traditional negative correlation has returned, meaning investors can once again use the bonds/stocks balance to provide a diversified portfolio, Lipski said.

With inflation cooling and central banks starting to cut interest rates, investors could consider investing in short-dated, high-quality government and corporate bonds “given the attractive yields offered”, he noted.

Therefore, global and strategic bond funds may make sense given their flexibility to invest across the fixed income landscape.

In terms of fund picks, Jupiter Strategic Bond got the nod in this area. Managed by “highly experienced managers” Ariel Bezalel and Harry Richards, the £2.3bn fund can “go anywhere” and the process includes both specific selection and macroeconomic calls.

At present, around 60% of the portfolio is invested in corporate bonds and over 20% is in government bonds.

“Given the fund’s flexibility and focus on downside protection, this makes it a strong core option for investors within a well-diversified portfolio,” he concluded.

The current yield is a little over 5%, which Lipski said was “attractive”, and it has come into its own over the past 12 months, up 12.9%. However, performance has been weaker over longer periods, as the below chart shows.

Performance of fund vs sector over 10yrs

Source: FE Analytics

Equity income

Next up is the riskiest part of the portfolio: stocks. Here Lipski highlighted two options – one focused solely on the UK and the other taking a more global approach.

Up first is Artemis Income, which aims to provide investors with a steady and growing income along with capital growth over the longer term.

The portfolio is “well diversified”, he said, with between 50 and 70 holdings. Managers Adrian Frost, Nick Shenton, and Andy Marsh look for stable, well-established businesses with the financial strength to pay solid dividends to shareholders.

It has been a top-quartile performer in the IA UK Equity Income sector over one, three, five and 10 years, as the below chart shows.

“The fund provides a solid, core UK large-cap equity income exposure for investors, and the current yield is almost 4%.”

Performance of fund vs sector and benchmark over 10ys

Source: FE Analytics

Meanwhile, from a global perspective, Fidelity Global Dividend is the choice. It has a yield target of at least 125% of that on the MSCI All Country World Index, but aims to deliver both income and capital growth over the longer term by investing in “high-quality mega-cap companies”.

“Manager Daniel Roberts adopts a conservative strategy, focusing on companies with clear business models, healthy cash flows and minimal debt.”

Like the Artemis fund above, it has made top-quartile returns in its IA Global Equity Income sector over one and 10 years, although it has slipped to the second quartile over three and five years.

The multi-asset approach

Investing at present can be daunting, with much uncertainty ahead in the form of the US election and the potential for central bank mistakes in their fight to combat inflation.

For investors who don’t want to manage their equity and bond allocations individually (or for those seeking further downside protection), multi-asset strategies will take care of the weightings for investors.

Capital Gearing Trust is one such option as it aims to preserve capital over any 12-month period and to deliver returns above inflation over the longer term, marrying potential short-term risks with long-term rewards.

“Rather than using exotic strategies or derivatives, the trust’s approach to avoiding drawdowns has been to hold a highly diversified portfolio of assets with some to be negatively correlated to risk assets,” said Lipski.

Managed by Peter Spiller since 1982, the trust has proven its worth as a “preserver of wealth in bear markets”. Returns look middling over the short and medium term, with the fund lagging during bull markets, but it rose to the top of the IT Flexible Investment sector in both 2020 and 2018 when peers made losses.

“This trust is a good fit as a core holding due to its defensive stance and high levels of diversification,” said Lipski.

The European fund management industry is at a critical juncture. As another wave of substantial regulatory change is imminent, the operational landscape is rapidly transforming in response to technological innovation, market shifts, fierce competition, cost optimisation and the scarcity of capital and talent. Gold plating and market entry barriers are coming on top.

For many European fund managers, navigating this complexity has become a core part of their value proposition, demanding both organisational and strategic agility.

Headwinds: A challenging regulatory landscape

Across Europe, new regulations are further burdening the industry. Notably, the Sustainable Finance Disclosure Regulation (SFDR), the European Taxonomy, the Corporate Sustainability Reporting Directive (CSRD), Alternative Investment Fund Managers Directive (AIFMD) 2.0 and, in the UK, the Consumer Duty, and the upcoming UK Sustainability Disclosure Requirements (SDR).

In the US, the Securities and Exchange Commission (SEC) has been pursuing a proactive regulatory agenda, focused significantly on private fund advisor regulations and enhanced environmental, social and governance (ESG) disclosure requirements.

However, recent court rulings have blocked some of these efforts, specifically also regarding the SEC's attempt to impose stricter disclosure rules. Nonetheless, many market players expect the SEC to reintroduce these regulations, with modifications to address the court's concerns.

The complex regulatory environment is particularly onerous for smaller players and is a significant driver of market consolidation, which may accelerate as the regulatory compliance burden and fundraising challenges persist and converge.

Market uncertainty and its ripple effects

Current market uncertainty is exerting downward pressure on fees and creating a challenging fundraising environment. Private equity fund managers are facing a tepid exit market for their investments, resulting in an ageing pool of assets and delaying the return of investor capital. This is fuelling investor reticence, driving further scrutiny and postponing reinvestment.

Adding to these pressures, investors and regulators are demanding greater transparency from fund managers regarding investment strategies and fees. This necessitates robust disclosure practices and adherence to evolving regulatory requirements on transparency.

Furthermore, there is growing pressure from investors and the public for firms to surpass mere ESG disclosures. Stakeholders increasingly expect investment managers to demonstrate real impact in areas such as climate change and social responsibility. This shift from disclosure compliance to proactive impact generation is becoming a defining trend.

Tailwinds: Embracing innovation for growth

Despite the headwinds, technological advancements offer a silver lining. Artificial Intelligence (AI), big data, and RegTech solutions can significantly improve efficiency, enhance decision-making accuracy, and strengthen risk management capabilities for fund managers.

The investment management industry was an early adopter of machine learning and AI technologies. Many advanced business applications of this technology are already in use within the fund management industry today, particularly in investment automation and pattern analysis.

At the same time, RegTech, FinTech and AI-powered solutions require careful handling, demanding time and additional resources. While technology offers solutions, they must still align with the legal and regulatory environment, which remains somewhat fragmented globally, necessitating a global approach and careful navigation by firms.

Furthermore, the introduction of new regulations such as the EU's Digital Operational Resilience Act (DORA) underscores the need for managers to not only innovate but ensure their digital infrastructures meet regulatory standards aimed at maintaining operational continuity and security across financial services.

Conclusion

The European investment management industry is navigating a period of transformation. While regulatory and market challenges abound, the future of investment management lies in effectively managing this complexity.

Those who can adapt to the ever-evolving regulatory environment, responsibly embrace technology, and identify emerging opportunities will be the ones who succeed.

Catherine Pogorzelski is international sector head of investment management and funds at DLA Piper. The views expressed above should not be taken as investment advice.

Following a long period of underperformance, the UK market has been rallying in recent months and investors might be considering adding to their domestic exposure.

That said, the discount on UK equities remains significant. The MSCI UK index is trading on a forward price-to-earnings (P/E) ratio of 11.7x, compared with 14.1x for the MSCI Europe ex UK and 21x for the MSCI North America.

Tom Stevenson, investment director at Fidelity International, said: “The UK stock market is no longer trading in absolute bargain territory - but it is pretty close to it. Valuations in the US – even after the hiatus in markets mid-summer – remain close to their recent peaks.

“Moreover, the UK is now underpinned by several factors including more growth and the actual onset of falling interest rates. That could fuel a further unwinding of the discount that’s been applied to UK shares ever since the Brexit referendum in 2016.”

Below, the Fidelity investment director highlights five funds investors considering buying UK equities might want to look at.

FTF Martin Currie UK Equity Income

Starting with active picks, Stevenson pointed to the £857m FTF Martin Currie UK Equity Income fund. Managed by Ben Russon, Will Bradwell and Joanne Rands, the fund aims to deliver an income higher than the FTSE All Share, doing so with a portfolio that tends to have the majority of assets in large-caps.

Performance of fund vs sector and index over 5yrs

Source: FE Analytics

“We like this fund as it invests primarily in companies listed in the UK, although the investment manager has the freedom to invest up to 10% outside the FTSE All Share index,” Stevenson said. “The manager is also committed to UK equity investing – which can be a rarity, as most investment firms tend to focus on global investing.”

Fidelity’s analysts said FTF Martin Currie UK Equity Income might be a good option for investors seeking dividend income from companies primarily listed in the UK.

Liontrust UK Growth

Next up is Liontrust UK Growth, which is managed by Anthony Cross, Julian Fosh, Matthew Tonge and Victoria Stevens. The £993m fund looks for UK companies with ‘economic advantages’, or intangible assets such as intellectual property, recurring business and distribution networks that are hard to replicate and provide long-term protection from competition.

Performance of fund vs sector and index over 5yrs

Source: FE Analytics

“It’s worth noting that this fund’s approach has a ‘quality’ bias, meaning it will buy companies that tend to be more expensive than others,” Stevenson said. “Due to this, the manager takes a very long-term view when investing.”

Because of this long-term approach, Liontrust UK Growth could be a holding for investors looking to invest for 10 years or more.

Fidelity Special Situations

The third active pick is the £2.9bn Fidelity Special Situations fund. It is managed by Alex Wright, with Jonathan Winton as co-manager, and has a strong long-term track record – currently in the top quartile over one, three, five and 10 years.

Performance of fund vs sector and index over 5yrs

Source: FE Analytics

“There’s a focus on companies that the manager believes are undervalued. Our experts like this fund because the manager is a ‘seasoned UK investor’,” Stevenson said. “There’s also a willingness to invest in smaller companies, an area in which Fidelity brings expertise.”

Wright’s contrarian approach means Fidelity Special Situations is a value fund and should perform better when the value style is leading the market, although it has also done well in growth-led markets. Analysts at Rayner Spencer Mills Research said the fund is suitable to hold over a full market cycle, but added it might be more suited to being a satellite rather than core holding.

iShares Core FTSE 100 ETF

Turning to passive options, Stevenson picked the iShares Core FTSE 100 ETF. As its name suggests, the ETF tracks the FTSE 100 index, meaning it provides exposure to the largest companies in the domestic market.

Performance of fund vs sector and index over 5yrs

Source: FE Analytics

“Our experts like this fund as BlackRock is a seasoned investor in passive funds and the fund’s costs are low,” he said.

The iShares Core FTSE 100 ETF may be suitable for investors who looking for exposure to large UK equities, have a long-term horizon and are cost-conscious, Fidelity said.

Vanguard FTSE 250 ETF

The final pick is Vanguard FTSE 250 ETF, which is intended to sit alongside a FTSE 100 tracker and offer exposure to UK mid-caps.

Performance of fund vs sector and index over 5yrs

Source: FE Analytics

The FTSE 250 tends to be more geared to the fortunes of the domestic economy, as its members are more likely to have significant business with UK customers, unlike the FTSE 100 where the bulk of revenues are derived from overseas.

“Given that the fund invests in medium-sized companies, there may be more volatility and risk arising compared to larger sized companies,” Stevenson added.

The UK’s largest fund supermarket Hargreaves Lansdown has added the multi-asset income fund Ninety One Diversified Income, to its best-buy list.

Co-managed by John Stopford and Jason Borbora-Sheen since 2012, the £844.9m fund is primarily defensive and aims to be less volatile than 50% of the FTSE all-share index over the long term.

While the fund invests mainly in bonds, it also has exposure to shares and investment trusts and groups them based on three main categories of growth, defensive and uncorrelated investments.  

Hal Cook, senior investment analyst at Hargreaves Lansdown, said the firm’s conviction lies with Stopford and his “vast experience in bond investing”, although he noted that the firm holds Borbora-Sheen “in high regard” and his presence should “reduce the key person risk associated with Stopford over time”.

This strategy has led to consistent long-term success, with Ninety One Diversified Income ranking within the top quartile of the IA Mixed Investment 0-35% Shares peer group over three and five years. Across both periods, the portfolio was one of the five best performers in the whole sector.  

Performance of the fund versus the sector over 5yrs

Source: FE Analytics

Cook said: “We think this would be a great option for investors looking to supplement their retirement income, or for more cautious investors looking for an alternative to cash as rates fall.

“The fund could provide diversification to an investment portfolio focused on growth or be a useful addition to a portfolio focused on providing an income.”

Ninety One Diversified Income is also included on the FE Investments Approved List.

Bond manager Alejandro Arevalo is set to leave Jupiter Asset Management in early 2025, a Jupiter spokesperson has confirmed.

Co-manager of four different emerging market fixed income strategies, including the IA funds Jupiter Emerging Market Debt and Jupiter Emerging Market Debt Income, Arevalo is responsible for running a total of £572m of assets under management.

After his departure, co-manager Reza Karim will be taking up the leadership of the funds. Jupiter remains “entirely confident” the transition will be “seamless” for clients, as all of Jupiter’s emerging market debt funds are managed on a team basis, a spokesperson said.

Arevalo’s tenure on these funds began in July 2020 and since then, the Emerging Market Debt fund has beaten the average IA Global EM Bond peer by four percentage points. The income strategy wasn’t as successful, as the chart below shows.

Performance of funds against sector and index since July 2020

Source: FE Analytics

The firm announced plans to expand the team as emerging market debt remains “an important asset class for Jupiter”.

A spokesperson said: “We have a strong team in place with the potential to materially increase our scale in this area, particularly in the institutional channel, as our clients’ needs continue to evolve”.

“To this end, we will be looking to supplement the team with additional investment talent in due course.”

Real UK GDP has shown no month-on-month growth in July, marking the second consecutive month of stagnation for the UK economy and the third time the UK economy has failed to grow in four months, according to data from the Office for National Statistics (ONS).

Forecasts were that GDP would grow 0.2% in July, but this failed to materialise. It was, however, 1.2% higher than July 2023. Overall, GDP has grown 0.5% over the past three months, compared with the three months to April, propped up by May’s reading.

The production and construction sector both faced a troubling month, with ONS data showing a decline in output of 0.8% and 0.4% respectively.

Lindsey James, investment strategist at Quilter Investors, said: “The UK economy was expected to continue to show modest momentum, but signs suggest that the growth from the first half of the year is now stuttering.”

Derrick Dunne, chief executive officer of YOU Asset Management, added: “While just a snapshot, these monthly figures show the UK’s economy is still moving at a pedestrian pace overall.”

“The year-on-year growth reported is certainly positive for businesses, households and government alike, but lacklustre growth is not going to solve everyone’s problems.”

However, there was still positivity, with the services sector, which grew by a modest 0.1% in July, and recent positive noise around the wider economy which has prompted better forecasts for the rest of the year.

James concluded: “There are signs that solid, if unspectacular, economic growth is returning to the UK even after today’s disappointing figure.”

Emerging market equities are often considered to be the riskiest of the world’s stock markets but for the past decade that assumption has not held true.

US equities – a region increasingly dominated by mega-cap tech stocks – have been more volatile than emerging markets in local currency terms by a considerable margin, as the table below shows.

Annualised volatility over different time periods in local currency terms

Source: FE Analytics

Sahil Mahtani, a strategist at Ninety One’s investment institute, said: “Investors need to re-examine their prior beliefs. Emerging markets have a lower beta to developed market (DM) equities outside of crises, have had lower volatility relative to developed equities in recent years and exhibit lower correlations to DM equities than most comparable asset classes of that size.”

Emerging market vs developed market volatility

Sources: Ninety One, Bloomberg, MSCI, data to 31 Dec 2023

The largest emerging markets “embraced reform after the crises of the 1990s” and have built stronger economies, bringing them “closer to developed markets in terms of governance and frameworks”, he explained.

“Substantial progress has been made across macroeconomic and corporate fundamentals and market structure – one reason why emerging markets outperformed during the period of monetary tightening that began in late 2021.”

The “notable broadening and deepening of liquidity” has been accompanied, at the corporate level, by “a push for higher standards of operating performance and corporate governance, which have helped to drive the rise of companies based in emerging markets, which are global leaders in their industries”, Mahtani added.

Emerging market vs developed market beta

Sources: Ninety One, Bloomberg, MSCI, data to 31 Dec 2023

Emerging markets also have a bad reputation for corporate flare ups and scandals but, as renowned emerging market investor Mark Mobius explained recently, these can happen anywhere in the world.

On the other side of the equation, the S&P 500 has become more volatile and more concentrated. The ‘Magnificent Seven’ tech stocks account for 32% of the index’s three-year volatility, said Michael Nizard, head of multi-asset at Edmond de Rothschild Asset Management.

Ben Jones, director of macro research at Invesco, added: “Since the US is the most richly valued of [the developed] markets, it may be expected to experience greater volatility on negative news flow.”

Macroeconomic factors are also fuelling volatility across developed markets that Jones said can “no longer rely on an ever-supportive central bank to lower rates or pump liquidity into the system at the first sign of trouble”.

However, although emerging markets have been less volatile than the US, they have suffered larger drawdowns – so on that measure, they are riskier.

Hugh Gimber, global market strategist at JPMorgan Asset Management, said that during the past decade, “US equities have been in negative territory for one-year returns about 5% of the time. In contrast, for emerging markets and the UK, the same statistic is 38% and 25%”.

The chart below shows rolling one-year returns and “while the grey line [representing the US] is a little more jagged than the blue or the green, US equities have also suffered far smaller downturns”, he explained.

Mahtani acknowledged that emerging market equities can be particularly vulnerable to sell-offs in times of crisis, but that has blinded investors to their diversification benefits, he argued.

“Under normal conditions, emerging markets tend to be less risky than people think. However, during significant crises, the potential losses can be greater. Notions of ‘decoupling’ in times of crisis were always unrealistic. Focusing on these short-term sell-off windows ignores the diversifying benefits that emerging market equities can offer under all other market conditions,” he stated.

Another factor at play is currency risk, which had a significant impact on how investors based on different sides of the Atlantic experienced volatility during the past decade.

Sterling investors would have experienced more volatility in emerging markets than in the tech-heavy US, as the table below illustrates, but the reverse is true for dollar-based investors and in local currency terms.

Annualised volatility over different time periods in sterling terms

Source: FE Analytics

Then there is the risk/return trade-off to consider. Volatility is not a bad thing if investors are rewarded for the risks they take.

Jones said: “Much of the positive news in the past couple of years has been around artificial intelligence and that has meant more upside volatility for US stocks.”

Emerging markets have underperformed other regions during the past decade but Mahtani attributed that to idiosyncratic factors, such as China’s property issues and government interference on tech, which he expects to play out differently going forward.

“Looking ahead, we anticipate that the drag on returns from sectors such as materials, energy, and financials will stabilise, while the emerging market tech sector will be the home of many winners,” he said.

Emerging market equities tend to outperform strongly in dollar downcycles, something that appears to be happening at present with the Federal Reserve poised to cut rates.

“Following a peak in the US dollar, emerging market equities have typically risen by 30-50% in the following six to 12 months,” Mahtani said.

The relative performance of emerging vs developed market equities compared to US dollar strength (1988-2022)

Sources: Ninety One, Bloomberg, data to 31 Dec 2023

Worries about a recession in the US and the likelihood of further market volatility have led BlackRock to shift its positioning away from US tech companies towards a broader set of opportunities.

The asset management giant has been investing in the artificial intelligence (AI) theme for some time, making it a key focus of its equity strategy. However, the latest update from the BlackRock Investment Institute explained how this has been tweaked.

Natalie Gill, portfolio strategist at BlackRock Investment Institute, said: “US recession fears and other factors have jolted markets. We could see more volatility flare-ups ahead of the US presidential election.

“We move from a US tech focus within our equity overweight, leaning further into a wider set of winners from the artificial intelligence buildout.”

The AI theme has dominated markets since the first large-language models (LLMs) such as ChatGPT were launched at the end of 2022, leading to stellar returns for companies involved in the emerging technology.

However, investors have become increasingly cautious on the theme in recent months amid worries that companies investing big into AI might have to wait some time to see the fruits of this.

As a result, some of the ‘Magnificent Seven’ (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms and Tesla) – stocks that soared thanks to their involvement with AI – struggled over the summer.

Performance of Magnificent Seven since the start of H1 2024

Source: FE Analytics. Total return in US dollars

Last week’s note from the BlackRock Investment Institute expressed confidence in the AI theme but reminded investors that patience will be needed to identify the long-term winners of this tech revolution.

It also outlined a three-phase roadmap to track the impact of AI.

In the first phase – which we are currently in – a buildout takes place as large tech companies race to invest in data centres. Early winners here include the big spenders and chip producers as well as firms supplying key inputs such as energy, utilities and real estate.

During the second phase, AI adoption expands to sectors beyond tech such as healthcare and financials. This may then lead to the third phase of broad productivity gains, although the size and impact of this are still uncertain.

Furthermore, the asset management house gave three ‘signposts’ it is using to assess the robustness of the AI investment theme: signs of stalling revenue growth at top AI companies; changes in still-low AI adoption beyond the tech sector; and any US growth downturn that could cause big tech companies to curb spending.

In the BlackRock Investment Institute’s latest update, Gill said: “We still favour the AI theme yet fine-tune our exposure. In the first phase of AI now underway, investors are questioning the magnitude of AI capital spending by major tech companies and whether AI adoption can pick up.

“While we eye signposts to change our view, we think patience is needed as the AI buildout still has far to go. Yet we believe the sentiment shift against these companies could weigh on valuations. So we turn to first-phase beneficiaries in energy and utilities providing key AI inputs – and real estate and resource companies tied to the buildout.”

WisdomTree is another asset management firm advocating for a broadening out from the immediate AI winners, although it is pointing investors to a wider range of opportunities than just other companies linked to the theme.

Aneeka Gupta, macroeconomic research director at WisdomTree, said leadership within stock markets remains “quite narrow”, attributing this to the “AI frenzy” and earnings concentration.

However, she expects the ongoing bull market to be maintained by policy easing from the Federal Reserve and growing earnings, although volatility could be pushed higher by the US election.

“The Magnificent Seven has been the most crowded trade amongst investors for 16 straight months. US equities have been more concentrated than at any point since the mid-1970s,” she added.

“A risk of returns being so concentrated within such a small segment of the market is that, when those companies fail to meet expectations, their performance suffers. [But] forward earnings growth looks set to expand beyond the current leaders.”

Comparison of earnings growth

Source: Factset, S&P, WisdomTree. Data as of 30 Jun 2024

Looking at areas that might benefit from broadening earnings, WisdomTree noted that the Russell 2000 index of small-cap stocks has lagged in its large-cap peers over the past decade.

While many investors have crowded into US mega-caps in recent years, Gupta suggested a barbell approach combining large-cap exposure with small-caps as a way to maintain a more balanced US equity allocation.

The strategist also pointed to value investing, especially in emerging markets, as an opportunity given that growth stocks have enjoyed more than a decade of outperformance in the developed world. European and Japanese equities are also highlighted for offering value.

Finally, she highlighted equity income investing as attractive and said ordinary dividends (excluding special payments) in Europe are expected to reach 4% this year, hitting a new high of €463bn.

Gupta finished: “Continued global earnings growth should lend a positive tailwind for a continuation of the rally.

“Yet global equity markets are not only concentrated by name but also by sector and factor, opening up a plethora of opportunities. The most attractive risk/reward prospects appear to be offered by overlooked areas of the market – small caps, dividend and value stocks.”

For years, Japan was the large developed market that many investors assumed they could ignore. If the returns of the past couple of years hadn’t put an end to that, the excitement of the past two months almost certainly did.

Having tumbled to a historic low, the yen spent July and August soaring 12% against the dollar. At the same time, the equity market plunged by almost 25%, wiping out a year of gains, before rebounding by more than 20%.

On top of that, after Japan became one of the few countries in the world without an election scheduled for 2024, prime minister Fumio Kishida’s decision not to stand in his party’s leadership election this month has made that a possibility, too.

Does any of this cast doubt on the positive outlook for Japan equities, one of the most broadly held views at the start of the year?

Beyond large-caps

Let’s start with the yen. The Bank of Japan is starting to hike rates just as the US Federal Reserve is getting ready to cut them. In response, the yen has bounced hard from its recent low.

Many commentators identified this move as the origin of the carry-trade unwind that ripped through global markets in August, especially through Japanese equities and US mega-cap technology stocks.

More volatility could come as more yen-funded leveraged positions are abandoned, but many hedge funds had been short Japan in anticipation of this carry-trade reversal. Also, the scale of the market rebound suggests that many of those positions were covered and we may have seen the worst.

Even so, further appreciation of the yen would have fundamental and technical implications for equities. In our view, one of the reasons Japanese large-caps have been performing so strongly is that these companies benefit directly from a weak yen by generating, by our estimate, some 60% of their revenues and 70% of their profits from overseas, in dollars.

Look beyond large-caps, however, and the story is very different. We estimate that Japan’s small- and mid-caps generate, on average, only 30% of their revenues abroad.

Moreover, many could even benefit from a stronger yen, as that would release funds for domestic consumption by reducing the cost of imported energy and goods.

This decline in consumer costs would be happening just as the government is pressuring employers to support real wage growth, which turned positive in July for the first time in two years. We think household spending is set for a sustained recovery after declining for much of the past 18 months.

We note that Japan’s Consumer Confidence Index has been climbing faster than economists’ expectations recently and that private consumption, which had been falling for a year, was a major driver of Japan’s strong second-quarter GDP growth.

These domestic consumption trends are likely to feed straight into Japanese small- and mid-cap companies’ top lines.

Rising rates and the rebound in yen are part of the necessary growing pains of an economy normalising after decades of stagnation and deflation. There will be volatility, but the trajectory is positive.

Shareholder value

How about the strong market rebound? Was that all just technical short-covering before another dip lower, or did it also reflect long-term investors buying on fundamentals?

We think investors appreciate the resilient fundamentals. Larger companies may miss an excessively weak yen, but they still reported robust second-quarter earnings and gave mainly positive guidance.

So valuations are lower now than they were in July, not just market prices. And with the yen apparently bottomed out, they look even more attractive to dollar, sterling or euro investors.

The longer-term trend toward focusing more on shareholder value remains in place, too, in our view. That is already translating into higher dividends, more share buybacks and stronger balance sheets.

We anticipate more of that as cross-shareholdings between public companies continue to be dissolved and company boardrooms are shaken up: June’s slate of annual general meetings saw further declines in support for director nominees at companies with governance issues.

That governance alignment is happening in response to growing shareholder activism, but also to keep the activists at bay. The number of shareholder proposals companies received during 2022, 2023 and 2024 was around double the norm in previous years, according to figures from Glass Lewis.

Household names in private equity, such as Bain, Carlyle and KKR, are setting up or expanding their Japan operations and launching dedicated funds, triggering a wave of management buyouts and takeover bids, often at meaningful premia to market prices.

We believe this growth of shareholder activism and M&A activity adds further support for small- and midcaps. These firms have lagged Japan’s larger, more internationally held companies on corporate governance, but outside pressure is now beginning to concentrate minds on boosting return on equity.

Between the market trough in October 2022 and the eve of this August’s sell-off, the MSCI Japan SMID Cap Index underperformed the MSCI Japan Large Cap Index by close to 25 percentage points. We think a sustained yen reversal combined with meaningful governance reform could go a long way to close that gap.

Active managers and engaged owners

Finally, how important might Kishida’s resignation be? He has been a market-friendly prime minister, building on the reforms of the late Shinzo Abe and Junichiro Koizumi, but his approval ratings of around 20% in several recent opinion polls had become unsustainably low and his resignation was therefore not a big surprise.

If the new Liberal Democratic party leader can command approval above 50%, the probability of Lower House elections in 2024 will rise. This might require a more populist pitch to the electorate, but all the leading candidates are in the economic mainstream of the party and, in any case, at the moment some consumer-friendly subsidies would be more likely to support than harm Japan’s economy.

In short, events in Japan over recent weeks have not changed the country’s fundamental investment story, in our view. They have merely made it slightly cheaper.

For active managers and engaged owners in Japan’s under-researched small- and mid-cap universe, in particular, we believe the long-term outlook will turn out to be even more exciting than the rollercoaster ride of August.

Keita Kubota and Kei Okamura are portfolio managers at Neuberger Berman. The views expressed above should not be taken as investment advice.

Companies paid out a record $606bn in the second quarter of this year, according to research by Janus Henderson, prompting the firm to lift its expectations for total income payouts across 2024.

The firm now expects companies around the world to distribute $1.74trn, up 6.4% year-on-year on an underlying basis and up from 5% at the time of the last report.

Jane Shoemake, portfolio manager on the global equity income team at Janus Henderson, said: “We had optimistic expectations for the second quarter and the picture was even brighter than we predicted thanks to strength in Europe, the US, Canada and Japan in particular.”

In total, some $606bn was paid out in the three months between April and June, up 5.8% year-on-year, while underlying growth was even stronger, up 8.2% once the drag caused by exchange rates, in particular the weak Japanese yen, was taken into account. Overall, some 92% of companies globally raised or held their dividend payments.

Source: Janus Henderson

The second quarter is an important one for income investors, marking the “seasonal high point” for European dividends as most companies pay a single annual dividend during this period.

A record high of $204.6bn was paid out by companies in the region, including record highs in France, Italy, Switzerland and Spain.

Meanwhile, in the US, large tech names such as Meta and Alphabet boosted the second-quarter numbers by initiating payouts. A total of $161.5bn was paid over the three months, up 8.6% on an underlying basis, although total payouts were only 7.1% higher as special dividends slowed.

“The initiation of dividends from big US media-technology companies, along with China’s Alibaba among others, is a really positive signal that will boost global dividend growth by 1.1 percentage points this year,” Shoemake said.

“These companies are following a path well-trodden by growth industries over the past couple of centuries, reaching a point of maturity where dividends are a natural route for returning surplus cash to shareholders.”

This has “confounded sceptics” who thought this would never happen and should “broaden their appeal” to include income investors, potentially encouraging more companies in the tech sector to follow suit, said Shoemake.

The biggest year-on-year rise came in the UK, with payouts up 13.8%, having dropped 10.4% in the second quarter of 2023. “The headline growth rate reflects the large special dividend paid by HSBC, which distributed the proceeds of the sale of its Canadian business,” the report noted.

However, underlying dividends rose just 0.7% as the mining sector cut heavily in the second quarter. Despite this, “in the UK, if you look beyond the impact the highly cyclical mining industry makes, dividend growth is encouraging,” said Shoemake.

Source: Janus Henderson

The only blemish was in Asia Pacific excluding Japan, where underlying dividends rose 1.1% year-on-year but the total paid out fell, largely due to a 24.3% drop in payouts from Australian businesses.

Woodside Energy, the largest payer in the second quarter of 2023, made a “very large reduction” to its payouts as profits fell due to lower commodity prices, inflationary pressures and asset impairments, the report noted. However, the second quarter is “not seasonally important”, it added.

At a sector level, banks were the biggest reason behind the uptick in global dividends between April and June, accounting for one-third of the underlying year-on-year increase. Higher interest rates in many developed markets have boosted their profits, which are being passed onto shareholders.

Insurers, vehicle manufacturers (especially in Japan) and telecoms were also important contributors to growth, the report noted.

“Around the world, economies have generally borne the burden of higher interest rates well. Inflation has slowed while economic growth has been stronger than anticipated,” concluded Shoemake.

“Companies have also proved resilient and in most industries continue to invest for future growth. This benign backdrop has been especially positive for the banking sector, which is enjoying strong margins and limited credit impairments, which has bolstered profits and generated a lot of cash for dividends.”

The FTSE 100 will be “the best-performing index bar none” in the next 20 years, according to Gervais Williams, co-manager of the Premier Miton UK Multi Cap Income fund.

It is an about-turn for the fund manager, whose fund rocketed higher in 2020 thanks to a put option it held against the FTSE 100 during Covid. This also benefited his Diverse Income trust, but last month the manager announced the investment company had pulled its FTSE 100 put option, something it had held for a decade.

The index has been performing well in recent times despite investors choosing to put their cash elsewhere. Outflows from open-ended UK funds have continued at “substantial levels” for the past three years, and yet, the FTSE 100 has beaten its record highs and broken out of its trading range on the upside.

Performance of index over 10yrs

Source: FE Analytics

Doing so when there is near-record levels of outflows by UK investors almost every month is “an extraordinary thing” and can be attributed to three factors, said Williams – buybacks, takeovers and, “most thrillingly”, international investors.

Many large-caps and some small-caps have been buying back their own shares in “vast amounts”, offsetting a lot of the outflows in the UK market, and to a certain degree, takeovers have done the same.

But ultimately, it’s international investors that will make the biggest difference, while domestic investors continue to sell.

“There is a little inkling of international investors with lots of capital growth strategies and exchange-traded funds (ETFs) just beginning to flex into a different way of making money, that is through good and growing income.”

Trustnet has reported on many industry experts tipping off income investing as a good option moving forwards, as income funds are poised to rebound as well as some sectors that are traditionally considered value powerhouses, including utilities, which should benefit from artificial intelligence (AI), industrials, consumer products and non-bank financials.

The comeback is fuelled by international investors realising that they don't want to be all-in on growth but need diversification in the form of income, at least at the margin of their portfolios.

"The UK is at knee height to a grasshopper, so even a flicker in the international markets makes a big difference to us,” Williams said.

“As we find that local investors sell less and perhaps international investors buy a tiny bit more, this UK breakout can be substantial.”

Performance of fund against sector and index over 1yr

Source: FE Analytics

Williams understands, however, that being able to say that the UK is “disgustingly cheap” is not enough. But when things are outperforming and they're getting into a sector that is outperforming, more investors come round to it and momentum builds, he explained.

This is what gives him the confidence to say that the FTSE 100 “will be the best-performing indices bar none for the next 20 years”, as the risk–reward ratio is now “very attractive”.

The manager had a taste of how substantial this turnover can be, as his Premier Miton UK Multi Cap Income fund went from being 73^rd in a 74-strong peer group, the IA UK Equity Income sector, over the past three years, to being the seventh over the past six months.

Last year, the fund was admittedly “very much the bottom of the heap”, as lots of other income funds focused on large-caps weren’t as badly affected as this strategy was, the manager said. Now that has reversed and, most notably, without stocks having moved. It was “a little tiny chink of sunlight coming our way”, Williams said.

“Large parts of the portfolio haven't moved, but the momentum has. This just shows that when things come, they don't just make money – they can make so much more return than most people expect,” he continued. “It makes you wonder what could happen if you get the rest of the stocks moving”.

This leaves an open door for the labour government to come in and push the market even higher through much-anticipated reforms, primarily to pension schemes, as Williams noted recently on Trustnet.

“It's unusual for governments to have the opportunity to influence capital allocation trends at when at the bottom of the cycle and things are beginning to move upwards,” he said.

His views were echoed by James Klempster, deputy head of the Liontrust Multi-Asset team, who said that, previously, many global investors may have deemed the UK political environment to be too challenging to merit adding to their UK positions, which has led to the UK to be an undervalued market.

“It could turn versus the other majors, however. It is hard to predict when, but it will not require a major catalyst,” he said.

“UK stocks have already had a relatively strong start to 2024 and its economy has surprised on the upside as the UK emerges from the shallow recession that started at the back end of 2023.”

The annual growth in employees’ regular earnings between May and July of this year was just 5.1%, the lowest wage growth since April 2022, according to data from the Office for National Statistics (ONS).

Pay growth including bonuses has also fallen in this period to 4% and, when adjusted for inflation, real earnings growth for the period was just 2.2% for regular pay.

Susannah Streeter, head of money and markets at Hargreaves Lansdown, noted that this would be good for interest rates and will “cement expectations” that the Bank of England will deliver two interest rate cuts before the end of the year.

Richard Carter, head of fixed interest research at Quilter Cheviot, added: “The Bank of England’s next interest rate decision is now just over a week away, and today’s data, alongside the inflation and GDP prints due out before it meets, will no doubt play a major role in whether it opts to reduce rates further or hold for now.

“Markets have been pricing in a more aggressive path of rate cuts in the US than the UK, and unless something remarkable appears in either of these prints it is unlikely we will see this change.”

However, analysts remain concerned about the labour market’s impact on people’s finances, with declining wage growth and the potential for rising inflation both hitting the public heavily.

Sarah Coles, head of personal finance at Hargreaves, said: “Already the barometer shows that just under a third of people still have poor financial resilience, and those on lower incomes, renters, single people and those who are out of work still have a horrible struggle to make ends meet.” 

Carter concluded: “The ONS data is also a lagging indicator, and yesterday's report from BDO suggested that, in August, the jobs market suffered its worst month in more than a decade as interest rates have started to bite.”

The US equity market has grown increasingly volatile, especially in the past couple of months. Questions have been raised over the likelihood of a recession and whether the ‘Magnificent Seven’ US stocks are coming off the boil, while the forthcoming presidential election augurs badly for investors who prefer certainty.

Yet the US has been the strongest regional equity market over the past decade, presenting investors with a conundrum: how can they hedge against downside risk without missing out on further potential gains?

One solution would be to choose a combination of strategies, pairing a defensively positioned fund with a growth-seeking strategy. To that end, Trustnet asked fund selectors to suggest pairs of US equity funds that complement each other and thrive in different market environments.

AB American Growth and Dodge & Cox US Stock

Invesco’s model portfolio service owns AB American Growth and the Dodge & Cox US Stock fund, said co-manager David Aujla. The former is a large-cap growth fund with significant positions in technology and durable growth companies, while the latter is a large-cap, value-oriented fund with “greater exposure to companies that could be described as more economically sensitive,” he said.

“Together this fund pair provides the portfolio with the potential ability to participate in US equity market performance whether it be a more momentum-led market or a valuation-led market. And we hope that over time the experience should be smoother as a result.”

Performance of funds over 5yrs

Source: FE Analytics

AllianceBernstein Sustainable US and Neuberger Berman US Large Cap Value

Schroder Investment Solutions has changed its line-up of US funds to make its portfolios more conservative, adding funds that own attractively valued companies with good fundamentals.

Portfolio manager Rob Starkey said Schroders used Dodge & Cox as its US value manager until October 2022 but switched to NB US Large Cap Value, which has larger allocations to defensive sectors such as consumer staples.

“The intention was to allocate capital to a manager that would vary its exposure to higher quality stocks depending on the environment,” he explained. Schroders’ model portfolios now have “a value tilt in the American allocation to reflect the risk/reward opportunity set”.

On the growth side, Schroders rotated out of Brown Advisory US Sustainable Growth into AllianceBernstein Sustainable US in the first quarter of last year.

“Brown Advisory, despite having similar metrics at the time in terms of quality long-term earnings growth, was a much higher valued strategy, so we wanted to shift to something that had less of a valuation risk while keeping those overall growth and quality metrics,” Starkey explained.

Performance of funds since NB US Large Cap Value’s inception

Source: FE Analytics

First Eagle US Small Cap Opportunity, Spyglass US Growth and Snyder US All Cap Equity

Downing has paired up two aggressive funds whose investment styles offset each other: First Eagle US Small Cap Opportunity and Spyglass US Growth.

Fund manager Simon Evan-Cook said these two strategies “might well be the most aggressive funds in the sector”.

Most US small-cap funds buy companies that would be considered mid-caps if they were listed in the UK, but First Eagle’s Bill Hench invests in minnows that would be considered small-caps on this side of the Atlantic as well.

“He is a proper deep value manager”, said Evan-Cook. Hench's philosophy is that if 10% of his holdings don’t go bust in any given year, “he’s probably not taking enough risk”. On the flip side, three out of every 10 investments will probably multiply tenfold.

The fund is highly diversified and geared into the US economic cycle so if the economy performs well it should deliver outsized returns, Evan-Cook explained.

Jim Robillard, chief investment officer of Spyglass Capital Management in San Francisco, operates at the other extreme of the style spectrum. He is looking for small and mid-cap growth companies that are “in the right place at the right time with the right tech to become five times bigger over the next five years”, Evan-Cook said. Robillard is “valuation aware”, unlike some high-growth investors.

With fewer assets under management, Spyglass can invest in small, growing companies, while its proximity to San Francisco close to many start-ups is also advantageous.

Performance of funds since First Eagle US Small Cap Opportunity’s inception

Source: FE Analytics

For a more conservative play, Evan-Cook highlighted Snyder US All Cap Equity. It invests in the highest quality companies in the US with strong competitive advantages, balance sheets, brands and management teams, but the firm also has a tight valuation discipline.

Evan-Cook compared the strategy to a Venn diagram with two circles encompassing the best companies and the cheapest companies in the US. Snyder is “trying to find that tiny little spot where the two circles cross over,” he said.

GQG Partners US Equity and Invesco FTSE RAFI US 1000 UCITS ETF

GQG Partners US Equity is a best ideas portfolio of 28 stocks managed by three FE fundinfo Alpha Managers – Rajiv Jain, Brian Kersmanc and Sudarshan Murthy – and it features on Bestinvest’s Best Funds List.

Jason Hollands, managing director of Bestinvest, said: “The approach is highly flexible and the managers do not shy away from making significant calls, which means relatively high turnover.

“For example, the managers significantly reduced tech exposure in May 2023. Part of their research approach is to use people with backgrounds in investigative journalism, which had helped them notice that job openings in tech were slowing, which they saw as a warning sign.”

Although he picked this fund for investors who are bullish on US equities, “the managers are very focused on downside protection,” he pointed out.

By contrast, the Invesco FTSE RAFI US 1000 UCITS ETF might suit investors worried about “frothy tech valuations” who want to diversify away from the S&P 500.

This exchange-traded fund (ETF) differs from market capitalisation-weighted trackers because it allocates to the 1,000 largest US stocks based on four fundamental factors: sales, cash flow, book value and average total dividends over five years.

“The outcome is broad exposure to the US market but with a tilt towards companies with attractive valuations and lower exposure to more speculative businesses,” Hollands explained.

In 2021, when the NASDAQ index plunged 24% and the S&P 500 was down 7.8%, the fund eked out a 1.8% return.

Performance of funds since GQG Partners US Equity’s inception

Source: FE Analytics

GLP-1 drugs such as Wegovy, Ozempic, Zepbound and Mounjaro have been the success of pharmaceutical companies Novo Nordisk and Eli Lilly since their approval as obesity treatment by the US Food and Drug Administration in 2021, but Ailsa Craig and Marek Poszepcyznski, managers of the International Biotechnology Trust, weren’t convinced they were a good investment until recently.

The two pharma companies above, together with United Health, make up the top-three names of the MSCI World Healthcare index, and have propped up its performance.

So much so, that its returns compete with the tech giants of the MSCI World index over the past three years, as the chart below shows.

Performance of fund indices over 3yrs

Source: FE Analytics

But the watershed moment for Craig and Poszepcyznski came after a study was released at the end of 2023 called Select, which triggered the managers to take the investment case in GLP-1 drugs more seriously.

“It was a major clinical trial showing that patients on GLP-1 drugs had a 20% reduction in cardiovascular events,” Craig said. “Before, the mindset was that obesity is not a disease, but a lifestyle issue. That trial changed all that. It was a real pivot for the whole space and it triggered us to take it seriously as well.”

It wasn’t only a change in perspective – the economic reason behind the investment was strong too. As the managers explained, what made the biggest difference is, once proven to extend or save lives, GLP-1 drugs be reimbursed by insurance companies.

This works even in places such as Europe, where a tender offer system is in place. As governments negotiate prices, proving that heart events such as strokes and heart attacks are reduced by the drugs allows the UK government to justify paying for these out of a small pot of public funds.

This change in conviction by the managers incidentally corresponded to a shift in backdrop that allowed them to allocate more money to the area.

Back in 2021, when Craig and Poszepcyznski had just taken over as lead fund managers, they took a defensive stance on the fund as they felt that things looked “quite bubbly and overvalued”.

“Now we think the inverse of that is true,” they said, and so, they are more ready to gear up (the current gross gearing of the fund is 8%) and tilt the fund out of the defensive names into the more exciting, earlier-stage names.

But the International Biotechnology Trust doesn’t own Novo Nordisk or Eli Lilly in its top-10 holdings. Its approach is to own a basket of names across a number of different technologies in developing stages, and GLP-1 drugs are no exception to that, as there are “lots of different ways people are trying to get a piece of that pie”.

Craig explained that many companies are at the early stages of developing improvements on different aspects of the medications available today, for example using tablets instead of injectable drugs or causing fewer side effects such as nausea or vomiting, all of which using different mechanisms.

“We are not putting all our eggs in one basket for the one next generation of product, we have four or five,” Craig said, “and then if a big pharma company acquires one, we're more likely to hit that, and the whole space will move up as well”.

Performance of fund against sector and index over 3yrs

Source: FE Analytics

Another widespread concern with Eli Lilly and Novo Nordisk are valuations, which for Craig are “very difficult” to judge.

“It is difficult to say if the valuations are justified at the moment, because we just don't know how much of the market Eli Lilly and Novo Nordisk are going to own. And it depends on all of these new companies succeeding.”

“But the sheer amount of potential competition around makes it quite unlikely that none will succeed.”

Her enthusiasm was also shared by Peel Hunt researchers Miles Dixon and Leolie Telford-Cooke. In a recent sector outlook they drew attention to an even more recent research paper, which found that, compared to a placebo, patients that received GLP-1s had lower rates of all-cause death, driven by a predictable reduction in cardiovascular death, but also – more surprisingly – non-cardiovascular death.  

Some limitations to this study mean that it does not actually meet the statistical threshold for significance, but the evidence seems to be accumulating momentum and GLP-1 drugs seem to be “the gift that keeps on giving”.

Following the market shakeout in October 2023, signs of recovery are starting to emerge. Even with the recent period of market volatility, it is worth noting that since the beginning of November 2023, the FTSE AIM index has recovered by 14%, whilst the Deutsche Numis Smaller Companies Index (excluding Investment Trusts) has increased by a very healthy 25%.

We can attribute this improvement to several factors positively impacting these markets, including steadying interest and inflation rates, the unexpected resilience of the UK economy, and the more recent political stability post-election.

So, while the recovery is in its infancy and the asset class remains cheap, the opportunity for investors is ripe.

Source: Lipper as of 9 August 2024

Whilst these returns over such a short period of time look excellent, they follow what has been a difficult period for the asset class.

We are increasingly of the view, however, that the market has seen the bottom and that we could be looking at an extended period of UK smaller company outperformance ahead.

UK smaller companies achieving significant long-term returns

Over recent years, what has been stark, has been the global equity market’s fixation on the performance of Nasdaq, and on a relatively narrow number of high-profile companies in particular – the so-called ‘Magnificent Seven’.

Recent US-led market volatility should remind investors of the risks associated with such narrow asset allocation, and the benefits of diversification.

If we consider the mid-to-long-term time horizon, as we suggest that most investors should do, it is worth reminding ourselves that returns from UK smaller companies have been comparable to the Nasdaq, despite the recent period of UK market malaise.

In the chart below we can see that, since the millennium, UK small-cap returns have slightly outperformed that of the Nasdaq, and that it is only since the recent ‘perfect storm’ of a derating of UK growth equities, coupled with a significant rerating of Nasdaq stocks, that US index’s returns have caught up with UK growth equities over this period. 

Source: Bloomberg and Octopus Investments. Covers period 03/01/2000 to 09/08/2024

Looking ahead, we expect UK smaller companies to once again deliver superior returns from their current levels as subdued valuation multiples continue to recover.

Our reasoning for this confidence lies in the strong underlying earnings fundamentals, and the material disconnect between operational performance and share prices currently seen in many stocks within the UK smaller companies sector.

UK smaller companies vs Nasdaq – similar growth expectations but very different valuations

Source: Factset as of 6 August 2024

Looking at the earnings growth expectations of the respective indexes above, you can see a comparable, and attractive, earnings growth profile for all growth markets highlighted – a healthy 20% compound annual earnings growth per annum.

Despite the similar operational return expectations from the underlying assets, with over two years of capital flows away from smaller UK growth companies, and a market fixation on Nasdaq recently, there is currently a significant valuation rating differential between markets.

Nasdaq is trading on a 25x price-to-earnings (P/E) multiple, whilst the other two UK growth indices are trading on 11x and 13x respectively. We suggest that this extent of valuation disconnect is unlikely to remain.  

A stable outlook for UK politics

Another major factor impacting markets has been the political fallout from the Brexit referendum and the period of political instability that ensued.

Ahead is the prospect of a more positive period of UK political stability following the commanding majority won by the Labour government in the general election. The message emanating from the party has been a focus on fiscal responsibility, and growth generation, both of which will be a further boost to UK equities.

This stability, when compared to recent history and developed market peers currently facing their own challenges, could serve as a catalyst for potential flows back towards the asset class.

UK smaller companies – the recovery potential from here

The resilience of the UK economy has been underestimated and we expect UK GDP growth to continue to compound at a faster rate than many of its G7 peers.

Interest rates, and relatively sticky UK inflation, have been additional factors impacting markets. Thankfully we’re now seeing levels gradually return to historic norms.

With all these factors aligning, we believe we are in the early stages of a market recovery. Clearly, it is difficult to assess exactly how far the market will recover but it’s worth reflecting on previous market trough to peaks.

Source: Bloomberg, as of 8 August 2024

Looking back over the past 30 years, recoveries following similar market pull-backs have been substantial, as seen in the encouraging returns highlighted above.

With the key concerns holding back UK equities now behind us, we strongly believe that we are merely at the beginning of a significant recovery period for UK smaller company equities.

Chris McVey is deputy head of Octopus Quoted Companies. The views expressed above should not be taken as investment advice.

Trustnet readers have been paying more attention to trusts in the global equity income, UK smaller companies and tech sectors this year, with one rapidly closing the gap with Scottish Mortgage.

The Baillie Gifford managed investment trust is the most heavily researched investment company among Trustnet users this year, accounting for 4.26% of the pageviews in the investment trust universe. As one of the biggest and best-known funds in the country, this should come as little surprise and the trust is always the most-viewed on Trustnet whenever this research is carried out.

JPMorgan Global Growth & Income, Alliance Trust, Polar Capital Technology Trust, F&C Investment Trust and City of London are other trusts with some of the highest factsheet pageviews on the website in 2024 so far.

However, a more interesting exercise is to find out the relative changes in research activity, to discover which trusts are receiving a higher or lower share of views than in the past.

To do this, we took all the factsheet pageviews in Trustnet’s investment trust section for 2024 so far and the whole of 2023 then worked out the percentage share of total research that each trust won. The difference between the two years indicates if a trust has been getting more or less research.

Source: Trustnet, Google Analytics

This table shows the 30 trusts with the largest increase in popularity along with their research shares for 2023 and 2024 to date and the change between these years.

JPMorgan Global Growth & Income comes in first place. In 2023, it accounted for 2.14% of the investment trust research on Trustnet but this has grown to 3.80% in 2024 so far; this moved the trust from being the ninth most popular last year into second place this year.

Indeed, the £2.6bn trust is closing the gap with Scottish Mortgage in terms of Trustnet pageviews on a scale we haven’t seen for some time.

In 2023, there were more than 2 percentage points between Scottish Mortgage and the second-most researched trust (F&C Investment Trust); there are just 46 basis points between JPMorgan Global Growth & Income and Scottish Mortgage.

Managers Timothy Woodhouse, Helge Skibeli and James Cook use a bottom-up approach to build a high-conviction portfolio of between 50 and 90 stocks. Top holdings include Microsoft, Amazon, Nvidia, Apple and Mastercard.

The trust has a strong track record – sitting at the top of the IT Global Equity Income sector over five and 10 years – and recently announced a significant increase in the dividend to be paid in the 2025 financial year (its 2025 dividend will be 23.6% higher than 2024’s).

Thomas McMahon, head of investment companies research at Kepler, said: “JPMorgan Global Growth & Income has delivered strong dividend growth as well as highly attractive capital returns in recent years thanks to the simple, yet effective strategy of asking the managers to invest in high-quality growth stocks without reference to their yield, while paying a dividend from capital where necessary.

“Investors have therefore arguably got the best of both worlds: index-beating total returns as well as a healthy dividend yield. Those who don’t want to draw an income from the strategy can simply reinvest the dividends back into the shares.”

But the move towards global equity income trusts is not confined to just this one. STS Global Income & Growth Trust and Invesco Global Equity Income Trust are another two with noticeable increases in factsheet pageviews.

Change in investment trust research on Trustnet between 2023 and 2024

Source: Trustnet, Google Analytics

Other broad trends can be seen when the Trustnet research numbers are collated by the Association of Investment Companies sectors.

Investors have been paying more attention to trusts in the IT UK Smaller Companies and IT UK All Companies peer groups than they did last year. This might reflect the growing hope that the UK could end its long spell of underperformance as investors respond to a stable government, attractive valuations and interest rate cuts.

However, there has been less research into IT UK Equity Income trusts as Trustnet users look to the global stage for equity income.

The IT Technology & Technology Innovation and IT North America sectors are also being researched more than in 2023, on the back of continued hype around artificial intelligence and the 'Magnificent Seven' stocks, while IT India/Indian Subcontinent trusts are benefiting from the very strong gains being seen in the Indian stock market.

Asset management giant Invesco has launched Europe’s first exchange-traded fund (ETF) tracking the MSCI World Equal Weight Index to capitalise on the popularity of passive funds.

This year there has been a marked rise in the money attracted by global equity ETFs, which accumulated more than $35bn in new assets over the year-to-date, making it second only to US equity for ETF flows in 2024 so far.  

While the MSCI World Equal Weight Index has performed poorly compared to the wider MSCI World Index, as the below chart shows, analysts at Invesco said the ETF range could be attractive to investors concerned about global market volatility and the rise in concentration among some of the world’s biggest companies – notably the US ‘Magnificent Seven’.

Performance of the MSCI World Index vs MSCI World Equal Weight Index over 3yrs

Source: FE Analytics

Indeed, the MSCI World index has reached its highest concentration in more than 40 years, with the top 10 stocks now representing 25% of the total index, meaning that short-term volatility such as poor results from firms such as Nvidia can have outsized impacts on returns.

Gary Buxton, head of EMEA and APAC ETFs and indexed strategies at Invesco, said: “The sharp equity market sell-off in July – while relatively short-lived – provided a timely reminder of how quickly individual company fortunes and investor sentiment can change.”

This overrepresentation of the top stocks can be seen in the composition of the S&P 500, which accounts for more than 70% of the MSCI World Index.

The charts below show two different depictions of the S&P 500, with the chart on the left showing the index divided by market cap, and the chart on the right showing the S&P 500 equally weighted, with each hold representing 0.2% per stock.

Breakdown of the S&P 500 by market cap and equal weights

Source: Liontrust, Bloomberg 31.07.24. *Representation of the ‘Magnificent Seven’

Analysts at Invesco added that this equal-weight approach would contribute to a more geographically balanced portfolio for investors, with the US allocation down to 42%.

Chris Mellor, head of EMEA equity ETF product management at Invesco, said: “That allows investors to capture increased exposure to Japan, the UK and other developed markets.”

The ETF joins Invesco’s existing S&P 500 Equal Weight and Nasdaq-100 Equal Weight UCITS ETFs.

Inflation affects all investors, whether they be in retirement or planning for the future. It is the minimal hurdle rate that all savings need to beat for the value of a cash pot to be worth more in the future than it is today.

As such, it is crucial to forecast the expected long-term rate of inflation so that investors can put their money to work accordingly.

Richard Champion, co-chief investment officer at Canaccord Genuity Wealth Management, said his firm is using a marker of 2.5% as the long-run average for UK inflation over the next decade.

This is higher than it would have been a decade ago when he said most experts were modelling their returns on inflation of 2%.

However, this undershot the reality. Following the rampant inflation between 2021 and 2023, the 10-year inflation average shot up to 2.8%, despite being subdued for much of the period. This gives him hope that 2.5% “isn’t a crazy number”.

UK CPI

Source: Office for National Statistics

Starting now, with inflation trending back to the 2% target coveted by central banks, Champion said there are reasons to believe that the Federal Reserve, Bank of England and others may have to accept a higher rate of inflation for some time to come.

“We think central banks will become more tolerant of 2-3% inflation than they have been before and there will be some evidence of that in the next few months as they cut rates even though inflation hasn’t got below 2%,” he said.

There are three main factors behind a higher long-term rate of inflation over the next decade than had been forecast for the previous one, according to the Canaccord Genuity co-CIO.

“It is not so popular at the moment but the greening of the economy is implicitly inflationary in terms of [the improvements needed in] the energy grid and infrastructure,” he said.

Another is the ageing of populations around the world, which he said “has some inflationary impacts”, although Champion noted this was “quite controversial” as others believe the trend will be deflationary.

Lastly, the onshoring of industrial capacity and the end of globalisation will create inflation, as people and companies have decided to trade off paying a bit more for the security that comes with sourcing products and services in their home market.

One example would be the move away from China as a manufacturing hub, particularly for US companies, who fear further sanctions between the two countries could cause difficult-to-navigate red tape.

Inflation has come back to the zeitgeist ever since it peaked at above 10%. Although returns from both equity and bond markets have been “nominally similar” in the 2020s so far compared to the preceding decade, in real terms it has been much tougher.

“In the 2010s central banks were giving out money for free, showering us all with money we didn’t need and it was quite easy to get real returns even if nominal returns weren’t particularly dramatic,” he said.

“We have had quite similar nominal returns so far this decade but we’ve got negative real returns. From a planner’s point of view, it is crucial to get the real number out at the end.”

He pinpointed 2022 as an example. On average, global stocks lost 7.8% over the course of the year, while bonds were down 5.7%. In comparison, the UK Consumer Prices Index was up 10.5%.

Performance of indices in 2022

Source: FE Analytics

“People say it was a correction but in real terms it was a bear market,” he said.

Going forward, however, Champion said there are signs that things are getting much better for savers.

At the end of 2021 and into 2022, when inflation peaked, investors and savers had few options available to them.

“Equity markets were at incredibly high valuations and bonds were generating hardly any yield, so were expensive. It was difficult from a planning point of view to say ‘how can I generate clients real returns over the short and medium term’,” said Champion.

Now, however, there are better prospects. Stocks outside of the ‘Magnificent Seven’ US tech names “don’t look too expensive”, while bonds and other assets such as cash are yielding far more than his long-run average inflation expectations.

Only four Baillie Gifford strategies out of 33 across all Investment Association sectors have achieved first-quartile performance over the past five years compared to their relative peer groups, data from FE Analytics has shown. Four more ranked in the second quartile, but almost 40% (12) didn’t rise above the fourth quartile.

These disappointing results are usually attributed to style. Baillie Gifford is renowned for favouring growth stocks, which have come under a lot of stress since the zero-interest-rates environment came to a close post-Covid.

If there is a soft landing and rates bottom between 3% and 4%, we will not get a repeat of the past decade’s boom in growth and the fund house might continue to struggle, according to director of Fairview Investing Ben Yearsley.

But this is not the only reason he finds for its underperformance, alluding to some “dubious” stock picking as managers got “so fixated on high growth that they missed the downside”.

“It felt like for a few years, they were missing the wood for the trees. Hopefully, the past few years will have made a difference to them in avoiding the obvious glaring mistakes,” he said.

One such mistake was bigging up Peloton after the bubble had burst, which “ wasn’t the most sensible”, according to Yearsley, who felt that “they got very entrenched and defensive in their approach” – all of which “probably cost clients.”

How much it cost them, however, depends on the strategies they were invested in. In the table below are the funds that underperformed the most, ranked by worst returns.

Source: FE Analytics

Baillie Gifford European was third quartile over 10 years and fourth ever since (over five, three and one year, as well as shorter time frames). The Global Discovery fund was never above the fourth quartile except in the past three months, when it was in the third and a similar fate befell Baillie Gifford UK Equity Alpha, another consistent underperformer.

Still challenged, but with a more nuanced track record, were Baillie Gifford American (which was first quartile over 10 years and seems to have turned a corner more recently) and the three IA Japan funds as well as Baillie Gifford Pacific (which all proved to be able to reach the first quartile of relative performance).

Turning to the more positive side, investors who bought the Baillie Gifford Long Term Global Growth Investment and Positive Change funds five years ago chose the only two Baillie Gifford funds in the IA Global sector (out of eight) to have achieved first-quartile returns over that period.

Source: FE Analytics

IA Global Equity Income and IA Global Emerging Markets funds are also less strained. In fact, Bestinvest managing director Jason Hollands said the Responsible Global Equity Income fund, managed by James Dow and Ross Mathison, is the only Baillie Gifford strategy on the firm’s recommended list.

“It is suited to investors wanting a sustainable approach and, due to its focus on stocks with dividend growth potential, has been less impacted by the style bias headwinds faced by other Baillie Gifford products,” he said.

Yearsley also liked Baillie Gifford funds that are less focused on all-out growth and “more nuanced”, such as Rodney Snell’s Emerging Markets Leading Companies and Spencer Adair’s Monks on the investment trusts side – both he described as “more rounded than many other Baillie Gifford managers”.

China and emerging markets have been more of an outlier in terms of style and “less ultra-growth focused”, Yearsley noted, as equity income tends to be an area less dominated by growth stocks and more skewed towards value.

To the question of whether investors should stick with Baillie Gifford funds, Yearsley said yes, provided they are part of a balanced portfolio.

“A few years back, many investors were caught with portfolios stuffed with Baillie Gifford, all nominally in different areas but highly correlated,” he said.

“Stick to Baillie Gifford, but ensure you have proper style diversification in your portfolio.” 

 Hollands agreed: “There is nothing to suggest this underperformance won’t prove temporary,” he said.

This is thanks to US rates likely to start declining this month, which “should broadly be supportive for the long-duration growth stocks” which Baillie Gifford’s managers typically favour.  

“Most investors focus on specific teams and products rather than arrive at an overall view of an asset manager unless it is going through a period of corporate upheaval or ownership instability; this is not the case with Baillie Gifford, which is a partnership owned by its senior professionals,” he said.

“This stability of ownership has led to strong retention of key people. I am sure Baillie Gifford will have its day in the sun again.”

Joe Richardson, discretionary investment manager at Dennehy Wealth, was more cautious.

“When you're renowned for having a style bias, things can quickly change depending on the environment and growth generally has been out of favour for a few years, so Baillie Gifford has seen outflows reflecting that,” he said.

“This does mean there could be more headwinds if value outperforms in the years ahead and it's obvious that valuations today are clearly stretched.”

Whether investors decide to stick to the fund house or not, Richardson warned them not to get caught up in fund manager worship.

“Like anyone, fund managers are flesh and blood and there are real dangers in putting them on a pedestal. No one manager is infallible and what matters is having a robust process and remaining disciplined in applying it,” he concluded.

James Budden, director of marketing and distribution at Baillie Gifford, replied: “Despite a difficult and extended period when growth investing has been sharply out of favour, we remain confident that many growth companies we currently own are resilient in terms of pricing power, sales growth, and operational leverage. Over the long term, share prices tend to follow fundamentals and recent operational progress has been excellent in many cases.” 

“As a result, we believe the market is underestimating the earnings potential of firms pioneering disruptive technologies, including artificial intelligence, synthetic biology, the digitisation of commerce, the electrification of transport and the transition to renewables. In addition, sentiment towards growth equities should improve from here given the pause and likely about-turn of interest rates and inflation.”

Asset managers previously covered in this series: Jupiter, Schroders, Liontrust, Fidelity and Artemis.