At such a point in the cycle, a look at some of the more defensive options out there is worthwhile, with more available than the typical fallbacks of UK income and large-cap equities.
Towry’s head of investment Andrew Wilson is one of several wealth managers looking at client portfolios after such a strong run in equities and has been introducing greater exposure to what he calls non-traditional strategies.
“What has been noticeable is that correlations both between and within asset classes are falling, which benefits skill-based investment approaches,” he says.
“In this environment, an active approach with the widest available set of tools, such as through the incorporation of non-traditional strategies into portfolios, is essential to managing risk and return.”
For Wilson, areas such as volatility, macro and managed futures could be crucial to generating outperformance in the coming months.
“Stock markets have doubled over the past four years but are unlikely to do the same over the next four, while fixed interest yields are on a rising trend,” he adds.
“Rather than relying on these, we believe the time has come to make money out of the trends and volatility within markets and capturing the movement in currencies.”
Wilson highlights non-traditional funds such as Indus PacificChoice Asia, Majedie Tortoise, Schroder GAIA Egerton Equity and Morgan Stanley Diversified Alpha Plus.
Ups from the downs
The Egerton fund is run by John Armitage. As a long/short global equity offering, it can obviously benefit from falling as well as rising share prices.
“We are positive towards stocks not because we are optimistic for corporate profits or valuation,” says Armitage.
“We feel earnings will be supportive rather than exceptional and that valuations are only average – thus, to us, equities are ownable rather than dramatically undervalued, unless interest rates remain at their current very low levels.
“However, we feel high-grade businesses with strong balance sheets are far more attractive than fixed interest securities or cash, and that, after a decade of poor returns, too many natural equity owners remain under-invested in stocks.”
Elsewhere, James Calder, head of research at City Asset Management also owns various alternative funds but stresses these are an ongoing part of diversified client portfolios rather than a reaction to short-term market fears.
“Holdings that offer more in the way of downside protection include Troy’s Trojan and Ruffer Total Return and we also have a few infrastructure plays,” he says.
“Within equities, there are managers that give us genuine alpha but also tend to lose less in down markets such as Schroder Asia Total Return for example.”
Trojan manager Sebastian Lyon personifies a more cautious approach, expressing concerns about investors starting to believe in a “fairy-tale world of no downside, only upside”.
“The absence of scepticism has combined with an ever-present faith in the bounty of central bankers and shares have had a relentless re-rating over the past 18 months at a time when earnings growth has stagnated,” he explains.
“We have now reached the point at which few assets have the ability to protect investors from the opposing threats of deflation (leading to default risk) or inflation (which should lead to higher interest rates).”
Lyon says equities are behaving like ‘Giffen goods’, something that subverts normal rules of supply and demand because it is consumed in greater quantities the more its price rises.
“Stocks can appear remarkably similar – the more they rise in price, the more investors and corporates typically want to buy them,” he says.
“This is paradoxical because as equities rise in price, they offer less value and provide a likely lower future return. At Troy, we do not view equities as Giffen goods – the more stock markets rise, the less we hold in equities, while the more prices fall, the greater our allocation to stocks. Investors forget at their peril that gains made in euphoric times have a tendency to not be retained.”
At present, his portfolio is around 30% in equities, 15% in gold (10% direct and 5% in shares), 30% in index-linked debt and 25% across cash and Treasury Bills.
Cassandra’s bear
“We continue to advocate our belief in a secular bear market which, as in 2007, is being ridiculed today,” adds Lyon.
“These are uncomfortable times for investors with an eye on value and it is periods like these, when investment seems so easy and obvious, that are the most challenging for us.”
Among other fund pickers, Gary Potter, co-head of multi-manager at F&C, is broadly bullish on equities but has a few funds in his portfolios, such as Artemis Strategic Assets, to offer uncorrelated risk and returns.
Echoing Lyon, Artemis’ William Littlewood says his positioning is currently the most cautious it has been for some time.
“If markets continue to rally ahead of corporate fundamentals, we anticipate further reducing our net equity exposure,” he says.
“Our currency holdings, exposure to precious metals and short positions in bonds should prove invaluable as the crisis surrounding sovereign debt escalates.”
His main concern centres on quantitative easing, which the manager expects will one day prove highly inflationary.
“In the short run, politicians are likely to embrace so-called growth policies, which will almost certainly involve much more money printing,” he adds.
“It represents the easy way out for politicians and is also popular with electorates, as witnessed by the 70% plus opinion poll ratings the Japanese prime minister is currently basking in. Further out, I strongly believe these policies will be seen as a colossal mistake.”
Think inside the box
Of course, seeking more defensive strategies should not exclude mainstream equities and bonds and there are plenty of options in both areas. Jason Hollands, managing director, business development and communications at BestInvest, highlights a range of equity funds where the managers focus on undervalued companies, taking in Europe, emerging markets and the UK.
One of his picks is Threadneedle European Select, where Hollands notes companies being almost indiscriminately de-rated on macro news despite their businesses not relying on the eurozone economy.
“This has led to the biggest disparity in company valuations between European stocks and their US rivals in many years, providing investors with an attractive opportunity to buy quality businesses,” he says.
Hollands also picks out First State Global Emerging Market Leaders, Liontrust Special Situations and Fidelity MoneyBuilder Dividend as funds with a more value tilt.
Meanwhile, Tom Becket, CIO at PSigma Investment Management, offers up a number of options for a more difficult fixed income environment, including two segregated mandates run by Twentyfour Asset Management.
“The Focused Bond fund was set up in March 2012 for the sole use of PSigma clients and we can advise on overall risk levels, depending on the market environment,” he notes.
“We designed the product to reduce duration and interest rate risk, which is increasingly dominant in fixed interest funds. The unique factor is that the majority of the bonds will redeem within three to five years and all should be called by end 2016. This finite life reduces duration risk and offers a reasonable degree of protection against rising interest rates with a yield of around 7%.”
Compelling opportunities
A second segregated mandate focuses on residential mortgage-backed and asset-backed securities, which Becket describes as among the most compelling opportunities available in global markets.
“There are risks, namely illiquidity and volatility, but we believe the cheap prices of these bonds more than compensate,” he adds.
“Defaults remain very low due to their structure and quality, and even though the ongoing economic environment is uncertain, we believe the opportunity far outweighs the risk.”
Elsewhere, Becket also highlights short duration products from Axa focusing on US high yield and emerging market debt.
