Medium-risk portfolio returns in Q4 2014 were almost five-fold that of the previous quarter, up from 0.5% to 2.3%. Yet, despite that marked rise, there was no real change on the allocation trends seen in Q3.
Equity allocation continued to edge upwards, while fixed income, cash and alternative exposures all experienced slight declines.
A new low
One of the biggest stories of the quarter was government bond yields hitting historical lows, which ultimately led to UK yields on 10-year gilts dipping below 1.4% after quarter-end.
Understandably, managers were less than keen on holding short bond positions, as Dan Kemp, Morningstar’s co-head of investment consulting and portfolio management EMEA, explains.
“Like the rest of the market, we were underweight duration and bonds in general,” he says. “In 2014, bond fund managers with short duration in their portfolios struggled with the lack of rising interest rates and small-caps not outperforming as expected, so there was some repositioning towards the end of the year. Managers have now increased the duration in expectation of low interest rates for longer.”
However, corporate and strategic bonds were another story, as C Hoare & Co chief investment officer David Cavaye explains.
“We are happy to have exposure to flexible strategic and corporate bonds,” he says. “We have tended to run at a slightly higher-than-average bond position, about 26% of the portfolio.
That has helped during the recent decline in bond yields.
“The bond weighting is partly because the timing of interest rate increases has been moved out and there is still the opportunity for yields to go a bit further. But we will probably rein it in a bit as we move forward – in November we reduced from 30% overweight to about 10%.”
Rising above rates
While Kemp’s expectation is for government bond yields to rise, he conceded there is still room for them to fall even further.
He says: “They could certainly go lower and they are already so low that even an incremental change could make a big difference to the capital value. We often see this towards the end of a cycle, where rates become almost parabolic – overvalued assets become extremely overvalued.”
Cavaye agrees, and subsequently added a 3% long gilt weighting in January, taking his overall bond allocation up to 26%.
“We are probably going to get some negative inflation, which could drive yields down,” he says. “But we are getting to the point where we can look forward to interest rate increases. We added [the gilt position] because we wanted more duration while the numbers are coming through.”
Cavaye and Kemp are opposed on their equities outlooks, with the former highlighting Europe in particular.
A steady ship
Cavaye believes that while concerns over a Greek exit may have temporary implications, the sheer size of the European economy will keep the ship steady over the longer term.
He says: “We are quite keen on Europe at the moment and put in a greater position at the start of the year. “Economic numbers are improving and there is a quite a lot of catch-up in earnings compared with some of the other developed markets. We hedged the euro back into sterling for most of our exposure in anticipation of QE.
“We may reduce US equities as we could do with a little more earnings growth to justify a holding there. The US is performing reasonably well but I think there is value in other areas, such as Europe and Japan.”
“Most developed market equities and bonds look overvalued,” Kemp counters, “the US is the most overvalued.”
However, of Japan and emerging markets, which account for 4% and 6% of his portfolio, Kemp says:
“There is still some value in Japanese and emerging market equities, where we can see more exciting returns. We are overweight both.”
One area Kemp is particularly keen on is UK property, which represents all of his 8% property weighting.
“Our biggest overweight is in property,” he elaborates. “All of our property holdings are in the UK. One of the best decisions we made last year was making a conscious move towards secondary property, which was undervalued. It has been a great performer for us.”
“However, there have been a lot of latecomers arriving in the market,” he adds. “This is a concern, and we are now wondering if we should still be overweight.”