Monday, 31 October 2016

Time to get excited about market valuations?

Investors should be excited about attractively-valued and under-the-radar opportunities at the moment rather than worrying about the strong performance of most major indices. The increasing popularity of high-quality, dividend-paying stocks has led to industry ‘laggards’ trading on attractive valuations and the price of value plays tends to have an inverse relationship with their returns and is therefore seeing plenty of opportunities across markets.

This comes at a time when many investors have been worried about valuations, with a number of managers opting to position themselves away from traditional assets given low yields on bonds and strong returns of dividend-paying blue-chips. However, given the high levels of geopolitical and macroeconomic uncertainty on the horizon, many are continuing to buy dividend-paying stalwarts in a bid to protect their portfolios.

A general focus on yield has morphed into a focus on buying high-quality companies, which has in turn led to a select group of defensive mega-caps performing exceptionally well over the last five years. As a result, there has been a greater dispersion between this select pool of stocks and those which fall outside of this category.

The aggregate valuation suggests that market ‘laggards’ are historically cheap and, although past performance is no guide to future returns, we could be near a turning point where value stocks will outperform growth holdings. However, investors need to have a long-term time horizon to utilize this trend and this is why active managers have struggled to outperform recently – not only have expensive, low-volatility stocks surged in popularity and outperformed, they are often extremely large companies and are therefore well-represented in their respective indices.

As such active managers would have to hold incredibly high weightings in these businesses in order to beat their benchmarks and, given that such companies don’t tend to offer the best returns over the long term, they are often overweight smaller companies instead.

From a regional perspective, we are underweight the US market for valuation reasons.  When looking at the S&P 500 index’s price-to-revenue ratio versus its real rate of return (return minus inflation), the index achieves a stronger performance when it is on a lower starting value. As you would expect, the lower the starting value the higher the subsequent return, which is a good sign – starting valuations really matter.

Bear in mind that inflows at the moment are all into S&P 500 trackers. Wake up everybody – I don’t know what you’re expecting but there’s a high risk you’re going to be disappointed. Instead, the area of the market we see the most opportunities in is emerging markets, although isn’t a blanket call as there are lots of different areas and pockets of opportunity throughout the sector.

As with other major indices, there are larger companies which also account for large portions of the indices that investors would do well to avoid. In developed markets companies with growth potential – the Amazons, the Microsofts – they’re really well-recognised and you pay massive multiples for them.

In emerging markets, companies with very good growth potential are far cheaper. This is where your macro risk comes in. A lot of people were saying this time last year that emerging markets are very risky and, low and behold, they’ve been the best-performing equity region this year. We have seen this start to unwind a little but we still think it has a long way to go. If you look at the price-to-revenue metric again, the divergence between emerging and developed markets is almost back to where it was in the early 2000s which saw significant emerging market outperformance. As always seek professional advice where appropriate.

Wednesday, 12 October 2016

What’s wrong with active investment funds in 2016?

Given that active funds have struggled to outperform their benchmarks over recent months, why has this year has been particularly difficult for active managers? Only 25 per cent of funds within the IA UK All Companies and IA UK Equity Income sectors have managed to outperform the FTSE All Share index year to date, according to data from FE Analytics.

Out of these funds, more than a quarter of them are also passive investment vehicles, suggesting that active managers have had a particularly difficult time in 2016. Ultra-loose monetary policy, a cheaper pound and a surprisingly positive market reaction following the EU referendum results have been cited as reasons that the FTSE All Share index has surged over recent months.

Since the announcement of a vote for Brexit on 23 June the index has returned 9.12 per cent, despite the outcome widely being seen as being negative for financial markets prior to the vote. While the index has done well though, actively managed funds have struggled to outperform their benchmarks, with the IA UK All Companies and the IA UK Equity Income sectors underperforming the FTSE All Share by an average of 5.05 and 5.52 percentage points respectively since the start of the year with returns of 7.6 and 7.13 per cent.

This trend can also be seen outside of the UK, with the IA Global and IA Global Equity Income sectors achieving approximately 87 per cent of the returns of the MSCI AC World index year-to-date. What’s more, figures from the Investment Association shows that equity funds suffered outflows of £2.2bn in July, which is the most recent time period the data covers.

Given this backdrop, why have actively-managed funds struggled so much in 2016 when so many have managed to outperform their benchmarks during previous years?

Two things have happened this year: high beta has been rewarded, and of course, we have had a Brexit result. Both of these did not suit the style of managers who were more focused on quality and less cyclical earnings. Also a number of managers that positioned themselves for a ‘Bremain’ vote and thus struggled in the sharp rally just following the referendum.

When markets are largely driven by macro events, as in 2016, it makes it difficult for active managers to consistently outperform. Not only did the ‘leave’ vote lead to many market areas being sold off indiscriminately, a number of other macroeconomic factors such as the changing oil price and Saudi’s decision to limit production meant that unloved sectors suddenly surged. 

It could be argued that, if there are indeed periods where actively-managed funds are likely to underperform, it could be more cost-effective to hold passive investment vehicles instead such as index tracking funds. The trend towards passive funds has been growing for years and will continue to do so, given that most active managers tend to underperform passive funds over time generally.
Ultimately investors need to identify the above-average active managers that are out there and in particular avoid buying and selling them at the worst times. If they do these two things, they can achieve superior outcomes with active than they could with passive. While some investors might be tempted to reduce their active exposure and buy into passives given the recent underperformance of many funds, our preference is for both types of investment vehicle to be dynamically blended to maximise returns.

A change in sentiment based on short-term fund performance is likely to do more harm than good to investors’ portfolios, despite the challenging macroeconomic climate. As always, seek professional advice where appropriate.