The Rathbone Global Opportunities fund manager explains why the gap between the strongest companies and the rest of the market will widen.
When FE fundinfo Alpha Manager James Thomson took over the Rathbone Global Opportunities fund in 2003, he wanted a simple but repeatable process that would enable him to scale up the fund over time.
This approach has proved successful, as the fund has returned 1,106.8% under Thomson’s 20-year tenure, ranking second out of 94 funds in the IA Global sector since November 2003.
The fund has amassed £3.9bn of assets and continues to be popular with investors. It was one of the top 10 funds for SIPPs on the Fidelity Personal Investing platform in May and was the tenth most-viewed fund on Trustnet during the three months to 20 May 2024.
Performance of fund under Thomson’s tenure and over 10yrs vs sector
Source: FE Analytics
Yet, Thomson believes that equity markets will generally be less rewarding going forward. However, he still sees glimmers of hope, for instance in artificial intelligence.
Below, he explains why the strong will get stronger, why the US is the ultimate growth market and why he avoids Japan and emerging markets.
Could you explain your investment process?
We want as many voices in the room as possible when we're generating investment ideas. We will use our internal analysts, but also a global network of external brokers and analysts. That's how we create a 360˚ view of the investment case. That feeds into our secret sauce analysis, which is a screen of qualities that we look for and qualities that we actively avoid.
The next step is to meet company management and try to understand the drivers of growth, the risks and the strategy and how they change over time. We want an ongoing relationship to understand where promises are being kept and where strategies are being changed and adapted.
Then we think about valuation, timing and suitability. Valuation has to be reasonable given the growth prospects. In terms of timing, we don't want an investment case that takes many years to come to fruition, we want a company that's firing on all cylinders now.
We also want to be able to manage risk effectively. That means having a defensive bucket of weatherproof equities. These are companies that have a more resilient defensive growth profile that's less linked to the economic cycle. That provides a buffer for the rest of the portfolio.
What differentiates you from your peers?
I think there are fewer than 100 UK-domiciled global equity funds that have been in existence for the past 20 years and I believe I am one of the few managers who have been in place for that time period.
Another thing that differentiates us is our willingness to admit that there are areas where we don't have skills and expertise. For example, we avoid investing in emerging markets or Japan. They are important parts of the equity market, but I don't have the skills nor the expertise to do it credibly. I think clients would be better off going to a dedicated emerging markets or a dedicated Japanese equity fund manager.
What have been your best-performing stocks over the past 12 months?
There's been a lot of market concentration around the Magnificent Seven, but I'm pleased that we've had a much broader contribution to our performance over the past 12 months. We own Nvidia and Amazon, but I would also point to businesses such as Costco, Boston Scientific and Amphenol.
Performance of stocks (in sterling) over 1yr
Source: FE Analytics
Outside the US, some of our best performers have been companies like Schneider Electric, which is a play on electrification, digitisation and upgrading electric networks, as well as Partners Group, which is a private equity business that has bounced back very strongly from the malaise in 2022 as rates were rising.
Next, the clothing and apparel retailer, has been a significant outperformer in a pretty soggy UK equity market.
Performance of stock over 1yr
Source: FE Analytics
And the worst-performing stocks?
It’s been primarily defensive, consumer-staple companies such as McDonald's, Coca-Cola, Mondelez and Heineken. It is not a surprise since the market has been looking for cyclicality, recovery in earnings potential and beneficiaries from falling inflation.
Performance of stocks (in Pounds Sterling) over 1yr
Source: FE Analytics
I would also highlight some of our China-exposed businesses such as LVMH, which has really struggled, particularly in its spirits division, and cognac company Remy Cointreau, which we have sold.
What is your view on equity markets hitting all-time highs?
I hope that's a precursor to earnings moving higher to reflect that. Valuation is often a poor predictor of future performance and expensive doesn't necessarily mean overvalued. Often, valuation is reflective of the quality of the earnings you are getting.
The US market is admittedly expensive, but you're paying for resilience, repeatability, adaptability and higher growth. So you're paying a premium in the US because you're getting premium growth credentials. The US really is the home of the growth investor.
What are the main investment themes in your fund?
I would put AI right at the top of my list of investment themes. The computer is no longer just instruction-driven, it is now intention understanding. It’s still early but we are already seeing applications. AI is used for drug discovery and development. Shopify told me that 30% of its coding is being done by generative AI. Video games are going to be produced in record time thanks to AI.
We're all probably going to have some sort of personal digital assistant that helps us with mundane tasks through generative AI.
One of my analysts thinks that AI is going to drive half of incremental GDP over the next decade and will represent 20% of global GDP by 2032. If that's correct, then this is the start of a new industrial revolution.
We have a broader theme called ‘the strong getting stronger’, which is about the increasing concentration of dominance, particularly in technology.
There’s going to be $275bn worth of capital expenditure within technology over the next year, but $200bn is being done by four companies alone.
It’s probably the most important theme we are running. In a world of slower and more inconsistent growth, we think the strong will get stronger.
In 2022, we changed about 20% of the portfolio and repurposed it into the stronger players. We sold some of the earlier stage companies with more expensive financing and an unpredictable demand picture.
We feel they will struggle to outperform in the current market, which is probably leading us toward a two-speed economy.
What do you do outside of fund management?
I have two daughters, so I help my kids to be as well-rounded, stimulated, happy and successful as possible.
I enjoy sitting on the sidelines of sporting events and I like playing tennis. The golf clubs seem to be attracting quite a lot of cobwebs and dust, but hopefully they will come out of the basement when the girls are a bit older.
Trustnet editor Jonathan Jones explores the impact rate cuts will have on markets.
This week, the European Central Bank took the lead on monetary policy by becoming the first of the big three central banks to cut interest rates.
It was the first time in five years the ECB has cut rates, with the Bank of England (BoFE) expected to join its peer from the continent in the coming months.
The big question is what the Federal Reserve will do. After all, experts have warned that the BofE and ECB can’t go too much further without the Fed doing the same, or risk currency fluctuations that would be prohibitive to their inflation targets.
Next week, the US central bank will meet for the fourth time this year, but there aren’t many signs it is gearing up for a rate cut.
Most expect the result to be the same as the previous three meetings: no change in the headline Fed Funds interest rate of 5.50%.
The CME Fedwatch service has a 2% chance of a Fed surprise drop of interest rates, which feels pretty conclusive.
Russ Mould, AJ Bell investment director, said: “As such, the wait for the first, elusive reduction in headline borrowing costs continues, especially as financial markets began 2024 expecting six rate cuts from the Fed, down to 4% by the end of the year, with the first of those coming in March.”
This has been scaled right back, with markets now predicting just two cuts in 2024 down to 5%, with the first one coming in September. Yet, even this is far from given.
“The Fed has to acknowledge that unemployment is low at 3.9% and inflation, as measured by the consumer price index, is 3.4%, still some way above its 2% target,” Mould said.
“The Atlanta Fed’s Sticky-Price CPI index is up 4.4% year-on-year, to suggest the central bank has more work to do, especially as producer prices and the Fed’s own preferred measure, the Personal Consumption Expenditure index, are showing fresh signs of heating up, rather than cooling down.”
As such, most predict the Fed is a few months away from starting its rate cutting cycle – as is the Bank of England, which could hold off to move in lockstep with its US counterpart.
For investors, it means the discount rate applied to growth stocks will remain higher for a little while longer, but there is still a general trends lower.
In the coming months, the likes of the big tech names should start to face an easier time of it from a macroeconomic perspective – as if they needed the help.
Cash rates will start to drop, although rates are not expected to plummet, which should mean they remain relatively attractive, while bonds too could thrive as yields start to drop.
In all, it could be a strong period for investors, who will have a litany of options to choose from to make money. At least that’s the theory.
In practice, these things are never straightforward and other shocks could derail any sort of stabilisation from the macro picture. Solid research and decision making will remain key, even if it seems as though the future looks bright.
Experts stick with the multi-boutique house despite some of its funds underperforming.
Having a consistent investment process is key in asset management, and a good manager will stick to their approach even when it is out of favour.
This has been happening to some of Liontrust Asset Management’s funds recently, particularly in UK small- and mid-caps, but experts agreed that the group’s overall offering remains strong.
Liontrust can be described as a “multi-boutique” whose teams have their own distinct processes and franchises, and its business model is based in part on strategic growth through acquisitions.
One thing the firm has got right with this model is retaining key talent, said FundCalibre managing director Darius McDermott.
Historically, Liontrust’s flagship has been the Economic Advantage team, which manages a range of UK equity funds, including Special Situations, UK Growth, UK Smaller Companies and UK Micro Cap.
The long-term track record of these funds is strong, with the UK Smaller Companies fund being the top performer in the 40-strong IA UK Smaller Companies sector over the past 10 years.
Over five years, UK Growth and Special Situations have fallen into the second and third quartile, respectively; Special Situations stayed in the third quartile over the past one and three years.
Historically, small and mid-cap stocks contributed strongly to the Economic Advantage funds, but weak investor sentiment towards these areas has impacted their performance in the past few years.
A Liontrust spokesperson said that the team remains “passionate believers” in the long-term compounding potential of the entrepreneurial, high-quality smaller companies in which they invest – and so did McDermott.
He emphasised the “excellent” long-term track record under FE fundinfo Alpha Managers Anthony Cross and Julian Fosh, who have returned more than 100% to investors over the past decade. McDermott said this is “concrete proof that the process of targeting companies which must have intellectual property, a strong distribution network or recurring revenues holds up well over the long-term.”
Jason Hollands, managing director at Bestinvest, agreed: “I’ve long been a fan of the overall approach, which has delivered very consistent performance. Liontrust UK Growth is also a Bestinvest top pick for the UK market.”
A prime example of Liontrust’s multi-boutique and inorganic growth strategy is the 2017 acquisition of Alliance Trust Investments, now the Liontrust Sustainable Investment team, which manages the Sustainable Future range of strategies.
For this range, 2022 was the most challenging year since inception in 2001. Only the Corporate Bond and the Monthly Income Bond funds managed to buck the downward trend, while the European Growth fund has been anchored to the bottom quartile of performance and Global Growth steadily fell from the second to the third, then the fourth quartile – as shown in the table below.
Source: FE Analytics
According to a Liontrust spokesperson, this was due to a series of headwinds, including an abrupt change to the macroeconomic backdrop, higher bond yields and weakness among the growth-focused and quality stocks in which the team invests.
Nonetheless, stocks in the Sustainable Future funds “delivered growth despite the low growth economy”, he said, which is “testament to the structural nature of the themes the team invests in, which the managers believe have strengthened, such as energy security, innovation in healthcare and environmental efficiency”.
For Hollands, the Liontrust Sustainable Future Growth fund’s underperformance “isn’t a surprise” and is “not problematic either”. Most environmental, social and governance (ESG) funds have underperformed, given they missed out on the rally in energy and commodities, he explained.
Hollands still regards the Sustainable Investment team as a jewel in Liontrust’s crown.
The Sustainable Future multi-asset offerings have also faced challenges, said McDermott, but are backed by “one of the most experienced and well-resourced teams in the game”.
“We retain confidence in their ability to deliver long-term growth, especially considering the continued relevance of the themes the team invests in – energy security, healthcare innovation and environmental efficiency,” he concluded.
Some funds attached to other investment hubs within Liontrust have also underperformed, including the Global Smaller Companies and US Opportunities funds, as shown below.
Source: FE Analytics
The US Opportunities fund is managed by Hong Yi Chen, who joined Liontrust when it acquired Majedie Asset Management in 2022. The fund has just been moved into the new Liontrust Global Equities team headed by Mark Hawtin. Its investment process has evolved to focus on companies with the potential to exploit change and with catalysts to unlock value.
But the area where Hollands was most sceptical was emerging markets.
Liontrust’s China strategy came 30th out of 36 funds by 10-year performance and has been relegated to the third quartile over the past one, three and five years; the Latin America strategy was the bottom fund in the nine-strong sector over five years.
But Hollands was more concerned about Liontrust Emerging Markets, which came to the group in October 2019 via the acquisition of Neptune Investment Management.
“It is a tiny fund at £9m and appeared in Bestinvest’s last Spot the Dog report as a serial underperformer. At such a small size and with its recent track record, I doubt it is viable,” he said.
Liontrust said most of the underperformance derived from its overweight positions in large-cap technology shares during 2021 and early 2022, which were costly due to a downturn in the semiconductor industry.
Additionally, Brazil dragged on performance as the team’s expectations of recovery initially proved too optimistic – although during the past year, Brazil’s recovery has been a positive contributor to performance.
Asset managers previously covered in this series are Jupiter Asset Management and Schroders.
After election-related volatility settles, consumption stocks are expected to benefit from new populist policies while infrastructure spending could slow down.
India’s election results have surprised everyone, unleashing a week of volatile swings in one of the world’s most expensive and most-watched stock markets.
Indian equities hit an all-time high on Monday 3 June in anticipation of Narendra Modi’s Bharatiya Janata Party (BJP) achieving a majority. The stock market then plummeted as results from the early vote count rolled in. A coalition government now appears the most likely outcome.
Peeyush Mittal, who manages Matthews Asia’s India strategy, expects “volatility to continue as the next government takes shape”.
The new coalition government is likely to introduce more populist policies to drive consumption but will probably hit pause on infrastructure spending, which had been a priority for Modi, Mittal said. As a result, he expects sectoral leadership in the stock market to change in favour of consumption stocks, away from capex-led themes.
“We think capital goods and infrastructure-related sectors spanning industrials and materials will face headwinds in the near term and associated stocks will likely be negatively impacted. There are grey areas, such as power and defence, which should be less affected as these are less sensitive to partisan issues,” he said.
“But it will be consumption-related sectors like consumer staples, traditionally strong areas like pharmaceuticals, and other areas that may be more favourably looked upon by an evolving coalition that could fare the best in the coming weeks.”
Mittal pointed out that consumption growth has been weak in India despite strong GDP expansion during the past two years, which he said indicates there are not enough employment opportunities for lower income groups.
“Post-Covid, the economic recovery in India has been K-shaped, with some sectors and socio-economic groups bouncing back while others have struggled and experienced a loss of savings, particularly citizens on lower incomes and those in rural areas,” he said.
He thinks consumption growth needs to improve for GDP growth to be sustainable.
Mittal also warned that small and mid-cap stocks are likely to experience prolonged volatility given their elevated valuations.
Amol Gogate, manager of Carmignac Portfolio Emerging Discovery, was more bullish about India’s prospects, even though managing a coalition could slow down the government’s pace of execution.
“While the election results are certainly a dampener for the markets and sentiment in the short term, they also showcase that India is a true democracy. And with Modi at the helm, it seems likely the next phase of economic development will proceed and the long-term investment case for India, for now, remains solid,” he said.
Investment into India’s bond markets is set to spike as a result of India’s inclusion in JP Morgan’s emerging markets government bond index this month and Bloomberg’s emerging market local currency index in September 2024. These events could bring in up to $40bn of foreign investment, which Gogate thinks will have a ‘halo’ effect on Indian equity markets as international investors become more familiar with the country.
“This capital boost, combined with Modi’s pro-business stance and a well-managed domestic financial system means Indian markets are poised to continue their upward march. However, with valuations already high, and a less certain political landscape, volatility may increase, so selectivity is becoming more important,” he explained.
His outlook for the stock market differs from Mittal’s. “In our view, small and mid-cap firms will benefit from a likely capex upcycle, as well as the financial services, high-end manufacturing and real estate sectors. The most disruptive businesses, with the highest potential for rapid growth will emerge on top thanks to a highly supportive ecosystem for budding companies,” Gogate said.
John Pattullo, co-head of global bonds at Janus Henderson, plans to retire in March 2025, leaving Jenna Barnard as sole head of the team.
Janus Henderson Investors’ co-head of global bonds, John Pattullo will retire in March 2025 after 27 years with the firm.
Jenna Barnard will assume sole leadership of the global bond team and retain portfolio manager responsibilities for the funds she runs alongside Pattullo, with whom she has worked for 20 years.
They both co-manage the £2.3bn Janus Henderson Strategic Bond fund and the £1bn Janus Henderson Fixed Interest Monthly Income fund, among others.
Nicholas Ware, who has been a fixed income portfolio manager at Janus Henderson since 2012, will become a named portfolio manager on all Janus Henderson’s strategic bond and developed world bond funds as part of the firm’s succession planning.
Analysts at RSMR said the Strategic Bond fund is a core option for conservative investors, with an emphasis on quality, capital preservation and consistent returns. Performance has trailed the sector average over five years, as the chart below shows, but RSMR’s analysts said this fund tends to perform better in risk-off markets.
Performance of fund versus sector over 5yrs
Source: FE Analytics
Barnard and Pattullo employ a thematic macro framework, looking at the structural drivers of economies such as excessive debt, inequality, globalisation, demographics and technology. “This approach results in more of a holistic view of what the managers term the ‘climate’ of investing and provides a framework which excludes a lot of the short term market noise,” RSMR explained.
Barnard and Pattullo describe their philosophy as “sensible income”, with the goal of delivering consistent returns via an understandable investment approach.
“The ‘sensible’ theme results in a large proportion of the investment universe being screened out,” RSMR analysts said.
“As you might expect, the screen removes highly cyclical and operationally and financially leveraged issuers and it also excludes industries and companies that fail to consistently generate value. The team is essentially looking to invest in quality credits and avoid unstable, risky sectors and companies.”
The recent rally may be a taste of things to come for the UK’s smallest companies.
The role of AIM stocks in tax mitigation is well-established; however, in recent years, with AIM impacted by broad disillusionment with the UK stock market, it has been harder to make the investment case. This has resulted in the valuations of many AIM companies hitting all-time lows, but there are several catalysts now evident that should help improve the performance of the index.
The UK’s smallest companies have been widely unloved. They have been on the front line of negative sentiment towards UK stocks and seen as more vulnerable to weakness in the domestic economy. They have been on the wrong end of a general flight to safety among investors. Rising interest rates have also been a headwind, with the valuations of smaller growth companies regarded as more sensitive to higher borrowing costs. However, markets tend to overshoot, and we see real value emerging today.
Operationally, many of the AIM businesses in which we invest have proved sound. They have continued to deliver strong growth despite a more difficult economic environment and have proved resilient in the face of higher interest rates. The combination of weaker share prices and stronger earnings has left many companies looking attractively valued, relative to their larger capitalisation peers.
A contributing factor has been a widespread misunderstanding of the relative risk of AIM companies. While there is certainly higher risk associated with speculative companies within the index, there are also plenty of well-established companies with strong business models, low debt and clear visibility on earnings.
An example of the latter is James Halstead, which manufactures and supplies flooring for commercial and domestic use. Its end markets include defensive sectors such as health and education, reducing exposure to the broader economic environment. It has cash on its balance sheet and the Halstead family still has a significant share of the ownership.
Valuations
Hardened investors understand that markets can often take time to reach a turning point and recognise that even cheap stocks can get cheaper before they recover.
The UK entered a technical recession at the end of 2023, which will do little to draw investors to its smaller quoted companies. Nevertheless – applying the caveat that stock picking rather than market timing is our strong suit – we are starting to see some green shoots.
While the economic environment remains lacklustre, it is slowly improving. Inflation has come down significantly and is likely to fall further over the next few months.
Previous peaks in inflation, such as those in 1975, 1980 and 1990, have been followed by remarkably strong performance from the UK’s smallest listed companies. In the three-year period following each of these peaks, total returns were 219%, 111% and 74%, respectively. (These statistics are based on the Deutsche Numis UK Smaller Companies index, the bottom 10% by size of listed companies, as it has a far longer track record than the AIM index.)
The Bank of England has hinted that rate cuts are on the horizon, even if it has been circumspect on the extent and timing of any cuts. AIM companies have shown inverse correlation with UK gilt yields; as interest rates rally, so gilt yields decline and the performance of the AIM index starts to revive.
We believe that as bond yields start to drop, it should help reverse some of the negative sentiment that has weakened the AIM market.
IPOs and M&A
There are also tentative signs of renewed optimism in the initial public offering (IPO) market. Last year was a fallow one for IPOs, but there have been encouraging signs of renewed activity over the past four months.
We've seen some interesting companies joining AIM; from disruptive fintech companies to England’s leading winemaker, which is starting to broaden our investment opportunities.
There has also been a revival in merger and acquisition (M&A) activity. While big deals such as those for Currys and Direct Line gather headlines, there is plenty of activity at the smaller end, with private equity and strategic acquirers buying up higher-quality companies at lower prices.
Political support
We also see a growing cross-party recognition that the UK isn’t doing enough to encourage investors to support British business. Most recently, this has been acknowledged by the introduction of a British ISA, which extended the tax-free allowance for investment in UK-listed companies.
There are also moves to encourage UK pension funds to invest more in UK equities (including AIM), starting with a disclosure regime. In the longer-term this may galvanise investment into smaller listed companies.
The recent rally may give a taste of things to come for the smaller end of the market. We believe a renewed optimism around the prospects for smaller companies will start to be reflected by the AIM index.
Of course, good stock selection is essential. The AIM index is a broad church, with a rich diversity of sectors and companies. Of the top 10 holdings in the index, only two are from the same sector.
The highest sector weighting in the index is in industrial goods and services at 15%, but technology (14%), consumer products and services (12%) and travel and leisure (10%) also make up a meaningful chunk of the companies.
There are over 650 companies currently listed on AIM, with up to £2.4bn in market capitalisation and many paying attractive and growing dividends.
There will always be companies that fail, or that struggle to manage costs effectively. However, careful stock selection can filter out the problematic companies, while focusing instead on those high-quality businesses with strong balance sheets and high returns on invested capital.
Overall, the quality of AIM stocks is as high as it has ever been, and we continue to find a wealth of choice for all our portfolios.
Simon Moon is co-manager of the Unicorn UK Smaller Companies fund. The views expressed above should not be taken as investment advice.
As anticipated, the European Central Bank has cut interest rates ahead of the Federal Reserve.
The European Central Bank (ECB) has lowered interest rates by 25 basis points, moving ahead of the US Federal Reserve in initiating cuts. As a result, , the ECB’s deposit facility rate stands at 3.75%, marginal lending facility at 4.5% and the main refinancing rate at 4.25%.
This cut was widely anticipated as the 2% inflation target in the Eurozone seems to be within reach.
Lindsay James, investment strategist at Quilter Investors, said: “While this news was well expected, it will no doubt provide relief to consumers and businesses on the continent. Ever since Russia’s invasion of Ukraine, Europe has struggled to combat the economic shock this produced, but signs are now improving, although uneven across the continent.
“While inflation has ticked up in recent months, the economic recovery is beginning to play out. This puts the ECB in a good position to cut further into a slowly improving picture, although the messaging is likely to remain restrained and cautious. As such, there may be some pauses on the way back down for rates in order to limit the scope of any divergence with the Federal Reserve.”
Yet, Neil Birrell, chief investment officer at Premier Miton Investors, warned that the path to further cuts will not be predictable or smooth, as inflation in the Eurozone is proving resilient.
For instance, the ECB has upgraded its economic projections, now forecasting inflation at 2.5% in 2024 and 2.2% in 2025, compared to the previous estimates of 2.3% and 2%, respectively.
Gurpreet Garewal, macro strategist, global fixed income at Goldman Sachs Asset Management, agreed. “The future trajectory of easing remains uncertain, given positive momentum in recent inflation and activity indicators, alongside cautious commentary from the ECB. We expect policymakers to maintain a data-dependent approach,” he said.
“We are closely monitoring inflation expectations, wage trends and services inflation. These are key indicators of inflation persistence that will determine the pace and scope of the ECB's rate cutting cycle. The Fed’s decisions and the euro's trajectory may also influence ECB policy in the second half of the year. We currently expect the ECB to adopt a gradual, quarterly easing strategy.”
However, Harry Richards, investment manager for fixed income at Jupiter Asset Management, believes that further cuts will be required as policy is still too restrictive, considering the likelihood that weak growth will persist and inflation will continue its "slow march" towards the target.
“We do not expect a 'one and done' scenario but, instead, believe we are on the brink of a full rate cutting cycle which should help to underpin returns within the fixed income space over the medium term,” he added.
Richards also believes that the Fed will follow suit in the coming quarters, as the labour market is softening, consumer weakness becoming apparent and shelter inflation fading.
“They may also fear unleashing the dollar wrecking ball if they do hold rates higher for too much longer whilst other developed market central banks are easing,” he said.
Finally, Quilter Investors’ James expects that today’s ECB decision may influence the Bank of England which is set to meet on 20 June 2024.
“The major central banks will not want to diverge too far from one another, and with political risk being ratcheted up, they also won’t want to be seen as too influential,” she concluded.
All three UK equity sectors are now among the highest returning of the year, Trustnet finds.
UK smaller companies funds have jumped to the top of the 2024 performance charts thanks to “sellers’ exhaustion”, a recovering economy and increasing mergers and acquisitions (M&A).
According to FE Analytics, the average fund in the IA UK Smaller Companies sector made a 10.8% total return over the first five months of 2024 – making it the highest-returning peer group.
The average smaller companies fund is even beating the IA Technology and Technology Innovations and IA North America sectors, which have been buoyed by the continued strength of the Magnificent Seven stocks.
The IA UK Equity Income and IA UK All Companies sectors hold fourth and fifth places year to date, with respective average returns of 8.5% and 8.1%.
Average return of Investment Association sectors over 2024 so far
Source: FinXL. Total return in sterling between 1 Jan and 31 May 2024.
This is a stark turnaround from earlier in the year, when the three UK equity sectors were much lower down in the performance tables, and is down to some strong returns from the UK in May.
Simon Evan‑Cook, fund manager on the VT Downing Fox multi-asset range, said: “The asset class has been so hated, and therefore heavily sold, that there are just fewer disillusioned souls left to sell them down.
“This is borne out by talking with our fund managers, who tell me that stock prices are no longer being eviscerated if the company reports slightly disappointing results. This had been the norm for the last few years, and this change in behaviour has the ring of sellers’ exhaustion to it.”
Source: FinXL
Rob Morgan, chief analyst at Charles Stanley Direct, added: “This rally has been a while coming. The area has long been cheap but what it lacked was a catalyst to break through persistent negative sentiment and reverse the flows out of UK assets that had been depressing share prices.”
He said a number of factors have combined to “tentatively” turn the performance of UK funds around, one of which is an improvement in the domestic economy. Although the UK’s economic numbers are “still not great”, they are better than many feared and support improving sentiment.
“When things seem very negative, a bit of good news goes a long way,” Morgan said.
He also pointed to positive trends at a company level. FTSE 100 companies with international-facing businesses have benefitted from the strength of the US dollar, which increases the sterling-dominated earnings and has led strong company results. Meanwhile, sectors such as energy, mining and defence, which are big constituents of the UK market, are benefiting from rising demand.
Snapshot of UK equity market over 2024 so far
Source: FinXL. Total return in sterling between 1 Jan and 31 May 2024.
Both Evan‑Cook and Morgan credited increased M&A as a positive for the UK. Years of underperformance from UK stocks has left them attractively valued when compared with international peers, leading to a series of approaches.
“In UK small-cap world it’s become common to hear the refrain ‘they’re so cheap that if you don’t buy them, somebody else will’,” Evan‑Cook said. “Turns out that was true, because all of a sudden corporate and private equity buyers are snapping up UK companies like it’s the end of an episode of The Apprentice.”
Morgan also argued that this creates a halo effect that bolsters sentiment towards the whole market, not just the target businesses themselves.
While all these factors are supportive of UK equities, they may have had a disproportionate impact on smaller companies.
“As the most undervalued parts of the market, UK small- and micro-caps have risen the most as sentiment has turned,” Morgan explained. “It’s also where liquidity is more limited so even a little bit of an uplift in interest can have a big impact.”
But whether the recent rally has legs is a more difficult question.
Morgan expects the M&A theme to continue to underpin valuations, but said it may not boost all stocks equally. Buyers such as private equity investors look for very specific characteristics in a target company, so the main beneficiaries would likely be active managers who are seeking the same qualities and who thereby end up owning natural M&A targets.
“Meanwhile, more extensive than expected interest rate cuts is a tide that would lift all the boats. Unfortunately, it isn’t that likely, but the gradual impact of lower interest rates further out should still help,” he finished.
“Finally, for UK small-caps the performance of the domestic economy is influential. Expectations are pretty low, so continued growth, albeit at a sedate pace, would create a benign environment.”
Retail investors in the UK continue to shun their domestic stock market despite its strong performance.
UK equity funds suffered their second-highest outflows on record in May, with domestic retail investors withdrawing £1.1bn despite strong performance since late February, according to the latest Calastone Fund Flow Index.
Calastone attributed these outflows to profit taking after the recent rally. Edward Glyn, head of global markets, said: “While buoyant markets usually attract new capital, many investors have seemingly chosen the UK rally as an opportunity to jump ship rather than a moment to reappraise the UK’s prospects.
“The election announcement made no difference to selling patterns during the month – this is a long-term trend of selling, not a news-driven flurry.”
On the other side of the Atlantic, US equity funds took in £826m in May, which was six times the long run average but one-third lower than April’s inflows.
Equity funds with environmental, social and governance (ESG) principles garnered £581m in May, with most of this money going to North American strategies.
“The heavy weighting of many US tech stocks in ESG funds helps explain why this is happening,” Glyn said.
“If we exclude North America, ESG-compliant funds have continued to suffer outflows in recent months. So what is going on? Investors can obviously buy funds that only invest in technology stocks though these are small in size, but they may be picking North American ESG-compliant funds as an alternative route to tech exposure.”
Global equity funds raked in £1.4bn and European equities attracted £462m in May.
Meanwhile, fixed income funds were hit by outflows for the first time since October 2023 as inflation data in the UK and US disappointed markets, rate cut expectations were pushed out further and bond yields remained high. Net outflows of £643m marked bond funds’ worst month since March 2020 and second-worst month during Calastone’s almost 10 years of data.
“The prospect of interest rate cuts in the US and the UK has receded yet again, with only the European Central Bank likely to move in the short term. Bond yields are approaching once more the post-global financial crisis highs they reached in late 2023, pushing down bond prices as they have climbed,” Glyn said.
“If you are confident rates will fall, then it’s possible to lock into these high yields for a very long time through fixed income funds, but the see-saw of hopes and fears over rates has finally led some investors to call time and withdraw capital for the first time in months, choosing instead to take refuge in cash or money markets.”
Indeed, investors moved £143m into safe-haven money market funds in May to access the relatively high yields on offer before central banks cut rates. Mixed-asset funds, however, suffered outflows of £531m.
The platform highlights stock market winners and losers from a potential Labour victory.
What impact the UK’s forthcoming general election will have on portfolios is a question that many investors are asking and AJ Bell investment analyst Dan Coatsworth has some answers.
Housebuilders, building materials suppliers, nuclear engineers and renewable energy specialists should perform well if the Labour party wins the election, while rail operators, outsourcing providers and UK oil and gas producers would flounder, he said.
Below, he addresses these sectors one by one, giving examples of companies whose activities complement Labour’s policies.
Industries and stocks that would prosper under Keir Starmer’s Labour
First up, housing. Coatsworth expect Labour to implement changes to the planning system and put greater emphasis on building affordable homes.
“This could be good news for companies involved in the provision of materials to the property sector and for housebuilders,” he said.
“Labour has pledged to upgrade draughty homes and help residents to stop wasting heat by it escaping into the great outdoors. That implies a boost for construction workers, engineers and electricians.”
There are multiple companies on the UK stock market that might benefit from Labour’s housing strategy, for example Travis Perkins, Wickes and B&Q/Screwfix-owner Kingfisher, all of which “could see higher demand from tradesmen and homeowners eager for the bits and bobs needed to spruce up flats and homes”.
But the list of companies that could get busier goes on to include construction groups such Morgan Sindall and Kier, ventilation specialist Volution and housebuilders, for example Vistry and MJ Gleeson.
Moving on to energy, where Labour’s Great British Energy initiative foresees the introduction of tougher measures on fossil fuel producers and a windfall tax on oil and gas projects to rack up £8.3bn. These proceeds will be directed towards wind, solar, hydrogen and carbon capture and storage technologies.
Some of the UK-focused oil and gas operators (such as Serica Energy and Harbour Energy) have already begun reducing their exposure to the UK North Sea, but others have doubled down on their exposure. Ithaca Energy, for instance, has purchased UK assets from Italy’s ENI.
Coatsworth highlighted specialists listed in the UK including Costain, which advises on energy transition work, and environmental services group Ricardo.
But an expected push for nuclear power would also play into Rolls-Royce’s strengths.
“Rolls-Royce has been among the best-performing shares on the UK stock market in recent years as investors bought into its recovery story,” he said.
“Being in a strong position to capitalise on small modular reactors looks like fortuitous timing for Rolls-Royce if Labour gets elected and could potentially act as another catalyst for its share price.”
Calls for the nationalisation of UK railways are creating a “major overhang” for FirstGroup, but ticket seller Trainline should come out of this situation intact, according to Coatsworth. The Labour party has said that it would not revive the Conservatives’ plan for a national retailing app for train tickets.
“Trainline’s shares have already experienced a wobble over potential changes to the UK rail system, but they’ve started to recover,” the analyst noted.
Industries and stocks unlikely to cheer for a Labour victory
Labour was responsible for the previous outsourcing boom and now it might be the architect of its demise, said Coatsworth.
“Starmer wants to bring public services back into government hands, suggesting that waste collection, cleaning, catering and maintenance services and more will no longer be a ripe opportunity for the UK’s army of outsourcing specialists,” he added.
“A lot of people think Conservative politicians awarded lucrative contracts to their friends and associates, and now Labour wants to bring an end to this questionable practice.”
If this is enforced, Serco, Mitie, Babcock and Capita all look vulnerable.
Retail, leisure and hospitality would also struggle. These industries have all benefited from immigration as a source of workers, but both the Conservatives and Labour favour stricter rules on immigration.
“Brexit has already made it harder for certain foreigners to find work in the UK and companies have faced a smaller pool from which to recruit, which has pushed up wages. Consumers have shouldered the brunt of these additional labour costs through higher prices,” Coatsworth said.
“This situation could be exacerbated if Labour wins the election and changes the zero hours contract system. It wants to ban ‘exploitative’ zero-hour contracts as part of a broader initiative to boost wages, make work more secure and support working individuals.”
Frasers is among the names on the stock market to have made full use of zero-hours and any change to the system means it has less flexibility for its workforce.
This scenario extends into other places such as the support services industry, with Mitie among the potential losers from a ban on zero-hours.
Finally, Rishi Sunak’s party looks ready to pass the baton onto Labour in its war on smoking and vaping – bad news for big companies in this sector such as British American Tobacco, Coatsworth concluded.
Passive funds tracking the FTSE 100 will be forced to sell St James’s Place, Ocado and RS Group.
Wealth manager St. James’s Place has been relegated from the FTSE 100 to the FTSE 250 index after regulatory pressure and fee changes prompted investors to jettison the stock. Online grocer Ocado and industrial services company RS Group have also left the UK’s large-cap index.
Meanwhile, Darktrace, LondonMetric Property and Vistry Group have been promoted to the FTSE 100 as part of FTSE Russell’s annual review. Darktrace, which specialises in cyber security using artificial intelligence, is being acquired by US private equity group Thoma Bravo.
The FTSE 250 Index has six additions and the same number of deletions. As well as the companies moving between the mid- and large-cap indices, Alpha Group International, Renew and XPS Pensions Group are joining the FTSE 250, while Ferrexpo, Mobico Group and Octopus Renewable Infrastructure Trust are leaving.
The changes will be implemented at the close of business on 21 June 2024 and will take effect from the start of trading on 24 June 2024. They will impact the portfolios of investors who own passive and exchange-traded funds tracking the UK’s large and mid-cap indexes.
St James’s Place’s (SJP) share price peaked in December 2021 and January 2022 but has plummeted since then, as the chart below shows.
SJP share price total returns over 5yrs
Source: FE Analytics
SJP scrapped its controversial exit fees last year in response to the Financial Conduct Authority’s Consumer Duty legislation. Fee changes had a detrimental impact on profit margins, according to David Cumming, manager of the BNY Mellon UK Income fund, who recently sold the position in St James’s Place he had inherited when he took over the fund two years ago. Not selling it sooner was a “mistake”, he admitted. “The management were more optimistic than things turned out and we probably stuck with it too long.”
SJP halved its dividend this year and held back £426m in provisions to refund clients who paid its ongoing advice fees but did not receive an “acceptable standard” of service, according to its full-year results.
Chief executive officer Mark FitzPatrick said: “A combination of the provision we have established and an expected decrease in the level of profit growth in the next few years as we transition to our new charging structure, reduces our ability to invest for long-term growth in our business over the next few years.”
Meanwhile, short sellers have been anticipating Ocado’s fall from grace, with the online broker becoming the UK’s second most-shorted stock last month. BlackRock, Millennium International Management and D1 Capital Partners, among others, are betting against the online grocer.
At the other end of the spectrum, LondonMetric Property and housebuilder Vistry joining the FTSE 100 augurs well for the property sector. LondonMetric Property merged with LXI REIT in January to create one of the largest publicly-traded property companies in the UK.
Vistry recently issued guidance that its annual and six-monthly profits would be ahead of last year. Dan Coatsworth, investment analyst at AJ Bell, said: “Investors like what they’re hearing and Vistry’s shares have steadily ticked up since last October with a 38% total return year-to-date (as of 29 May 2024). That makes Vistry the best performing housebuilder in the mid-cap index and the 21st best performing FTSE 350 stock so far in 2024.”
Experts suggest UK and global funds from Evenlode, Guinness, Fidelity and others.
Retired investors often have a specific income target and an aversion to losses. Bonds, therefore, make up a significant part of their portfolios but equities have a role to play as well by providing dividend income and capital growth.
Equity income funds tend to hold up better than bonds during periods of inflation, said Richard Parkin, head of retirement at BNY Mellon Investment Management.
He thinks actively-managed funds make more sense than passive trackers, “if you buy into the idea that retirement isn’t about maximising returns, it’s about avoiding losses”. Although most active managers struggle to keep up with raging bull markets, the best are adept at cushioning investors from bear markets and avoiding “howlers”, he said.
Jason Hollands, managing director of Bestinvest, recommended prioritising managers who focus on income growth potential, rather than trying to maximise current yields. “If you are going to supplement your retirement income through equity income funds, you will probably want to avoid erratic payouts but will also need to see both capital growth and income growth over time, so that payouts can keep pace with inflation,” he explained.
To that end, Trustnet asked fund selectors to recommend equity income funds that combine downside protection with growth potential.
Martin Currie UK Equity Income
Tom Stevenson, investment director at Fidelity International, argued for an allocation to UK equities.
“For investors looking to achieve a high and growing income stream in retirement, a UK equity income fund might fit the bill. The UK is traditionally a good source of equity income and today our domestic market stands at an attractive valuation discount to many other markets,” he said.
FTF Martin Currie UK Equity Income was Stevenson’s first choice. It is managed by FE fundinfo Alpha Manager Ben Russon, Colin Morton, Joanna Rands and Will Bradwell, who Stevenson said “have good experience in finding companies that can pay sustainable and growing dividends”.
The fund is relatively focused with 48 holdings, including Shell, BP, Unilever, AstraZeneca, National Grid and Imperial Brands.
BlackRock UK Income
Hollands suggested BlackRock UK Income because it “balances the need for stable, growing payouts with continued capital growth”. Managers Adam Avigdori and David Goldman have produced attractive returns with an above-market yield and the fund has held up well in difficult markets.
“The focus is on companies able or with the potential to pay a growing dividend alongside rising capital, rather than investing in businesses paying a high but stagnant yield. The managers are nimble and are able to move the portfolio around depending on the market environment and valuations,” Hollands said.
Performance of UK equity income funds vs benchmark over 10yrs
Source: FE Analytics
Evenlode Income and Evenlode Global Income
Hollands also recommended Evenlode Income, managed by Hugh Yarrow and Ben Peters. “The team has a clear and consistent investment philosophy, focused on high-quality companies with strong free cash flow that can support dividend growth and with a high return on capital. The managers prefer capital-lite businesses where shareholder capital isn’t constantly being drained by the need to reinvest heavily in things like plant and machinery,” he said.
“The fund may tend to lag in rising markets, but it has historically delivered strong and consistent outperformance.”
The fund’s global sibling is another solid choice for retired investors, according to Kamal Warraich, head of fund research at Canaccord Genuity Wealth Management. Evenlode Global Income focuses on generating attractive total returns, dividend growth and a sustainable income, he said.
“The portfolio is biased towards quality companies that generate high and consistent levels of free cash flow. Importantly, the hallmarks of this process tend to provide protection on the downside,” he explained.
JPMorgan Global Growth and Income and JPM Global Equity Income
Samir Shah, fund research analyst at Quilter Cheviot, said the JPMorgan Global Growth and Income trust is a good option for retired investors because it provides growth plus a 4% yield.
“The fund selects from only JPMorgan Asset Management’s firm-wide highest conviction ideas that offer superior earnings quality with a faster growth rate. In addition, it pays a dividend set at the beginning of each financial year equivalent to 4% of net asset value, which is funded by a combination of revenue and capital reserves,” Shah explained.
“Along with a strong track record of returns, the ability to pay a market-leading yield while also providing their best ideas from a total return perspective is attractive.”
The trust was trading at a discount of -1.1% as of 3 June 2024 and has £2.7bn in total assets. It is run by FE fundinfo Alpha Managers Helge Skibeli and Timothy Woodhouse along with James Cook.
Juliet Schooling Latter, research director at FundCalibre, recommended another JPMorgan AM strategy managed by Skibeli – JPM Global Equity Income, which takes a value-oriented approach. “The fund's experienced management team prioritises risk management, seeking to deliver a compelling yield without compromising growth potential,” she explained.
“The managers strategically balance ‘compounders’ (companies with consistent long-term growth), high-yielding stocks and higher-growth opportunities within the portfolio. This well-diversified strategy positions the fund as a core holding for investors seeking a balance of income and capital appreciation.”
Guinness Global Equity Income
Guinness Global Equity Income is an equal-weighted portfolio of around 35 stocks, split between cyclical and defensive names. Managed by Ian Mortimer and Matthew Page, the fund has low turnover, which limits transactions costs.
Sophie Turner, a research assistant at FE Investments, said: “This fund focuses on stocks with quality characteristics and low debt, which the managers believe can provide consistent performance throughout the entire economic style. It invests into companies which have strong balance sheets and the ability to grow their dividend stream over time.
“This strong emphasis on quality and dividend growth names means the fund protects well in downturns but tends to lag in strong bull markets. The fund has shown consistent best-in-class performance over a long period, as a result of its well defined, robust and repeatable process.”
Performance of global funds vs MSCI ACWI over 10yrs
Source: FE Analytics
Fidelity Global Enhanced Income and Fidelity Global Dividend
Fidelity Global Enhanced Income uses derivatives to generate extra dividend income, with 40-60% of the fund overlaid by a covered call sleeve. This boosts the fund’s defensive profile, so it should protect capital in a falling market, although performance will lag when the stock market is rising, Turner said. Indeed, performance has been slightly below the fund’s benchmark since inception but with far less volatility.
The fund’s underlying stocks are also quite defensive, Turner pointed out. The managers – David Jehan, Fred Sykes, Jochen Breuer and Vincent Li – invest in companies with strong balance sheets and high-quality earnings which are trading at attractive valuations.
Meanwhile, Schooling Latter suggested another Fidelity International fund. “Fidelity Global Dividend is a core global income fund designed for investors seeking a stable and potentially rising stream of income,” she said.
The fund invests in companies with healthy and sustainable dividend yields, aiming to provide regular and growing distributions while prioritising capital preservation.
“We commend manager Dan Roberts’ value-driven philosophy, which emphasises disciplined investment. This reduces the risk of overpaying for stocks and potentially mitigating losses during market downturns,” she stated.
Premier Miton explains what fund managers usually get wrong.
Many traditional fund managers fail to understand a simple market dynamic that would help them build truly defensive portfolios, according to Anthony Rayner, co-manager of the £268.6m Premier Miton Cautious Monthly Income fund.
Managers who buy bonds to diversify from equities, for example, show a lack of understanding that volatility and correlation levels vary according to the investment environment.
“The more traditional fund managers will be looking for bonds to diversify equities, reflected in the common narrative that bonds are always good diversifiers of equity,” the manager said. “This is also reflected, for example, in the fact that most funds have very little in commodities like gold.”
But they aren’t the only ones who are getting this wrong. Index funds are drawn to have a “material” exposure to government bonds and a bias to longer duration, while funds with a sustainable focus will have a bias against oil, despite it being “one of the best diversifiers from equities” over time.
This tendency leaves investors to choose from a pool of investments funds that are blindly looking at what is working right now to diversify equity risk, rather than what has worked in the past and extrapolating that forward. In other words, people are failing to recognise the wake-up call of 2021, when equities and bonds took everyone by surprise crashing simultaneously.
The two graphs below look back over the past 50 years. The first chart looks at the correlation between US equities, as represented by the S&P 500, and 10-year US government bonds.
Correlation between US equities and US bonds
Source: Premier Miton, Bloomberg Finance L.P and S&P 500
“There are a number of important observations to make. Firstly, there are extended periods when bonds don’t diversify equities and, in fact, bonds have generally only diversified equities during periods of disinflation, that is when inflation risk isn’t elevated,” Rayner said.
“Secondly, in more normal periods, meaning when inflation is elevated, equities and bonds tend to be strongly correlated to each other.”
The second chart looks at the correlation between US equities and the Bloomberg Commodities index.
Correlation between US equities and commodities
n
Source: Premier Miton, Bloomberg Finance L.P and S&P 500
In the majority of the same periods where inflation risk is elevated and bonds have been correlated with equities, commodities have proven to be “a pretty good diversifier”, the manager noted.
“Intuitively it makes sense that commodities do well when inflation is elevated, even if equities and bonds don’t. Oil and foods are often primary drivers of inflation spikes, while gold often responds positively as an inflation hedge,” he said.
“This has been borne out in more recent times, which both charts show, as the environment has been characterised by inflation, so bonds have been correlated to equities, whilst commodities have provided some diversification.”
Recognising that the same asset class has not always been the best diversifier of equity risk over time is particularly important for a defensive portfolio but also for all multi-asset portfolios, as investors understand the importance of having a defensive element to their portfolio.
“For most multi-asset portfolios, equity beta tends to be the biggest portfolio risk. Therefore, from a risk perspective, one of the most pertinent questions is how, and by how much, to diversify equity beta,” he said.
“It might sound blindingly obvious that the environment drives an asset class’ behaviour, but all too frequently investors do not follow this logic through when it comes to the practice of portfolio construction,” Rayner concluded.
It’s natural to worry about how possible regime change in Westminster may affect our investments, but we see four reasons for comfort.
The context of the forthcoming election is that the Conservative Party has a mountain to climb to avoid a heavy defeat. Labour has a large lead in the polls (around 20 percentage points) that has been sustained for more than a year and a half.
The polls can of course be wrong, or shift – but it would take a historic swing in such a short time to make a big difference to the outcome.
UK election opinion polls
Source: Rathbones
It isn’t just the polls suggesting that the Conservatives face an uphill battle, the public rate Labour better than the Conservatives on all three of the issues they care most about – the economy, the NHS and immigration.
Rishi Sunak is personally unpopular too, in contrast to the start of his premiership. His net approval rating is now close to that of Liz Truss at the end of her ill-fated time in Number 10, and far behind that of Keir Starmer.
Local elections earlier this month also saw the Conservatives lose hundreds of councillors, while several recent by-elections have seen swings to Labour well above 20 percentage points.
In other words, the chance of a change in the political landscape, after 14 years of Conservative rule, is high. It’s natural to worry about how possible regime change in Westminster may affect our investments, but we see four reasons for comfort.
No dramatic short-term change in fiscal policy on the cards
Shadow chancellor Rachel Reeves has taken a leaf out of the Blair/Brown 1997 playbook in shadowing a lot of existing economic policy. She has pledged not to raise the most significant taxes – income tax, national insurance, capital gains tax and corporation tax.
And she has committed to follow a set of fiscal rules virtually identical to the current ones (as well as showing her commitment to those rules by ditching previous pledges which don’t comply with them).
This cautious strategy means the election is not likely to alter the short-term path of the economy much, or to upset the gilt market. Labour’s clearest points of difference on fiscal policy are arguably its plan to charge VAT on private school fees and to change the tax treatment of carried interest.
That’s significant for those affected but doesn’t move the needle for the economy. We’d expect it to continue its recovery from the shallow recession of last year.
Total managed expenditure
Source: Rathbones
Whichever party wins the next election will eventually have to confront the so-called ‘fiscal fiction’ which underlies current spending plans. This is the assumption that there will be significant spending restraint in key departments, which are likely to prove politically impossible in practice. But that isn’t a Labour-specific issue.
Labour has dropped radicalism of Corbyn era
The past general election in 2019 offered voters two radically different economic visions, Boris Johnson’s pledge to ‘Get Brexit Done’ against Jeremy Corbyn’s socialist agenda.
But the Labour Party has transformed since then, emphasising ‘partnership with business’ and courting the City. There are some key differences between the two parties’ economic policy platforms today, but these are much smaller than in 2019.
Gone is Labour’s commitment to nationalisation. The party does plan to renationalise virtually all passenger rail services within five years, as existing contracts with private operators expire. Yet things have been moving in this direction by stealth anyway.
The current government has already taken over several major rail franchises, including Southeastern, LNER, ScotRail and TransPennine. Labour also plans to establish a publicly owned company to invest in green energy, such as floating offshore wind, but this is no wholesale nationalisation.
New government may have political capital for much-needed reform
Reflecting the long-term poor performance of the UK economy, there are a few key areas which both main parties have identified as ripe for change, but where the current government has failed to muster the political capital to pass any significant reform. A new government with a fresh mandate could make a positive difference.
GDP per hour worked in dollars
Source: Rathbones
The context behind all of this is the weakness of productivity growth in the UK since the global financial crisis, which in turn is linked to the long-term weakness of investment. (shown in the chart above and below.)
Investment as a percentage of GDP
Source: Rathbones
Many of the specific problems policymakers worry most about – from regional inequality to the state of the health service – are ultimately connected to insufficient investment.
A key issue both parties have identified as a barrier to investment is the UK’s unusual planning system. Our system is discretion-based, whereas virtually every other advanced economy relies more on zoning and rules.
It is slow and unpredictable, discourages development and makes building much-needed infrastructure harder. Infrastructure projects here face much higher costs than other advanced economies, in part because of planning-related delays and legal challenges.
London’s CrossRail, for example, cost 10 times as much per mile as Madrid’s metro system. The spiralling costs of HS2 are notorious, and the project has been the defendant in 45 separate legal cases since 2018.
This would be an appealing area for a new government with a fresh mandate to address, particularly as it can be done without the need for large spending commitments.
Rachel Reeves said, “This Labour Party will put planning reform at the very centre of our economic and political argument.”
There is likely to be a more standardised approach to what is and isn’t allowed. More planners will be hired to reduce backlogs and delays too. So-called ‘grey belt’ land may be targeted for development – things like car parks and wasteland which are currently part of the green belt.
Investors have set the bar for success low
UK assets currently appear cheap compared to their fundamentals on a variety of different measures. International investors fell out of love with UK equities in the period of instability which followed the 2016 Brexit vote. It wasn’t until then that the gap between the valuations of stocks in the UK and elsewhere (particularly the US) emerged.
Price-to-earnings ratios, adjusted for sector composition
Source: Rathbones
The gap is much larger than can be explained by the relative growth and quality characteristics of UK firms, or by the sectoral makeup of the UK market. The story is similar when we analyse currencies – sterling trades well below measures of its ‘fair value’ based on economic fundamentals.
Some reasons for international investors’ antipathy towards UK assets could change. Following years of domestic political instability – characterised by a succession of prime ministers and a lack of policy space to address structural issues – the possibility of a new government with a reasonable majority engenders hope.
Stability alone might be an improvement on the political and economic turmoil that has existed since 2016. Investors have set the bar for success for the next administration low.
Oliver Jones is head of asset allocation at Rathbones. The views expressed above should not be taken as investment advice.
Three Allianz bond funds have their ratings removed following Mike Riddell’s departure.
Three of Allianz Global Investors’ bond funds have been expelled from the Square Mile Academy of Funds, the investment consulting and research firm announced today.
Baillie Gifford and GAM funds also lost ground.
The departure of Mike Riddell, lead manager of the A-rated Allianz Strategic Bond, Allianz Index-Linked Gilt and Allianz Gilt Yield funds, spurred Square Mile’s decision to remove its ratings from all three strategies.
“Julian Le Beron, chief investment officer of core fixed income at Allianz, will assume immediate control of the funds, bringing a different investment approach,” Square Mile explained.
“As the funds’ ratings were centred around the analysts’ conviction in Riddell and the process which he built over several years at Allianz, they feel they can no longer support their inclusion in the Academy of Funds.”
In the wake of Riddell’s move to Fidelity International, fund selectors suggested five alternative strategic bond strategies for investors looking to move their money.
Elsewhere, Baillie Gifford Multi Asset Growth also lost its a rating after its medium-term performance failed to live up to analysts’ expectations.
“This, coupled with changes within the underlying team, has led to conviction falling to a level where they no longer feel they can support the fund’s place within the Academy of Funds,” Square Mile noted.
Performance of fund against sector and index over 5yrs
Source: FE Analytics
Square Mile’s conviction in the GAM Star Japan Leaders fund also waned, due to “instability in the management team over recent years and a continual decline in assets under management”.
The size of the fund peaked at approximately £320m in September 2021 and steadily declined to today’s £73m. Therefore, the analysts decided to remove the fund’s A rating..
Moving to the new entrants, two strategies joined the Academy of Funds with newly awarded A ratings.
The first was the Fidelity China Special Situations trust, which Square Mile said was ideal for long-term investors seeking broad exposure to China, offering access to both listed and unlisted companies, as well as those with significant interest in Chinese markets.
It has significant exposure to medium and smaller companies and was prized by Square Mile analysts for the combination of “an experienced portfolio manager supported by a well-resourced analyst team, and an efficacious process within an under-researched opportunity set”.
While the IT China/Greater China sector only includes three trusts, Fidelity’s solution has topped the rest across all time frames and came first for performance over 10, five and three years, as well as one month.
Performance of fund against sector and index over 5yrs
Source: FE Analytics
The second entrant was Capital Group New Perspective, which was officially launched in 2015, but the broader strategy dates back over half a century. It has “a proven track record of delivering excess returns through the cycle” and of keeping up when market leadership changes.
“Drawing upon Capital Group’s multiple-manager approach, the fund takes a flexible approach to managing assets to identify transformational changes in the global economy and to benefit from long-term structural trends in markets,” Square Mile analysts said.
“Overall, we believe this fund to be a solid offering for long-term investors looking for a global equity strategy that is managed in a risk-aware manner and seeks to remain competitive across most market conditions.”
Source: FE Analytics
Finally, the Premier Miton Multi-Asset Distribution and Multi-Asset Monthly Income funds were downgraded from AA to A ratings as the long-standing co-head of the multi-manager team, David Hambidge is stepping back from day-to-day fund management responsibilities on 1 July.
David Cumming, who manages the BNY Mellon UK Income fund, has taken counter-consensus positions in real estate and oil companies.
Income investors tend to swim against the tide, buying companies that are undervalued and therefore are paying out yields above the market. This method of investing has been a tough one in recent years as growth investors – and in particular those favouring technology – have thrived.
Yet David Cumming, who manages the £1.6bn BNY Mellon UK Income fund, is sticking with his contrarian stance. “One of my favourite lines is: only dead fish swim with the stream,” he said, implying that investors should challenge the conventional wisdom.
He is a big believer in meeting with company management and through these conversations, he aims to identify trends early and take counter-consensus views. These currently include owning oil companies, going overweight banks and going “slightly long” property, which he thinks has “probably bottomed”.
Real estate investment trusts are trading at 30% discounts while the underlying assets are yielding around 6%, he said. He owns Land Securities and Hammerson and favours retail property, which should benefit from the UK’s economic recovery and interest rates plateauing.
His contrarian bets are paying off. Cumming has been running the fund for just over two years, having joined Newton Investment Management (the BNY subsidiary where he leads the UK equity team) in March 2022 from Aviva Investors.
Performance of fund over 2yrs vs benchmark and sector
Source: FE Analytics
Between 1 April 2022 and 28 May 2024, the fund has delivered top-quartile performance and ranks 13th amongst the 77 funds in the IA UK Equity Income sector. Over three years to 28 May 2024, it is the second-best performing fund within its sector.
One of his biggest calls has been to buy banks, which used to be a lonely position but is becoming more mainstream, with Barclays and NatWest rallying strongly since February.
Performance of banks year-to-date
Source: FE Analytics
Banks underperformed for a decade after the financial crisis while they steadily built up their capital reserves. “A lot of people just stopped owning them and ignored the fact that they've become very cheap,” he observed.
As interest rates increased, banks’ profit margins improved, which was the catalyst for a re-rating but even Cumming, who has been long banks for a while, was surprised by the speed and scale of their recovery this year.
He owns Barclays, Lloyds, Standard Chartered and HSBC, all of which he said have good management teams, good cash flows and high dividends. “If you add buybacks and dividend yields together, you're getting 10% plus,” he said. Barclays and Standard Chartered are still trading at around half book value despite the recent rally, he added.
The fund can invest up to 20% of its assets outside of the UK and Cumming has bought shares in Swiss private bank Julius Baer, which should be able to take market share following the collapse of Credit Suisse and its merger with UBS, he argued. The company also has a strong position in Asia where wealth is growing quickly.
Cumming has also invested in asset management group M&G this year, as it pays a 9% yield and has “double-digit upside potential”.
“There's a high payout ratio and growth, which is quite a combination,” he said. M&G’s shares should track or beat the market but he expects a higher total return because of the dividend.
M&G has a strong position in fixed income, robust distribution capabilities, good investment performance, an established market position in Europe, and it is growing its business in the Middle East, he concluded.
Cumming also thinks oil companies have plenty of upside, good recovery prospects and low valuations. BP and Shell tend to trade at 30% discounts to equivalent US-based companies and have double-digit free cash flow yields.
Demand for oil and for energy is increasing and while climate change is still a vital issue, people are acknowledging that oil is a necessary part of the transition. “I would say the [environmental, social and governance] ESG zeitgeist is going more pro-oil,” he said.
BP could be vulnerable to bids from international acquirers given its low valuation, he said, although he is not entirely sure that the government would allow BP to be acquired.
Cumming is also leaning into the UK’s economic recovery by increasing his exposure to economically sensitive sectors, including materials and industrials, as well as financials and energy. On the other hand, he is light consumer staples, telecoms and utilities. “Most income funds are low beta but we’re the opposite. We hope to outperform in a rising market,” he explained.
Gleeson is leaving AXA IM in August.
Jeremy Gleeson, head of AXA Investment Managers’ (AXA IM) technology investment team and lead manager of its Global Technology and Digital Economy funds, will leave in August 2024 to pursue an external opportunity.
Gleeson has spent 17 years at AXA IM. He has been managing the £1.3bn AXA Framlington Global Technology since 2007 and the £602m AXA World Funds Digital Economy fund since its launch in 2017.
Performance of fund under Glesson's tenure vs sector and benchmark
Source: FE Analytics
The former fund ranks sixth out of 11 in the IA Technology & Technology Innovation sector under Gleeson’s tenure, but it has lagged behind the MSCI World/Information Technology index over that period.
The latter fund has consistently outperformed the MSCI ACWI since inception.
Performance of fund since launch vs sector and benchmark
Source: FE Analytics
Gleeson also managed AXA World Funds Robotech with AXA IM's head of global thematic strategies Tom Riley and portfolio manager Brad Reynolds between December 2016 and August 2023.
Before joining AXA IM, he was a senior portfolio manager at Close Investments (formerly Reabourne Technology), a subsidiary of Close Brothers Group.
After his departure, Gleeson’s funds will be managed by Tom Riley, Brad Reynolds and and portfolio manager Pauline Llandric.
A spokesperson for AXA IM said: “They are a team of experienced portfolio managers who have worked alongside Gleeson to run the strategies and will continue to directly manage the strategies on a day-to-day basis.”
Trustnet uses Investment Association data to highlight the top payers in the sector.
Just six funds have consistently beaten the FTSE All Share’s yield by more than 10% each year, a study from Trustnet has found.
Income investing has been resurgent of late as investors have started to put their cash to work ahead of impending interest rate cuts from the Bank of England later this year.
Top of most agendas is getting a decent payout from dividends, with yields of particular interest to investors who want to get the highest income possible.
The IA UK Equity Income sector has strict rules in place to ensure investors are getting a fair yield. At present, each fund in the sector must achieve a yield that matches the FTSE All Share index over three years. If it fails, it is removed from the Investment Association (IA) peer group.
Additionally, should a fund deliver less than 90% of the FTSE All Share’s yield in any given year, it will also be excluded. It is worth noting, however, that these rules were relaxed during Covid, with funds given a pass on these requirements in either 2020 or 2021 (they could choose one, but were not permitted both).
With this, all of the funds in the sector have achieved their goal and remain in the peer group. However, these current rules only came into effect in 2017.
The new guidelines were amended after a swathe of income funds – including some of the largest portfolios at the time – failed to meet the previous criteria. This was to achieve a 110% yield over a three-year period.
For this study, Trustnet increased this hurdle rate one step further, looking at funds that have achieved a yield that is higher than110% of the FTSE All Share’s in every year since 2010, when the IA began collecting these records.
To do this we used data from the IA and took the yield as at the fund’s own end of year reporting window.
Source: Investment Association
Just six funds had a 100% track record. Fidelity Enhanced Income and Santander Equity Income Unit Trust were the two with the longest track records, achieving higher-than-market yields in each of the 14 years looked at. It currently yields 6.91%.
The former has been managed by David Jehan since its launch in 2009, with Rupert Gifford joining in 2020. The strategy is specifically designed to produce an income that is 50% higher than that of the index. To do this it predominantly invests in equities, but can also use derivatives such as cover call options to enhance the income.
Gifford runs the equity portion having worked closely with former longtime manager Michael Clark, identifying steady companies, which have tended to cope well with difficult economic conditions. Jehan looks after the derivatives portion of the fund.
Analysts at Square Mile Investment Consulting & Research give the £219m fund a ‘Positive Propsect’ rating and said: “The combination of these two elements is an appealing proposition for investors who have an income requirement. However, unit holders must recognise that what is gained on the swings is likely to be lost on the roundabouts.
“In this case, income will be higher than more traditionally managed UK equity income strategies, but this is likely to be at the expense of capital appreciation. That being said, on a total return basis (i.e. the combination of income and capital growth), there is unlikely to be too much difference, particularly on a risk-adjusted basis, in returns over the very long term.”
The £118m Santander fund has been managed by Robert McElvanney since 2020, who has continued its track record of beating the FTSE All Share yield by more than 10% in each year, although its aim is to match the current guidelines set by the IA.
It currently yields 4.34% and has been by far the best performer of the group over the past decade, returning 76.9%, placing it in the second quartile of the IA UK Equity Income sector over this time.
The fund managed to make the list ahead of its Santander Enhanced Income Portfolio stablemate. This fund, like the Fidelity portfolio, aims for a yield of 5% per year, but failed to beat our high hurdle rate in 2020, when its end of year date (31 March) coincided with the market collapsing due to the pandemic and the FTSE All Share had a supranormal yield.
Next, Premier Miton Monthly Income has achieved the feat in 13 consecutive years, while its cousin Premier Miton Optimum Income has achieved a yield of above 110% of the FTSE All Share in 10 years.
Emma Mogford has run the former as sole manager since 2020, replacing Eric Moore, who had in turn replaced Chris White. She was also added as co-manager to the Optimum Income fund at the same time, running it alongside Geoff Kirk.
Analysts at RSMR rate both funds and said the firm has a “highly experienced UK Equity Income team”.
On the Monthly Income strategy, they said it was a “traditional, uncomplicated UK equity income fund which has performed well (particularly from an income perspective)”.
“The focus on dividend growth has help contribute to income returns. The fund provides a better than average dividend yield with lower volatility. In addition, the manager aims to grow the dividend yield by 5% per annum. This has been achieved over the previous five consecutive fund years.”
On the Optimum Income fund, they liked its “core large-cap strategy”, while highlighting its use of a covered call strategy to enhance the overall level of income.
IFSL Marlborough Multi Cap Income and VT Downing Small & Mid-Cap Income are the final funds on the list to achieve the feat. Both invest predominantly in mid- and small-cap stocks. This has hit performance in recent years as this area of the market has struggled.
Sectors not regions will be the way to outperform as US exceptionalism wanes, according to Pictet Asset Management.
Double-digit returns from US and global equities will be consigned to the history books as the factors underpinning US exceptionalism and high valuations dissipate, according to Pictet Asset Management.
Overall, global equities will deliver 7.6% per annum for the next five years, but the way to generate much higher returns going forward will be to choose the right sectors, said chief strategist Luca Paolini.
Technology, healthcare and industrials will benefit from innovation and artificial intelligence (AI), ageing populations, climate change and protectionism. These three sectors should outperform global equity benchmarks by a cumulative 20% over the coming five years, he said.
“These industries are pivotal in resolving some of our greatest long-term challenges, namely climate change, fraught geopolitics and growing labour shortages. In other words, in times of increasing uncertainty, we seek exposure to sectors that are the problem solvers,” he explained.
Pictet expects returns from growth and value strategies to be more evenly balanced over the next five years. Growth strategies will benefit from developments in AI but value strategies with a higher weighting to industrials will profit from onshoring, nearshoring and “muscular industrial policy”, Paolini added.
The markets that will do well
From a geographical perspective, Pictet is expecting annualised returns of 7.5% from US equities over five years – still around the world average but below its recent dominance. “Elements of US exceptionalism are rolling over,” Paolini said. He thinks low taxes and record amounts of government spending are unsustainable, while US leadership in AI and GLP-1 weight loss drugs will boost growth only marginally.
The S&P 500 is trading at a price-to-earnings (P/E) multiple of 21x compared to a long-term historical average of 16x. Paolini thinks a P/E multiple of 19x would represent fair value over the next five years and said the stock market’s current rich valuations will compress long-term returns.
US exceptionalism will not necessarily go into reverse but it will pause, giving other regions the chance to catch up, he predicted.
Emerging market companies in particular are getting better at translating economic growth into earnings growth and India is the world’s fastest growing region, he said.
Pictet expects emerging market equities to return 8.3% per annum in US dollar terms for the next five years and Latin American equities to do even better, returning 8.5%, as the chart below shows.
Five-year return forecasts in US dollar terms
Source: Pictet Asset Management, Refinitiv, Bloomberg
Inflation is a headwind for emerging market stocks – which explains their flat performance this year – but if inflation normalises and the global economy holds up, then emerging market equities should perform well, Paolini explained.
The UK and Europe are falling behind
Languishing at the bottom of the league table are UK and eurozone equities, which are projected to return 6.7% and 6.8%, respectively.
The UK is a defensive market full of well-managed, cheap companies but it does not have a vibrant or large technology sector so the market is “not very exciting”, Paolini admitted.
Arun Sai, senior multi-asset strategist, described the UK as a “stagflation play” because of its exposure to commodities. “You would need a peculiar macro set up for the UK to out-deliver on earnings versus global peers,” he noted. “The UK is essentially defensive value.”
A word on bonds
Turning to fixed income, total returns from 10-year US government bonds are forecast to be 5.6% on an annualised basis for the next five years, with 10-year Treasury yields settling at 3.75%. This means that equities will still outperform bonds, but by a relatively slim margin, as rising bond yields enhance the appeal of fixed income.
Paolini suggested that asset allocators move some money out of equities into credit, predicting a 6.3% annualised return from US investment-grade bonds. Returns from corporate bonds are likely to be on a par with equities, but with less risk and lower volatility as default rates remain benign.
Currencies and alternatives
Currency movements will assume greater relative importance going forward as they will eat into the muted returns that Pictet expects equities and most other asset classes to deliver.
Pictet predicts that the US dollar will weaken gradually by 2% per annum over the next five years, which will be a tailwind for local currency emerging market debt – an asset class that is forecast to return 8.9% per annum, beating hard currency emerging market debt and emerging market equities.
Meanwhile, Paolini believes investors should maintain exposure to alternatives and real assets but he acknowledged that these strategies are less attractive relative to listed assets than in the past.
In private equity, private debt and real estate, the gap between the best and worst performing managers is “massive” so manager selection is more important than asset allocation, he said.
The ultimate winners in the AI race have yet to be determined but the infrastructure needed to support AI, from data centres to semiconductors, is already experiencing a capex boom.
The rapid development of generative artificial intelligence (AI) tools has been a central concern of businesses and markets over the past three years. Demonstrated by the dominance of the ‘Magnificent Seven’, valuations reflect the widespread expectation that this will be an ongoing phenomenon.
Much of the discussion about AI technologies has focused on the hypothetical. Speculation is at fever pitch regarding the potential for AI to transform tasks as mundane as grocery shopping and as advanced as surgery. Yet, few tools have become mainstays of daily life.
Up until now, activity in the AI sector has focused on training models and machine learning. This has aimed to produce systems sophisticated enough to support complex requests and applications.
The significant transition that is only just beginning is for the technology to rotate from training to usage.
It is here that the outlook for the sector becomes murkier. The ‘winners’ in terms of both models themselves and their makers have not been determined.
However, capital expenditure has been – and continues to be – significantly ramped up in a bid to capture future markets. Companies such as Meta and Microsoft have staggering sums of money to spend, supported by their prodigious earnings growth from their existing businesses and cash-rich balance sheets.
In the first quarter of 2024, Microsoft’s capex rose 79% to $14bn, while Meta plans to increase its capex in 2024 overall by at least $5bn.
The question that most readily comes to our minds is: where is all that money going?
It is here that a more certain set of winners lies. AI may itself have a dramatic impact on our lives, society and physical world. The resources needed to support its evolution, though, are already experiencing – and creating – such an effect.
The expansion of AI requires significant infrastructure support – and that needs to be firmly in place before any transition can happen.
With this in mind, tangential operations such as data centres have become increasingly central to the AI revolution. Estimates suggest that AI-supporting data centres use two and a half times more energy than legacy data centres. With extra processing comes extra heat produced. As such, cooling technology has become a central requirement in the AI transition, accounting for up to 40% of that energy use.
Another example is memory. Devices will need to have additional memory capabilities to support the most challenging AI applications. As these functions come online, that hardware will need to be in place already.
As Nvidia’s meteoric share price rise demonstrates, semiconductors are a crucial component of this transition. This opportunity is investable via semiconductor producers themselves, through to the producers of the equipment used to manufacture the chips. The AI investing pool runs deep.
Indeed, down to the cabling required to carry so much additional data both within the data centres and around the world, a global supply chain is establishing itself.
Another question to ask ourselves though is: who will be the eventual winners among the AI service providers?
Ultimately, this is hard to forecast. One thing that seems certain is that our technology platform is likely to expand dramatically. Cisco has predicted that 500 billion devices will be connected by 2030, a rise from 13 billion in 2013.
This ultimately circles back to having the resources in place to support any applications that do come online. The demand for energy has already surged with the use of large language models. This exacerbated the increase in electricity use that was already coming from electric vehicles, heat pumps and other areas of the green transition.
The tension that this represents was most clearly reflected when Amazon purchased a data centre with its own nuclear power source earlier in the year.
With Western societies unused to energy needs increasing, this presents a significant challenge. However, among established energy producers, it also presents an opportunity.
Ben Lofthouse is the fund manager of Henderson International Income Trust. The views expressed above should not be taken as investment advice.
Experts discuss the departure of the manager and investment case for the fund.
Veteran manager Kevin Murphy will leave Schroders after 24 years at the firm to join his brother Dermot and former Jupiter Asset Management fund manager Ben Whitmore at the newly founded Brickwood Asset Management.
With the move, he will give up his role as co-manager of the Schroder Recovery, Income and Income Maximiser funds. Schroders has announced that Nick Kirrage, who currently leads the global value team, will join Andrew Lyddon and Andy Evans on all UK value portfolios, taking back a position that he held between 2006 and 2022.
A Schroders spokesperson said: “Continuity is key with the transition and succession being meticulously managed on behalf of our clients whose service and investment focus will remain unchanged.”
Performance of fund against sector and index since Murphy’s tenure
Source: FE Analytics
Murphy’s departing has dealt “a blow” to the Schroders team, according to Tom Green, fund analyst at FE Invest.
“This is a blow to the team, as Murphy was one of the founding members of the value team and does a lot of the work around the evolution of the funds process,” he said.
The income fund has a “long-term, successful track-record in value investing” and was recommended by FE Investments for its ability to move into positions quickly when stocks sell off aggressively as well as the team’s contrarian positions, which historically paid off in the long term.
The exit doesn’t necessarily impact these strong points, according to Green, who retained his conviction.
“Other members of the team also work with Murphy and due to the very experienced wider team, we have fewer concerns than if this was a single-manager structure,” the analyst concluded.
Ben Yearsley, investment consultant at Fairview Investing, broadly agreed with Green.
“It's a slightly strange move [for Murphy], as it results in two big beasts of the value jungle [Murphy and Whitmore] together. Maybe the opportunity to work with Whitmore as well as his brother was a big draw,” he said.
“It’s a shame for Schroders, as Murphy and Kirrage have always made an excellent team. But long gone are the days when it was only the two of them – it’s a much broader team now, which will be headed up by Kirrage solely.”
As for how investors in one or multiple products run by the team should react to the news, Yearsley said that “those who were happy holders before have no reason to change that view”.
Also not changing their views were the analysts at Square Mile Investment Consulting and Research, who have an ‘A’ rating on the Schroder Income fund.
Senior investment research analyst David Holder said that while it is “disappointing” that the Schroders team has lost “such a seasoned value investor”, the main effect of the move is to “further enhance Brickwood’s credibility” within the value investing space.
As for the consequences for Schroders, the re-introduction of Kirrage into the team “should very much comfort investors”.
“The three-person sub-team overseeing all UK value mandates is very well placed in terms of collegiate understanding, depth of investment knowledge and experience in this area of the UK market,” Holder said.
“The strength and depth of experience within the team remains cohesive and strong and as such, Square Mile has retained the A rating on the Income fund as well as the Recovery and Income Maximiser funds.”
Alphawave Semi’s transition away from China has hit its earnings expectations.
Alphawave IP Group (known as Alphawave Semi) has been targeted by short-sellers after revising its earnings expectations downwards. The company, which provides high-speed connectivity solutions for data centres, artificial intelligence and 5G wireless infrastructure, revealed in mid-April that its 2023 earnings would fall below its original forecasts due to its “accelerated transition away from China”.
The company warned that its investments in research and development would have a negative impact on profits and that revenues from “long-term contracts in advanced nodes” would be lower than expected.
Alphawave Semi published its annual report a week later, on 23 April 2024, with revenues of $321.7m for 2023. This represented a 74% increase compared to 2022 but fell below the company’s original outlook of $340m to $360m.
JPMorgan Asset Management disclosed a short position in Alphawave Semi last month amounting to 1.4% of the latter’s share capital. Marshall Wace, GLG Partners and Kuvari Partners have placed smaller bets against Alphawave Semi, according to the Financial Conduct Authority.
These bets have catapulted Alphawave Semi into the 10 most shorted UK-listed companies, ranked by the percentage of their share capital in the hands of short sellers.
Alphawave Semi listed on the London Stock Exchange three years ago and its share price peaked at £4.52 on 6 August 2021. It fell to £1.80 by 5 November 2021 and has been fairly range-bound since then. It was trading at £1.36 at the time of writing on 3 June 2024.
Short-sellers have also increased their bets against Ocado, which was the second most-shorted stock last month and risks being ejected from the FTSE 100 in its imminent reshuffle.
Dan Coatsworth, investment analyst at AJ Bell, described Ocado as “one of the most Marmite names on the UK stock market”.
“Investors either love or hate the quasi grocery/technology group and some even change their mind on a daily or weekly basis,” he said.
“There is always a ‘will it, won’t it’ element in trying to second guess what Ocado is doing strategically. On paper, the business model is focused on winning more grocery clients to power its online shopping warehouses, while also trying to improve the performance of a joint venture with Marks & Spencer. In reality, progress has been lumpier than gravy in a school canteen,” he concluded.
Energy facilities company Petrofac remains the UK’s most-shorted stock, as the table below shows.
Source: Financial Conduct Authority
Don’t miss out on the possible resurgence of the domestic market, experts warn.
Momentum is gathering for UK stocks, which surged through record highs last month, and the upcoming elections are drawing even more attention to the domestic market.
Indeed the FTSE 100 peaked at 8,445.8 in May, almost 600 points ahead of its pre-Covid levels, although it remains some way below the likes of the US’ S&P 500 index (11.2% return year-to-date), with the UK large-cap index up 9% in 2024 so far.
Whether this resurgence will be enough for investors to reconsider their preference for global investments and return to the unloved UK market remains to be seen, but experts are becoming more vocal about the opportunities cropping up domestically.
Trustnet has recently asked whether it's time for a patriotic punt on the UK stock market and many commentators pointed out the favourable entry point due to cheap valuations, increased international merger and acquisition (M&A) activity, improvement in economic data, imminent rate cuts and “voracious” share buybacks.
On top of that, many UK stocks have surged past most of the magnificent seven, with very few people noticing.
Hal Cook, senior investment analyst at Hargreaves Lansdown, said there is a lot to like about the UK stock market.
“With mature industries such as banks, oil and gas and tobacco, the UK has been known as a good place to look for dividend income, but there are plenty of growth opportunities too – from big consumer goods companies selling their products globally to smaller businesses looking to grow into the giants of tomorrow,” he said.
“We think this combination and the discount on offer compared to other regions make the UK an attractive place to invest right now.”
The main way – and the cheapest – to invest in the UK are exchange-traded funds (ETFs), according to Cook, whose preference was for two iShares and one Vanguard solutions.
For investors who want to get exposure to the largest UK companies, he recommended the iShares Core FTSE 100 ETF, which tracks the performance of the FTSE 100 index.
Performance of fund against sector and index over 1yr
Source: FE Analytics
“It does this by investing in every company and in proportion with each company’s index weight. This is known as full replication, which can help the ETF track the index closely,” he said.
The £2.2bn fund is passively managed by Blackrock, has achieved an FE fundinfo passive fund Crown-rating of five, and only charges 0.07%.
ETFs also offer access to income-paying stocks and Cook’s pick was iShares UK Dividend ETF, a low-cost option for tracking the performance of the FTSE Dividend UK+ index with a price tag of just 0.40%.
Performance of fund against sector and index over 1yr
Source: FE Analytics
This £848m vehicle offers exposure to 50 of the highest dividend-paying stocks listed in the UK, while still making sure it’s diversified across multiple sectors. The trailing 12-month yield is currently 5.45%.
Finally, medium-sized companies enthusiasts should consider the Vanguard FTSE 250 ETF, which aims to track the performance of medium-sized companies in the UK as measured by the FTSE 250 index.
Performance of fund against sector and index over 1yr
Source: FE Analytics
FE Investments analysts highlighted this fund for its simple method of replicating the performance of the index by direct ownership of all the underlying securities as well as its usage of stock lending, a practice by which a select third party borrows a limited amount of the passive fund’s holdings in exchange for a fee.
This supplements fund returns and compensates for the trading costs involved with direct ownership of the securities.
Among the investment management houses, Hawksmoor has been betting big on a UK recovery. Chief investment officer Ben Conway said that a FTSE 250 tracker would be a good option to capture a broad spectrum of opportunities in the mid-cap space, but fans of active management can also consider Aberforth Smaller Companies and Odyssean.
Not everything will be smooth sailing for the UK, however, and work remains to be done in a number of areas. The finance industry has been advocating for a number of changes to get Britain back on track.
Chelsea Financial Services and FundCalibre managing director Darius McDermott examines the catalyst for continued outperformance from emerging markets.
The last decade has been challenging for investors who have backed the emerging markets (EM) growth story. In that time the MSCI Emerging Markets index has produced around a third of the returns produced by developed markets (73% vs. 213%)*.
There are plenty of reasons for this – many EM economies have suffered since the 2001-2010 boom, which was fuelled by the likes of China’s rapid growth and the commodities super cycle. This is because many had uncompetitive currencies and failed to reform, particularly among those who exported commodities. The US dollar has also been largely strong since 2014, hampering US-dollar earnings-per-share growth for EM companies. We’ve also seen commodities prices ease, China’s growth engine slow and intensified geopolitical concerns.
The start of this year saw the MSCI Emerging Markets index fall 4.7%, the largest fall since January 1998**. This was because investors believed the strength of the US economy would lead to the Federal Reserve holding rates at their peak for longer. But the expectation of loosening financial conditions (lower rates) across the globe has started to initiate a broader recovery, with riskier assets like EMs up 6.1% in the past three months alone***.
Could a recovery in earnings growth, resilience in the US economy and the potential peak in US interest rates be the catalyst for continued outperformance in EMs from here? Clearly there are still dangers, there are plenty of elections in the region this year (not to mention the US), while many believe there is a lagged effect from high interest rates which will drag on the economy.
Falling rates one of a number of reasons for optimism
Although more rate cuts were anticipated at the start of 2024, the expectation is they are not too far away now and they should benefit many EMs, particularly areas like Latin America. This is where the US dollar comes into play, as rates come down in the US the dollar should stabilise (it will not be as strong) and weaken against other EMs. History shows the positive impact of rate cuts on EMs – with equities in the region rising by an average of 14% in the initial 12 months following the first Federal Reserve rate cut****.
GDP growth in EMs is also accelerating at a time when it is slowing in the developed world. Figures from the International Monetary Fund project growth of 1.7% and 1.8% for developed world economies in 2024 and 2025 respectively (vs. 4.2 per cent for EM’s in both years)^. Part of this is because EMs came out of Covid later, meanwhile EM consumers were not supported by governments in the emerging world, this means the recovery for the consumer has taken longer.
The third point is the ripple effect of China’s underperformance on EMs. Having fallen over 40% since February 2021, the re-rating of its equity market has been indiscriminate – and that has created plenty of valuation opportunities in the region for active managers^^.
Then there is earnings growth and valuations across the board. Consensus earnings growth for EM in 2024 and 2025 stands at 19% and 15% respectively, compared to 11% and 13% in the United States**. Meanwhile valuations look compelling, with EMs trading on a price-to-earnings multiple of 12x, compared to 18.9x for the developed markets and 21.9x for the US**.
Dispersion the order of the day
As we know many of these markets have different drivers supporting their growth today, so dispersion across countries and sub-regions is likely to be rife. Research from S&P Global indicates growth may moderate for many countries that outperformed in 2023 (such as Brazil, Mexico, and India) but remain relatively strong. By contrast those who underperformed last year (Colombia, Peru, Thailand, Hungary, Poland and South Africa) will grow modestly faster this year^^^.
When you add in the long-term demographic tailwinds and the rise of the middle-class, EMs do look attractive at this point, but you have to accept those bumps in the road. You also have to have a view on China and the impact it has on the wider region, but there are now plenty of different ways to invest across the region without being tied to one specific theme.
Those looking for exposure to the asset class might want to consider the likes of the JPMorgan Emerging Markets Investment Trust, which invest in around 60-100 high quality business, with the average investment held for 10 years. An alternative high conviction name would be the FP Carmignac Emerging Markets fund, a high conviction portfolio of 35-55 large and mid-cap firms.
Those who want a reasonable exposure to China may want to look at the FSSA Global Emerging Markets Focus fund, managed by Rasmus Nemmoe and Naren Gorthy, which currently has a third of its exposure in the country with names like Tencent, Tsingtao Brewery and JD.com sitting in its top 10 holdings^^^^.
By contrast, those who are wary of China might look to the likes of the Jupiter Asian Income fund, with manager Jason Pidcock citing political concerns as the main reason for not investing in China. He sold his last remaining mainland China stocks, as well as one Macau-based business, in July 2022, but had been underweight China for some time, due to his low expectations of corporate profitability relative to the rest of the region. Pidcock aims to yield 20% more than the respective benchmark. The portfolio is typically high conviction with between 30-50 stocks held. The focus on large companies with reliable returns, makes it an attractive defensive option.
*Source: FE Analytics, total returns in pounds sterling, from 30 May 2014 to 30 May 2024
**Source: Lazard, Outlook for Global Emerging Markets, April 2024
***Source: FE Analytics, total returns in pounds sterling, from 27 February 2024 to 27 May 2024
****Source: Franklin Templeton, 8 January 2024
^Source: International Monetary Fund, World Economic Outlook, April 2024
^^Source: FE Analytics, total returns in pounds sterling, from 1 February 2021 to 30 May 2024
^^^Source: S&P Global, Economic Outlook Emerging Markets, 26 March 2024
^^^^Source: fund factsheet, 30 April 2024
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above are his own and should not be taken as investment advice.
Experts explain the differences between Scottish Mortgage and Ark Innovation and share their preference.
Cathie Wood’s ARK Invest recently launched three of its exchange-traded funds (ETFs) in Europe, including the firm’s flagship strategy ARK Innovation ETF.
The latter is an aggressively-managed fund aiming to identify businesses that can be transformational and have the potential to generate exceptional long-term growth.
As a result of this investment process, the ARK Innovation ETF has proven to be volatile and has struggled in risk-off markets when the growth investment style fell out of favour.
This description may remind UK investors of a fund they are perhaps more familiar with: Scottish Mortgage.
Alex Watts, fund analyst at interactive investor, said: “There are some similarities in philosophy and positioning. Both funds take unconstrained approaches to investing in disruptive businesses that are driving innovation and are at the helm of cutting-edge and growing themes.
“This naturally leads them to invest in higher-multiple growth stocks, compared with more conventional and benchmark conscious peers.”
Despite their similar high growth approach, ARK Innovation and Scottish Mortgage differ in many ways too. As an investment trust, Scottish Mortgage has access to additional tools, such as the ability to leverage its portfolio and hold unlisted assets. It is also subject to a premium/discount mechanism, offering investors the possibility to buy assets below their net asset value. As an exchange-traded fund, ARK Innovation does not have access to these instruments.
They also diverge in their respective investment strategies: ARK employs a more active trading approach, whereas Scottish Mortgage uses a buy-and-hold strategy.
At the portfolio level, there are also significant differences between the two funds. For instance, Tesla is the only common stock in both funds' top 10 holdings, although the two portfolios share a few other names such as Shopify, Roblox, and Moderna.
Dan Coatsworth, investment analyst at AJ Bell, said: “One could argue that ARK’s portfolio is higher risk than Scottish Mortgage’s, certainly judging by the top 10 positions. For example, it offers exposure to cryptocurrencies via Coinbase and Block. It also holds web conferencing platform provider Zoom whose share price soared during the pandemic and crashed soon afterwards when people started returning to work in offices and Microsoft’s Teams system became more widely used, and has flatlined for the past two years.
“In contrast, Scottish Mortgage has quite a few well-established businesses which are giants in their industries including Nvidia, Amazon and ASML. Its stake in PDD is also interesting as the Chinese company’s latest results show a highly profitable business that is growing fast, helped by the runaway success of its e-commerce platform Temu, which is the talk of the town in the retail industry.”
ARK is also less diversified in terms of the number of holdings as well as geographic distribution. The ETF only invests in 30-50 holdings compared to approximately 100 for the more diversified Scottish Mortgage.
The investment trust is also more global, with sizeable allocations to Europe and the emerging markets in addition to North America. In contrast, ARK Innovation is significantly US-centric, with 95% of its portfolio invested in the US.
In terms of cost, Scottish Mortgage boasts a lower ongoing charge figure of 0.34%, whereas ARK Innovation charges more than double those fees at 0.75%.
As for performance, the British investment trust has done significantly better than its American ETF rival since 2014, with the outperformance being even more striking over five years.
Performance of funds since October 2014 and over 5yrs
Source: FE Analytics
However, ARK Innovation long had the upper hand until late 2021 when inflation and interest rates started picking up. Although both funds suffered from this dramatic change in the macroeconomic environment, the ETF was even more impacted.
What are experts’ preferences?
When asked to pick a favourite between the two, most experts voted for Scottish Mortgage. Darius McDermott, managing director at Chelsea Financial Services, prefers Scottish Mortgage’s buy-and-hold approach, although he recognised that there have been some misses.
He said: “We like Scottish Mortgage’s desire to run its winners, however there have been occasional instances, such as with Moderna at its peak, where the team missed opportunities to take profit.
“Overall, Scottish Mortgage's core strategy demonstrably aligns with a long-term mindset. Also, we believe the trust’s private market exposure continues to be a significant advantage.”
Another expert speaking in favour of Scottish Mortgage was Gavin Haynes, co-founder of Fairview Investing, who holds the investment trust.
He said: “Whist it has had some tough times the long-term returns have been impressive. I like the trust structure which allows access to unlisted companies and the competitive charging structure.
“Although the glory days were largely under previous manager James Anderson, I believe that Tom Slater is now making his mark on the portfolio and the returns over the past year have been encouraging.”
As for Watts, he highlighted that Scottish Mortgage features in interactive investor’s Super 60 rated list but finds it "encouraging" to see new participants in the UK market offering investors access to disruptive growth strategies.
“It’s exciting to see Cathie Wood, who has such a following in the US, bring a highly active strategy via an active ETF structure to the UK market,” he said.
He warned, however, that there is a significant key-person risk with ARK Innovation as Wood is simultaneously the founder, chief executive officer and chief investment officer of ARK.
Global equities have delivered an annualised return of about 4.9% since 2000. Not bad, but when investors can lock in coupon payments at yields close to historical equity returns we think we are in a new golden age for bonds.
Corporate bond yields began climbing rapidly at the start of 2022, creating difficulty for many market participants. However, the rise in yields sets the stage for bond investors to reap higher levels of income than previously available.
This is because the average European investment grade corporate yield is around 3.9%, as measured by the Bloomberg Pan-European Corporate Bond Index. Meanwhile, high-yield corporate bonds yield around 7.7%, as measured by the Bloomberg Pan-European High Yield Index. This compares to a dividend yield for the MSCI World Index of around 1.8%.
Critically, many corporate issuers have funding costs well below current market yields, so have been insulated from the rise in rates. That’s because 63% of investment-grade corporate bonds and 69% of high-yield bonds were issued before 2022.
While a bond investor should care about yield and not typically make issuance year a focus, this dynamic provides some cushion to bond investors as corporate funding costs are only rising slowly as bonds mature and need to be refinanced.
This sets up a win-win for bond investors and the companies in which they invest: a win for the investor because they can harvest today’s higher yields from high-quality companies, and a win for many corporations as they can comfortably service their debts at pre-2022 coupon levels.
With rate cuts nearly upon us, the rates environment should become friendlier for corporate refinancing in the years ahead.
Exploiting market inefficiencies
Given where we are in the economic cycle, plus the political landscape, we expect volatility to increase, which should create plenty of market dislocations to exploit.
The rise of passive investing in the past decade has dramatically reduced the cost of investing in bonds, but it has also created significant inefficiencies for active bond investors to exploit, as comparatively less active money has been available to arbitrage away relative or absolute value opportunities.
A key risk for passive bond investing is that fixed income benchmarks are fundamentally flawed in a way that equity indices are not. Unlike equity indices, bond indices tend to apply weightings based on debt outstanding. This can mean passive bond investors are unintentionally overweight and overexposed to more heavily indebted companies.
An active investor can generally seek to avoid this scenario, particularly in an environment where growth may be challenged, calling into question the creditworthiness of the most indebted borrowers.
Who stands to benefit?
We believe an active approach to bond investing allows investors to take more intentional tilts in favour of bonds backed by companies with strong credit characteristics and those at an attractive valuation, among other risk factor tilts.
A savvy bond investor can exploit the many inefficiencies that arise from large index-tracking strategies that are focused on closely tracking a benchmark, rather than risk-adjusted return generation.
Consider, for example, actively managed multi-sector fixed-income strategies that offer yield and some shelter from volatility. Additionally, a strategy focused on a single sector such as high-yield bonds can offer equity-like returns with a lower risk profile than stocks.
Targeting inefficiencies effectively means casting a wide net across the fixed income universe, including corporates, governments, municipals, mortgage-backed securities, global bonds, emerging markets, and structured credit, and combining the best opportunities with precise risk scaling.
As economic growth is expected to slow, managers also need robust credit analysis capabilities, not just across corporate bonds but all forms of bonds, which requires extensive resourcing commitments.
Market inefficiencies are often durable but not large. Most notably, the risk premium available on individual bonds can be inefficiently priced, allowing credit-focused managers to target multiple security selection opportunities.
Unfortunately, some strategies might be just too large to implement a meaningful security selection position based on the volume of bonds outstanding. As a result, we find the largest bond funds are often overly reliant on duration positioning, which can be very volatile.
We believe managers need to be resourceful enough to find inefficiencies across the whole fixed income universe, such as employing credit analysts across the globe to cover issuers in their local market.
However, they also need to be nimble to have any hope of exploiting them, for example, by managing strategies small enough to take a security or sector selection position that can have a meaningful impact on performance.
Bonds might lack the glamour and buzz of many of the investment trends of the past decade, but they have the income, return, risk profile and staying power many are seeking. Welcome to the new golden age of bond investing.
Peter Bentley is co-manager of the BNY Mellon Global Credit fund and deputy CIO of fixed income at Insight Investment. The views expressed above should not be taken as investment advice.
Trustnet reveals where investors should have put their cash last month.
Domestic funds dominated the leaderboard in May, with all three major UK equity sectors in the Investment Association universe among the top five peer groups over the course of the month.
IA UK Smaller Companies topped the billing, with the average fund making a 6.1% total return. IA UK All Companies and IA UK Equity Income were in third and fourth place, making 3.2% and 3.1% respectively.
Splitting the UK sectors was IA European Smaller Companies (up 4%) while IA Europe Including UK rounded out the top five (3.1%).
It was a similar story in the investment trust sphere, where the average trust in the IT UK Smaller Companies sector marched 7.9% higher, while IT UK All Companies constituents made an average gain of 7.4%.
They were topped, however, by specialist strategies in the IT Infrastructure Securities sector (10.8%).
Source: FE Analytics
The month was a busy one for the UK, with prime minister Rishi Sunak shocking the nation with an early general election in July.
Ben Yearsley, director at Fairview Investing, said: “The polls look like it’s a one way bet, with Keir Starmer the next prime minister. However, the parties are yet to publish their manifestos which may contain some surprises. Unfortunately, most of the surprises will probably cost money although both parties are being very careful to rule out tax rises.”
Perhaps Sunak’s rationale centred around economic data, where official UK inflation was 2.3% in April, down from 3.2% the prior month.
Meanwhile, the UK has exited recession with growth of 0.6% in the first quarter beating forecasts of 0.4%. “Was it this that pushed Rishi into his election gamble or was it that household confidence is at its highest for three years?,” asked Yearsley.
Both the UK’s FTSE 100 and US’ S&P 500 indices hit new highs last month, yet it was the domestic funds that benefited the most.
“It is slightly odd when you consider all three main US indices hit new highs in May, however the US dollar was weak knocking returns to most UK investors,” said Yearsley.
At the foot of the table was Latin American funds, with the IA sector down 4.8%, while both China and India stocks also fell.
Turning to individual funds, there was a resurgence for renewable energy portfolios, with the top three - Invesco Solar Energy UCITS ETF, First Trust Nasdaq Clean Edge Green Energy UCITS ETF and Luxembourg Selection Fund Active Solar – all making 14% or more.
TM CRUX UK Smaller Companies, managed by Richard Penny, was the top domestic fund, with the £7.8m fund up 12.6%. It was joined in the top 20 by peers Invesco UK Smaller Companies Equity, WS Amati UK Listed Smaller Companies, FP Octopus UK Micro Cap Growth, SVS Dowgate Wealth UK Small Cap Growth and WS Gresham House UK Smaller Companies, while its larger stablemate TM CRUX UK Special Situations also made the top performers list.
Source: FE Analytics
Yearsley said: “Following on from April’s new FTSE high, May has continued the same trend. The UK market finally appears to be garnering attention. Takeovers and M&A are almost a daily occurrence now. Some are rebuffed like BHP’s attempt at Anglo and the PE approach for Hargreaves Lansdown, while others go through.
“It’s fascinating though that UK small-cap is also joining the party topping the performance charts in May – the rally is spreading. Despite this, the UK still looks cheap offering good yields and defensive characteristics - the only thing missing is proper growth stocks.”
In terms of losers, there were many individual emerging market ETFs under pressure last month, with Indonesia, Brazil, Korea India and the Philippines all represented in the bottom 20 funds. Worst of all however was WisdomTree Cybersecurity UCITS ETF, down 8.1% in May.
Among active funds, Fiera Capital Europe's Magna MENA was the bottom of the pile, down 7.3%, while Morgan Stanley US Advantage lost 7.1%.
In the trust world, Foresight Sustainable Forestry topped the list after it received an offer from another Foresight managed product, making a return of 44.4% over the month. Yearsley asked: “Is it only time before all specialist trusts under say £200m in size get bought out?”
Source: FE Analytics
At the foot of the table, Sancus Lending lost 31.8% after the firm announced it would make a loss of around £10m for 2023 due to write-downs on legacy loans.
Fund managers highlight four common pitfalls in fixed income investing and reveal strategies to safeguard against them.
Bond funds have been in the spotlight since the major central banks ended their rate hiking cycle last year, as investors and fund managers endeavoured to lock in historically high yields and position themselves to make capital gains when yields started to fall.
In light of renewed investor interest, as well as the volatility seen in bond markets during the past couple of years, Trustnet asked fund managers to highlight some of the risks involved with fixed income investing and to suggest ways to mitigate them.
Don’t get too greedy
Credit spreads are tight, which means that corporate bonds are not offering investors much compensation for taking additional credit risk, said Nicolas Trindade, who manages a range of short duration strategies for AXA Investment Managers.
On the other hand, sovereign bonds yields, particularly in the US, have repriced significantly higher this year in reaction to sticky inflation data. “Treasury yields are 50 basis points higher on a year-to-date basis and the market has gone from expecting six interest rate cuts from the US Federal Reserve at the end of 2023 to two. So, it is amazing to me that risk assets have barely reacted at all,” he said.
“Credit spreads tightened substantially at the end of last year because the market thought the Fed would cut a lot. Now no-one thinks the Fed will do that, but credit spreads haven’t really widened to reflect that significant change of view.”
Therefore, Trindade warned investors to remain cautious, given that inflation could still surprise to the upside.
“The risk – the thing that will finally break the market – is that the Fed opens the door to interest rate hikes. That is not our central scenario, but investors must have it at the back of their minds. Investors should not get greedy in an environment like this. Yields have come right back up after the sell-off, so you don’t need to take big risks to get a good return.”
Short-dated bonds are attractive from a yield perspective, he continued, and given that sovereign yield curves are inverted, there is little incentive to buy longer bonds.
“If inflation continues to surprise to the upside, particularly in the US, investors will get better protection from short-dated paper. Investment grade bonds at the front of the curve offer a nice combination of better yields, less duration and solid fundamentals.”
Credit investors can’t afford to ignore sovereign debt
Corporate bonds are priced off the government bond yield curve. Therefore, credit investors should check whether the equivalent government bonds of the appropriate currency and duration are correctly priced and reflect their view on interest rates, said Emma Moriarty, an investment manager at CG Asset Management.
By way of example, the duration of CG’s sterling corporate credit portfolio is two years, so Moriarty has been analysing two-year gilts, which are “probably fairly priced for our rate expectations so that’s a duration we’re comfortable to ride”.
She agreed with Trinidade that investors are getting less compensation for credit risk as spreads have tightened. CG has reduced its sterling corporate credit allocation over the past few months after making capital gains because there is “not much more room”.
Corporate bonds behave like equities in a crisis
In times of stress, corporate bonds – especially BBB-rated bonds – can become relatively illiquid and cease to provide diversification against equities, said Will McIntosh-Whyte, a fund manager in Rathbones’ multi-asset team.
“If you have lots of people running for the exits at the same time, these things can move to big discounts, particularly in a 2008-type scenario. They can then suddenly behave more like equities because they're not always the most liquid, and particularly when you get down into the BBB area. In really difficult markets, it can become quite difficult to sell them at all, unless you want to take a nasty haircut to the price,” he explained.
“I'm not saying you should never hold corporate bonds, but I think you just need to be wary of what they are.”
Rathbones’ multi-asset team classifies asset classes into three buckets: liquidity, equity-type risk and diversifiers. Corporate bonds belong in the equity risk bucket, while government bonds are in the liquidity bucket because “you can always sell them in any market at the market price”.
Government bonds are not necessarily low risk, however. “You don't really have that credit risk, but you can have volatility because you've got that interest rate risk and obviously, we saw that in spades in 2022.”
This is why Rathbones has a third bucket of uncorrelated return streams, such as a US rates volatility trend note and S&P 500 put options.
Avoid fallen angels
Corporate bond prices plummet when the company that issued them is downgraded, especially if it falls off the cliff from investment grade to high yield, said Adam Whiteley, head of global credit at Insight Investment.
Insight Investment uses a ‘landmine checklist’ to spot which issuers might get downgraded ahead of time. Companies that are taken private or that undergo management buyouts with an element of private equity funding raise a red flag because transactions are often financed with debt, he said. This can lead to ratings downgrades due to higher levels of debt on the company’s balance sheet.
The firm’s landmine checklist looks out for characteristics that might attract private equity acquirers, such as: a share price that is underperforming versus the peer group; a modest size so the whole entity can be acquired; and stable earnings and cash flow to pay off the debt used to finance an acquisition.
The next step involves digging into the bond documentation. Some bonds have a clause where they must be redeemed at par if the issuing company’s ownership changes hands. When corporate bonds are trading below par, a change of control can deliver some upside, he explained.
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