People adopting a healthy lifestyle by drinking and smoking less is arguably a good thing but it put a dent in the Liontrust UK Growth fund last year. Shares in British American Tobacco and Diageo fell 23% and 20%, respectively, in 2023 and cost the fund 1% of performance each.

Anthony Cross, head of the Economic Advantage team at Liontrust Asset Management, is keeping faith with Diageo. He looks for companies with intangible assets such as large-scale distribution networks that are hard to replicate and favours international consumer goods companies such as Diageo and Unilever. The big unknown for Diageo is how widespread the take-up of American diabetes and weight loss drugs will be, given that people who take these drugs consume less alcohol.

The fund’s strongest recent performers are companies that specialise in data and software tools. Sage, which provides accounting software and cloud-based services, was on a tear last year climbing 61%, while RELX, which supplies analytics and decision tools for the medical, legal and government sectors, rose 39%.

Cross manages the £1bn Liontrust UK Growth fund with Julian Fosh, Matt Tonge and Victoria Stevens. The large-cap iteration of the Economic Advantage investment process, it has achieved top-decile performance for the past decade, earning Cross and Fosh a nomination for FE fundinfo’s Alpha Manager of the Year award.

Cross told Trustnet why he doesn’t think he can add value by making macro calls and why intangible assets drive long-term returns.

What is the UK Growth fund’s investment process?

The process starts with the hunt for businesses that have strong barriers to competition through intangible assets. Three intangible assets are the gateway into any of our funds: intellectual property, distribution and high recurring revenues (more than 70% of a company’s income should be recurring).

Stocks must have at least one of these factors but several of our holdings have two or three. Sage is rich in intellectual property and data-driven distribution and more than 90% of its turnover is recurring income.

Once stocks are through the gateway, we look at other intangible assets such as brands, customer relationships, franchises, licences and culture, which are difficult for competitors to copy and give companies pricing power.

Our companies have an average 12% cash flow return on invested capital versus 7% for the broader market. It’s a really nice test for us as to whether those barriers to competition are actually working.

Finally, when we buy these businesses for the first time, they need to be cheaper than the market on a number of standard measures, such as free cash flow yield, dividend earnings and price-to-earnings ratios, to make sure we’re skewing the odds in our favour.

Why should investors buy the UK Growth fund?

This is the fund to own if you want large-cap exposure. The UK Growth fund has 70% in the FTSE 100, 20% in FTSE 250 stocks, 7% in small-caps and 3% in cash.

There are 44 positions in the portfolio. Most companies go in at 2% plus their index weight so some of our holdings can be quite big. We own 8% in Shell and AstraZeneca, 5-6% in BP and 4% in Diageo.

What you’re going to get with this fund is a quality footprint and compounding. It also has a nice international flavour if you’re a bit bearish about the UK, given that 82% of our companies’ sales come from overseas versus 76% for the FTSE All Share.

Performance of fund vs sector and benchmark over 10yrs

Source: FE Analytics

Which stocks were your best and worst performers last year?

Shell, Sage, BAE Systems and RELX each added 1% of performance to the fund last year. With RELX and Sage, not only were they delivering on earnings but you’ve got that general data excitement going on, so they enjoyed an increase in their price to earnings ratios.

Performance of shares vs FTSE 100 in 2023

Source: FE Analytics

We bought Sage five years ago on a free cash flow yield that was larger than the market. Everyone had given up on Sage at that point; people thought its customers would move to competitors.

Sage has a strong base of clients using its accounting software who are unlikely to change providers. We thought the stickiness of its distribution network would enable the company to migrate to more cloud-based products, which is what happened. Sage is delivering high-single-digit to double-digit organic growth. If growth slows down it could underperform so we have taken profits and trimmed our exposure.

In terms of detractors, British American Tobacco and Diageo each cost us 1% in 2023. The jury is still out with Diageo. It performed well during the successive lockdowns but since then people are drinking less and there has been a cost-of-living crisis.

Diageo also had a stocking problem in Latin America, where the wholesale market was overstocked and demand was not pulling through. This led to a profit warning with a brand new set of management.

Invidior cost us 0.8% last year but it has performed strongly this year, adding 0.5% to the fund already. Invidior had some dangling liabilities and litigation issues which were biting last year and it faced pressure from competitors, but this year the business has performed well and it has dealt with the litigation.

Invidior vs FTSE 100 since 1 Jan 2023

Source: FE Analytics

What are your highest conviction investments?

We have most conviction in some of the small-cap stocks from a valuation perspective. Gamma Communications provides phones and conference call systems to small and medium-sized businesses. It has gained some larger enterprise and government clients and is expanding into Europe, which is quite underdeveloped when it comes to cloud-based telephone systems.

Market research provider YouGov has faced a tough backdrop with declining media spend but it has a strong brand and terrific data sets and could grow a lot more in America.

Future, a mid-cap digital publishing business, is trading on a price-to-earnings ratio of 5x and has a double-digit free cash flow yield. Its magazines, from Country Life to TechRadar, earned revenues from affiliate marketing during lockdown, but since the pandemic, purchasing habits have changed and revenues have dropped.

How much attention do you pay to the broader macroeconomic backdrop?

We don’t attempt to predict where inflation, interest rates or foreign exchange are travelling because we don’t think we could add any value doing that.

Our companies themselves are always thinking about interest rates, currency movements and political upheavals in the countries they are supplying. One has to rely on businesses themselves doing their homework in terms of where they want to be exposed and what the dangers are.

What do you do outside of fund management?

I live near Perth in Scotland and I have a cottage further north. I’m a big believer in having a hinterland to put things back into perspective so I go fishing, which is a head-clearer and I enjoy skiing.

Investing for income can be a priority for many investors, whether it be to supplement a salary, earn a living entirely or to keep comfortable in retirement.

The UK is perhaps the market most synonymous with income, thanks to its higher-than-average dividends and yield. Unlike countries such as the US – where companies focus more on growth and reinvesting their spare cash – UK stocks have long history of returning excess money to shareholders.

Many will look at the FTSE 100 as the best place for this, with big payers such as the oil giants, miners and banks all residing at the top of the domestic market.

Yet those that rely on these mega companies are putting their eggs into an increasingly small basket. More than half (57%) of all dividends in the index are paid by just 10 companies, with the remaining 43% coming from the other 90 names, according to data this week from Octopus Investments’ ‘Dividend Barometer’.

What’s more, the traditional income sectors might not be the best areas of the market to invest in going forward from a total return perspective.

Investors can get much more diversification further down the market. On average, the 10 largest dividend-paying companies in the FTSE 250 accounted for just 22% of the total paid out by constituents of the mid-cap index, Octopus found. This rose slightly to around a third of FTSE Small Cap companies and 36% of the amount from those quoted on AIM.

But this is not the only reason why mid- and small-caps might be a better option for income seekers than their larger counterparts.

Among the four indices mentioned, companies in the FTSE 100 have the lowest dividend cover, a measure of a stock’s earnings relative to the amount of money paid out to shareholders each year.

Additionally, while investing as a whole took a big hit during the pandemic in 2020 as companies held back cash to cover shortfalls, the lower parts of the market have been quicker to recover. While FTSE 100 dividends are still some way from their pre-pandemic levels, companies outside of large-cap status are much closer.

And this is set to continue. Octopus forecast FTSE 100 dividends to remain 11% behind 2018 levels by the end of 2025, while the rest of the market will overtake previous highs by the end of next year.

Of course, mid-caps are not going to be right for everyone. Smaller stocks tend to be inherently riskier and therefore may not suit retirees, for example.

But even this is a double-edged sword as they also have the potential for higher gains as they have more room to grow. And this is a crucial part of income investing that many forget.

Buying stocks where the share price should in theory rise more quickly (as is the case with mid- and small-caps) creates a double-whammy for investors.

Now this is by no means a reason to sell all of your large-caps and move lower down the market, but if you do need income, it is worth considering putting a sleeve of your portfolio into stocks further down the cap spectrum.

UK GDP rose 0.1% in February thanks to improvement in the services and production sectors, according to data from the Office for National Statistics.

Although GDP growth last month slightly dipped compared to the 0.3% rise recorded in January – which was revied up from 0.2% in the latest reading – the UK is now on track to exit the technical recession it entered at the end of last year.

Stephen Payne, portfolio manager on the global equity income team at Janus Henderson, said: “Industrial production was stronger than expected, continuing its recent pick-up, whilst construction activity was hampered by the very wet weather.

“Growth for the first quarter is now set to come in stronger than the Bank of England’s anaemic forecast, but it is still only a modest recovery that does not threaten the on-going disinflation in the economy.”

As a result, Payne believes that the stage is set for the Bank of England (BOE) to start cutting rates, as base rates remain “comfortably” above the rate of nominal GDP growth.

As such, the UK appears to be in a better position than the US to start its interest rate cut cycle, as inflation across the pond came in higher than expected earlier this week, dampening hopes for rate cuts in June, while more bearish market participants wrote off any rate cut in the US in 2024.

Meanwhile, the European Central Bank (ECB) opted to maintain its rates unchanged yesterday, with President Christine Lagarde confirming the ongoing disinflationary process. Therefore, the ECB may consider rate cuts at its next meeting in June should inflation persist in its downward trajectory.

Neil Birrell, chief investment officer at Premier Miton Investors, said: “With inflation tracking back, the BoE might be persuaded to start cutting rates sooner rather than later and after the CPI data out of the US and the ECB meeting over the last week, we could well see the Fed being the last of the three to take any action on rates. That would be quite a shift over a period of a few months.”

However, Danni Hewson, head of financial analysis at AJ Bell, warned that there are a few “wildcards” in play that could impact the UK economy in the coming months. That includes tensions in the middle east, which have recently pushed the price of oil over $90 a barrel, and the fact UK shoppers will have a few more pennies thanks to the cut in National Insurance contributions and the rise in the National Living Wage.

Ed Monk, associate director at Fidelity International, also sees a contradiction in having a recovering economy and the relief of lower rates at the same time.

He explained: “If today’s reading is positive for growth overall it may end up being bad news for both borrowers and financial markets, in the short-term at least. Both are waiting for the Bank of England to cut rates but wage rises and now better performance in parts of the economy are adding to inflationary pressures.

“Expectations of rate cuts this year have softened and markets now expect only two cuts before 2025.”

Nonetheless, both the FTSE 100 and FTSE 250 were up at the market open, as the positive GDP figure gave investors hopes that the UK is on its way out of recession.

Russ Mould, investment director at AJ Bell, said: “Housebuilders and supermarkets were in demand as investors took the view that a stronger economy will give a boost to consumer confidence and provide a better backdrop for spending.

“Miners also helped to give the FTSE 100 a lift as copper prices continued to climb thanks to the twin engines of supply fears and brighter demand prospects.”

Polar Capital and Fidelity International offer the most reliable actively-managed thematic funds. Their technology, healthcare and financial services strategies performed consistently well during the past decade, data from FE Analytics showed.

Funds run by Polar Capital and Fidelity topped the tables by outperforming the most common benchmarks in the Investment Association Healthcare and IA Financials and Financial Innovation sectors since 2014.

A noteworthy exception was technology, where passives took the lead.

Amongst the 32 funds in the IA Technology & Technology Innovation sector, only 13 vehicles have a 10-year long history and were therefore part of this study.

Only two funds managed to beat the MSCI World Technology Index (the most common benchmark for the peer group) in seven of the past 10 years – the L&G Global Technology Index Trust and the SSGA SPDR MSCI World Technology UCITS ETF.

Both are passive vehicles, which benefitted from the Magnificent Seven’s relentless growth last year.

This burgeoning of just a few companies, particularly in the past year, left active managers who scan the market for underappreciated opportunities behind.

With £2.8bn of assets under management, the L&G Global Technology Index Trust is a popular option for investors. It tracks the FTSE World Technology Index and returned 53.27% last year, charging a mere 0.32%.

Marginally cheaper, with an ongoing charges figure (OCF) of 0.3%, and significantly smaller (£497.4m), the SSGA SPDR MSCI World Technology UCITS ETF tracks the MSCI World Information Technology Index Capped 35/20 instead. It stood behind our reference benchmark in 2022, 2018 and 2015, as the table below shows.

Source: Trustnet. The red highlight represents underperformance against the reference benchmark.

In the active space, the most consistent strategy was the $6.6bn Polar Capital Global Technology fund, co-managed by Ben Rogoff, Nick Evans, Fatima Iu and Xuesong Zhao, who were highlighted by Square Mile analysts for their skill at “identifying changing industry trends and the companies that are poised to benefit as a result”.

“A plus for the fund is the experience of the managers, who have witnessed first-hand a plethora of seemingly promising businesses that have fallen by the wayside, alongside the gains that can be generated through companies that succeed in sustaining the growth of their business,” they said.

“We believe this is an attractive fund for long-term investors who are looking for exposure to rapidly growing technology companies.”

Moving on to the IA Healthcare sector, where only seven of 22 funds qualified for this study, the £3.1bn AB International Health Care Portfolio stood out with eight years of outperformance against the MSCI World Healthcare index in the past decade.

The fund is managed by John H. Fogarty and Vinay Thapar, who focus on companies that are expected to attract healthcare spending through the introduction of new treatments and therapies or by offering customers cost reduction opportunities.

Their top holdings are Eli Lilly (8.1%) and Novo Nordisk (7.5%), which are among the most successful pharmaceutical companies of the recent past and contributed to the fund’s performance in an otherwise difficult period for healthcare funds.

The portfolio is concentrated in 43 names and the top 10 holdings constitute 55% of its assets.

Source: Trustnet. The red highlight represents underperformance against the reference benchmark.

Fidelity Sustainable Health Care, Polar Capital Healthcare Opportunities and Wellington Global Health Care Equity also stood out having outperformed the benchmark in six of the past 10 years.

The Fidelity and Wellington funds are similar – both invest almost exclusively in healthcare and they have a correlation of 87% – whereas Polar Capital Healthcare Opportunities is more diversified across sectors, with biotechnology and medical making up 47% of the portfolio, healthcare 25.2%, medical products 11.8% and pharmaceuticals 15.72%.

All three funds have more than £1bn in assets.

We conclude with the IA Financials & Financials Innovation sector. Here, eight funds out of 14 had a 10-year track record and the largest of them were also the most consistent.

Fidelity Global Financial Services (£1bn) and Polar Capital Global Insurance (£2.2bn) had seven strong years. Fidelity’s fund slipped up in 2022, 2021 and 2016, while Polar Capital struggled in 2023, 2021 and 2017, as the table below shows.

Source: Trustnet. The red highlight represents underperformance against the reference benchmark.

The Polar Capital fund is managed by Dominic Evans and Nick Martin, who are the chief reason why Square Mile analysts favour the vehicle. They also like the “sensible” strategy that emphasises well-managed and proven insurance companies that have high returns on equity and good underwriting records.

“Martin has built a deep pool of company knowledge and is well informed as to the intricacies of investing in this sleepy sub sector of markets that is not widely covered, is perceived as complex and includes plenty of companies of variable quality,” they said.

“Evans’ promotion to fund manager in March 2022 was a natural progression for both him and the fund. We believe that the managers of this fund should be able to achieve their objectives over the long term.”

With exposure to distributors, healthcare, insurance and transport, Polar Capital Global Insurance is quite different to Fidelity Global Financial Services, which almost exclusively focuses on financials and combines a bottom-up fundamentals approach with top-down macroeconomic views. The two are only 57% correlated.

This article is part of an ongoing series on consistency. Find the previous instalments here: Emerging Markets, IA Global, Europe, IA UK Equity, IA UK Equity Income, UK Small Caps, UK bonds, cautious funds, balanced funds, adventurous funds.

Canaccord Genuity Wealth Management has increased its weighting to quality stocks with the addition of Fundsmith Equity and Evenlode Global Income.

Kamal Warraich, head of equity fund research at Canaccord, explained that the stressed economic environment, recent technical recessions and the slowdown in global economic growth have led the wealth management firm to seek refuge in the quality factor.

He said: “Quality gives you meaningfully consistent and good risk-adjusted returns, decent upside capture and the best in terms of drawdown.

“We think quality is the place to be, not just for the next few years, but for the foreseeable future. We are willing to pay more for the quality bias.”

Performance of fund vs sector and index since launch and over 5yrs

Source: FE Analytics

The funds Canaccord chose to beef up its exposure to the quality factor are Fundsmith Equity and Evenlode Global Income.

Warraich said: “We've introduced some high quality global fund managers into the portfolio to improve the profitability characteristics.

“Fundsmith is quite an obvious candidate for quality growth on a global scale, whereas Evenlode Global Income provides us with a dividend growth factor and gets us quality in a different way.”

Performance of fund vs sector and index since launch and over 5yrs

Source: FE Analytics

Among the sectors traditionally associated with the quality factor, Warraich particularly likes consumer staples in Europe but even more in the UK.

He said: “In the UK, they're trading on much cheaper valuations than their like-for-like international peers, because of the Brexit effect, the government issues, Liz Truss’s mini-Budget, etc.

“We would broad brush consumer staples and say that, notwithstanding issues, Diageo still looks attractively valued on certain metrics.”

However, Warraich highlighted that some of Europe’s biggest companies, known as the ‘Granolas’ (GSK, Roche, ASML, Nestle, Novartis, Novo Nordisk, L’Oreal, LVMH, AstraZeneca, SAP and Sanofi), look fully valued.

For instance, Nestle recently disclosed a revenue slowdown as inflation has hurt the demand for some of its products.  

Luxury products and alcohol – which are sub-sectors often associated with the quality factor – have also suffered in recent months, but these are more short-term issues, he said.

For instance, Burberry issued a profit warning at the beginning of the year as the demand for its products has diminished due to the rise in the cost of living and the surge in interest rates.

Diageo also recently had a profit warning, as it faced overstocking problems in Latin America.  

Warraich added: “It's not perfect across the board and sometimes these companies are priced a little too perfectly or are fully valued. You have to be quite careful and minded that there are still some pressures.

“But the key is to look at the long term. When you look at the short term, there are a lot of problems, medium term less so and long term, fewer problems still.”

Another sector associated with the quality factor that Warraich finds compelling is healthcare, as it has had a few difficult years after the Covid rally.

It is, in fact, one of the few ‘unloved’ areas Canaccord has recently gone overweight alongside UK small- and mid-caps, China and infrastructure.

In addition to quality, Canaccord has some exposure to the value factor, but uses it more as a satellite play.

Warraich said: “Value can be prone to big bouts of cyclicality. It's highly correlated to interest rates and the yield curve. You can have big cycles where commodities and banks do quite well.

“We don't mind having some of that exposure, but we're minded that it's more of a secondary component.”

The underlying feeling in the UK equity markets is that good news is coming. The inverted yield curve was right in forecasting a recession – even if it was much milder than the Bank of England’s (BoE) Monetary Policy Committee (MPC) prediction – and we’re now on the cusp of falling interest rates again, as central banks await the data that will allow them to start what looks to be a long descent.

For investors allocating to UK equities, this is therefore an appropriate juncture at which to ‘dress for the weather’ and prepare their portfolios for the changing conditions. The MPC doesn’t cut rates often, but history teaches us there are trends in performance when they do.

We looked back at the BoE cutting cycles of 1992-94 (post early 90s recession), 2000-03 (dot.com bust) and 2007-09 (global financial crisis) to see how performance varied across the market-cap spectrum both during the cutting cycles and in the subsequent twelve-month periods. This is what we found…

A lesson from history

As rates were cut in the wake of the early 90s recession, equities rose, with the FTSE All Share rising a phenomenal 49% between September ’92 and September ’94. This was in sharp contrast to their performance since the Millenium.

During the subsequent rate cutting periods, they fell 27% in the dot.com bubble of 2000-03 and 44% during the global financial crisis (GFC).

However, as illustrated in the chart below, if we look beneath the FTSE All Share, we see a differing picture – and an important underlying trend – across the market-cap spectrum.

In 1992-94, whilst every part of the index rallied, the FTSE 100 was the worst performer, with a total return of 40%. But the FTSE 250 (ex-Investment Trusts) rose an astonishing 87%. Halcyon days.

Source: Martin Currie

In 2000-03, the FTSE 100 total return was a horrible -30%, but the FTSE 250 once again outperformed, down a ‘mere’ 3%. This was the markets’ ‘Fright Night’.

The GFC saw further losses as rates were cut – markets fell and the FTSE 100 was down 43%. This time, the FTSE 250 was worst affected, down 48% over the whole period.

However, this doesn’t show the whole picture.  If we look at the chart below, we can see that the FTSE 250 recovered earlier, hitting the market low in November 2008 and recovering quicker than the FTSE 100 in the subsequent 12 months.

So, history suggests that in periods of economic stress it is wise to consider UK mid-caps.

Source: Martin Currie

After the dust settles

What happened in the years after these rate cuts had ended? In all three subsequent twelve-month periods, UK equities made positive returns, but again the market-cap picture was nuanced.

The wild ride post-GFC saw increases of more than 60% for all the indices, but mid-caps were once again the winner, with a 71% total return.

Life was a little more sedate in 2003-04, when the FTSE 100 rose by 13%. But again the more growth-orientated FTSE 250, consisting of companies with greater exposure to the domestic economy, was arguably better positioned into the recovery – it returned 23%.

Some 30 years ago, 1994-95, was the only time when the FTSE 250 did not keep its crown, despite returning a respectable 7.5%. The FTSE 100 produced its only gold medal finish, a podium-topping return of 21%.

Beware sector-level volatility

The data makes the case that when the BoE is cutting rates it’s time to consider the often-overlooked UK mid-caps, but investors also need to be mindful of significant sector rotations and volatility.

For example, in the 1992-94 period, healthcare went from worst to best performer in the subsequent recovery. The opposite was true for basic materials. In the wake of the dot.com bust, industrials went from being one of the weakest sectors to one of the leaders.

Likewise, in the GFC, healthcare and utilities were among the strongest but became the worst performers in the recovery, while financials and basic materials powered back to the top.

Source: Martin Currie

When economic conditions change, we can expect the market impact to be nuanced and fluid. In such environments, an active investment approach with a discerning emphasis on companies themselves can capture the potential of the mid-cap space, while limiting exposure to weaker performing areas to help navigate the volatility.

While past performance, as we always say, is not a guide to future returns, understanding these historical patterns can help investors to navigate this transitional moment – and to better position their own portfolios for what consensus suggests is a brightening market outlook.

Michael Browne is chief investment officer at Martin Currie. The views expressed above should not be taken as investment advice.

Global equity markets look quite hot at present after a huge run up in performance since November last year, leaving investors wondering whether they should try to capture further upside or take profits. At noisy times like these, it can be helpful to take a step back and focus on fundamental principles applied by successful investors, such as Berkshire Hathaway’s Warren Buffett.

Troy Asset Management has espoused Buffett’s famous mantra, “be fearful when others are greedy and greedy when others are fearful”, and developed a complementary approach to long-term investing of its own.  

Gabrielle Boyle, who manages the £724m Trojan Global Equity strategy, said Troy’s DNA is “we have time on our side, we can afford to step back from the crowd and take a long view”.

Boyle describes her fund as “a very purist interpretation to our approach at Troy” – an approach can be boiled down to the five guidelines below.

Performance of fund vs sector and benchmark over 10yrs

Source: FE Analytics

Mantra one: Be wary of valuations

With the equity market arguably priced for perfection, Boyle is taking a cautious tack. “Things do feel quite hot,” she observed. “We are living through a pretty extraordinary period.”

To protect and grow capital, investors need to be careful around valuations, she warned. She invested in Adobe in 2022, intending for it to be a long-term holding, but as a valuation-conscious fund manager, she has been proactively taking profits. “The problem with these stocks is we are seeing huge moves.”

Mantra two: Underestimate tech innovation at your peril

Boyle is not, however, avoiding the exuberance surrounding artificial intelligence (AI) and the ‘Magnificent Seven’. With technological change and AI, “I’d underestimate these forces at your peril,” she advised.

The Trojan Global Equity fund invests in Alphabet, which she first bought in 2013, and Microsoft. “We love investing in businesses with very high rates of reinvestment,” she said.

Nonetheless, she is cognisant that the equity market has become highly concentrated after the exponential performance of the Magnificent Seven last year. “We’ve been taking profits on some of these darlings that have done very well and recycling profits into companies that have not done so well.”

Mantra three: Know your limits

Boyle has steered clear of the tech hardware and semi-conductor sector, which she described as the “hottest” area currently but one which is cyclical and capital intensive, with “incredible periods of boom” followed by leaner spells when order rates slow down. “We don’t like the highs and lows,” she added.

“In investing, you’ve got to know the boundaries of your competence,” Boyle said, which is a lesson she learned from the late Charlie Munger (Warren Buffett’s business partner).

The Trojan Global Equity fund invests in big brands that have been around for a long time, selling goods and services that are fundamental to people’s lives, with the capacity to grow and adapt, such as Visa. Boyle has owned the credit card company, which is profiting from the growth in digitalised payments, since 2016.

Mantra four: Look for stocks that have been left behind

Boyle has been investing in “good businesses that got left behind through this extreme period”, adding LSEG, owner of the London Stock Exchange and FTSE Russell, to her fund last year.

FTSE is a fundamentally important business to its clients, she explained. For instance, if a fund manager uses a FTSE index as a benchmark, “you’ve got to show your performance versus the FTSE so you’ve got to pay their bills”.

LSEG was created through the acquisition of Refinitiv, which was completed in January 2021, and Boyle thinks the business has been optimised and better managed since this merger.

LSEG has a lower valuation than Moody’s or S&P Global, which she also owns, because it is domiciled in the UK and it is “not the easiest business to understand” due to its different component parts.

All three financial data companies have a huge opportunity to use AI and large language models to exploit their data, she said.

Another relatively new addition to the fund is RELX, which Boyle picked up last year at an attractive valuation due to the “malaise” of the UK stock market. RELX is “one of the most attractive companies in the UK,” she said. It is highly profitable, cash generative, innovative and “well managed in an understated way”.

RELX develops information-based analytics and decision tools for professional and business customers in the legal, scientific, technical and medical sectors. Boyle thinks that RELX will emerge as a “winner” by using AI to leverage its data.

Mantra five: Invest through discomfort

Boyle has been adding to positions that have underperformed recently including LVMH, which was hurt by China’s slowdown and which she has owned since 2022, and Diageo. The latter experienced high demand for its premium spirits brands during the Covid lockdowns but sales have been weaker since then. Nonetheless, “we believe the premiumisation of spirits will continue,” she explained.

In a similar vein, during the 2022 tech sell-off “we got a lot of stick for owning Meta” but “we lent into that”, Boyle recalled. She increased her fund’s exposure to Meta, which sowed the seeds for performance subsequently.

“Being able to invest through that discomfort is very important for a global equity manager. You’ve got to be able to take a bit of pain,” she said.

The multi-asset teams at Liontrust Asset Management, Invesco and Legal & General Investment Management have all gone overweight emerging market equities.

After a period of relative underperformance, emerging market equities are now so cheap that this constitutes a buying opportunity, they believe. Moreover, emerging markets are set to benefit from accommodative monetary policy and a resilient global economy. Below Trustnet looks at the main reasons for their optimism.

Attractive valuations

James Klempster, deputy head of multi-asset at Liontrust, said emerging market are “trading at levels that historically, in pretty much any equity market, have been a rewarding long-term entry point.”

Emerging markets have lagged developed markets for the past decade but the divergence in performance has been especially stark since Covid, as China entered an extended lockdown and then struggled to rebound.

Performance of emerging vs developed markets over 10yrs

Source: FE Analytics

One exception is India, where valuations have ridden up, although some market participants argue that India is a quality play and deserves to be expensive, Klempster noted. Given that emerging market equities including India are, as whole, attractively valued, then without India the other markets look exceptionally cheap.

Accommodative monetary policy and other tailwinds

Meanwhile, the potential for financial conditions to loosen in both emerging and developed markets is a significant tailwind, said David Aujla, lead manager of Invesco’s risk-targeted Summit Growth portfolios.

“Some emerging market central banks have already started to cut rates, while in the US, it is highly likely that monetary policy will be eased over our tactical timeframe of one to three years,” he noted.

“Interestingly, the past few US interest rate peaks have typically seen the outperformance of emerging equities over the following 12 to 24 months. The US dollar, which when weaker or weakening, can be a help for emerging markets.”

Klempster added that emerging markets are correlated to the global economy, which is “in a reasonable shape”, and to global trade, consumption and demand, which should receive a boost from monetary loosening. “The reason we are positive on emerging markets is we’re positive on the global economy,” he concluded.

Myriad themes are likely to favour the different countries and regions within emerging markets, Aujla continued. “India is expected to benefit from positive demographic trends while certain economies in Latin America, such as Brazil and Mexico, should continue to benefit from nearshoring trends and an increase in foreign direct investment.

“North Asia on the other hand seems well positioned to capitalise from the rush to artificial intelligence, with a large part of the technology supply chain residing in South Korea and Taiwan.”

China – the fly in the ointment

Being bullish on emerging markets is by no means a consensus trade. Scopic Research, which tracks sentiment amongst multi-asset managers, reported in March that several firms were forecasting a negative return from emerging market equities in the next 12 months, including Janus Henderson Investors, abdrn and Royal London Asset Management. However, that data might be clouded by bearishness over China, which has struggled to regain its form post-Covid and had many issues surrounding its property and private equity sectors.

As Klempster said: “The ambivalent sentiment – I think it might be worse than ambivalent –ultimately stems from China. We think of it as similar to the UK in the sense that you’d struggle to find anyone who will give you a positive narrative about the economy and the market.”

He argued that bearishness on the Chinese economy should not be allowed to cloud the investment thesis as the macro story “is not the same as an investment case”.

“Clearly there are relationships between an economy and the stock market, but especially with large-cap stocks, it is a fairly loose connection. That’s the point we made when the game was very good for China and it’d be remiss of us to stop making it now,” he explained.

Oliver Blackbourn, a portfolio manager in Janus Henderson Investors’ multi-asset team, disagreed. Forward valuations for emerging markets outside of China are in the top quartile relative to the past 20 years, he said. Earnings in emerging markets still look quite depressed, but earnings growth would feed through into improved performance, he added.

12-month forward price-to-earnings ratio of emerging market equities

Sources: LSEG Datastream, Janus Henderson Investors, as at 9 Apr 2024

China, meanwhile, has become somewhat disconnected to the rest of the emerging markets. “There is potential for some big upside in China if the government adjusts its policy settings to become more wholehearted in its stimulus. So far, we've generally seen smaller tweaks rather than the sort of broad-scale stimulus that people want to really change that outlook,” Blackbourn observed.

“But in the meantime, China also has the potential go nowhere because it has structural problems, especially the over-indebted property sector.”

Another threat for emerging markets would be if the US Federal Reserve adopted a higher for longer policy, he added.

Nonetheless, Blackbourn is more positive on emerging markets outside of China. “We are seeing an improving cyclical outlook [globally], a bottoming out in the manufacturing cycle and a bit of an upturn. It's a little bit noisy at the moment, but we think we're going to see that continue and that's going to benefit more cyclical areas. Emerging markets outside of China look quite cyclical along with Europe, so we think both of those could do reasonably well going forward.”

Implementation and manager selection

In terms of practical implementation, Klempster prefers active managers for emerging markets due to the plethora of idiosyncratic risks and the differences between regions and politics.

Liontrust’s multi-asset portfolios combine Vontobel Sustainable Emerging Market Leaders with BlackRock Emerging Markets to achieve multi-factor exposure. “For us, its always about the blend, it’s never about the individual manager,” he explained.

Vontobel focuses on quality, return on invested capital and profitability, while BlackRock provides core exposure and does not have large biases.

Global CO₂ pricing is on its way: just a decade ago 8% of the planet’s emissions were priced while today, this is closer to 25%.

In the past decade, CO₂ pricing has not been material, however across the US, European Union and China – the three biggest CO₂ emitting areas – we are now seeing a broader adoption of CO₂ pricing and increasing CO₂ price levels.

We expect this to be the new regime for the coming decades. This change will make a company’s decarbonisation trajectory more financially material for generating alpha, since the costs of CO₂ will weigh on the valuation of companies that have not decarbonised.

For sectors with material CO₂ emissions, material CO₂ pricing will present a significant challenge and reveal companies to be either leaders or laggards.

The US utilities problem

Amidst the global economic downturn, utilities offer a safe haven for those looking to position their portfolios defensively. However, the sector in the United States is responsible for 25% of total greenhouse gas emissions and the introduction of global CO₂ pricing will have a marked impact on valuations.

The winners will be those companies which decarbonise the fastest and hence minimise the impact of carbon emissions pricing schemes. The losers will be those that decarbonise the slowest and hence will be most exposed to these costs.

The question for investors going forward will be how to meaningfully identify which is which.

With so much carbon data available, it is essential to apply strict goal setting and to plan execution criteria. Without doing this, investors are left potentially susceptible to greenwashing by giving companies more credit than they are due.

Dig into the detail

The ability to forecast carbon emissions and carbon costs is a critical piece of the puzzle.

The approach we take is to analyse publicly available information, such as the US Energy Information Administration (EIA)’s overview of all US power generation facilities (via S&P Capital IQ).

From this data set, it is possible to construct a comprehensive picture of all US announced coal and gas plant decommissions, coal to gas conversions, and gas plants being built in the US over the coming three decades – and then to estimate the future greenhouse gas (GHG) emissions of planned power plants, and forecasting the change in GHG emissions from each facility.

An informed, granular approach provides a more reliable estimate of decarbonisation pathways to better inform investment decisions.

The future is already here, it’s just not very evenly distributed

Incorporating the future matters. Were we to only examine a screenshot of the present, we would importantly miss out on relevant information regarding the environmental trajectories of companies.

For example, a utilities company which has disclosed the decommission date of a significant number of coal power plants clearly has a more credible strategy than a competitor which has communicated the ambition to phase out coal but has yet to announce when and how this will be done with any meaningful detail.

What’s the cost?

To estimate the financial impact of a carbon pricing scheme on US utilities companies, there are two key factors to consider: allowed emissions and emissions cost.

In Europe, carbon allowances represent about 50% of the total carbon emissions, above which the companies will be priced. Using Europe as a proxy, it is reasonable to estimate that half of the total emissions a US utility company produces will be subject to a cost.

By modelling higher climate scenarios against carbon price estimations and forecasts, it is possible to measure the relative impact these changes would have on each company’s market cap. This approach also preserves the valuation of companies which have already decarbonised and hence do not show a declining carbon emissions pathway.

A robust approach that informs valuations

On the positive side, the more credible and material a company’s decarbonisation plans are, the more they will be rewarded by investors. All things being equal, this will increase valuation upside and hence more capital will be allocated.

However, when the decarbonisation pathways do not fulfill the required criteria, the company is more likely to be penalised in the investment process.

This shortfall in commitment can often become a trigger for engagement, where investors actively raise the issue with management and set expectations for a change which is to the benefit of shareholders, and wider society.

The polluter pays

Pricing externalities adheres to the ‘polluter pays’ principle and is an efficient manner to reallocate capital towards sustainable economic activities. Carbon pricing schemes will therefore play a key role in the decarbonisation of companies.

This has already happened in Europe, where companies are only permitted to emit up to a certain threshold of carbon, above which they have to buy carbon credits to offset extra emissions. Furthermore, the price of European carbon credits has been rising – from around €20 per ton of CO₂ in 2020 to around €90 per ton of CO₂ in 2023.

In the US, there is an active debate to initiate a similar policy and other countries, such as China, are following as well.

This represents a foreseeable expense in the near to medium term for utility companies, making it all the more important for investors to adopt frameworks that allow them to effectively identify those which are materially decarbonising. Ultimately, investors need to be able to cut through a company’s stated sustainability ambitions and uncover its credible ambitions. This will protect from claims of greenwashing and more broadly, help separate the leaders from the laggards over the coming decades.

Jags Walia is head of infrastructure at Van Lanschot Kempen. The views expressed above should not be taken as investment advice.

St James’s Place (SJP) has softened on high yield bonds and emerging market equities, choosing to go overweight non-US developed markets, according to the latest quarterly update from chief investment officer Justin Onuekwusi.

Yet SJP remains underweight developed markets as a whole, largely thanks to its lack of conviction in the US, where Onuekwusi believes companies are “richly valued”.

It is the only part of the stock market where the firm is underweight, despite its continued dominance. So far this year, the S&P 500 is up 10.2%, leading all major equity markets. Japan’s TSE Topix index is in second with 8.8%, while at the bottom of the list the FTSE All Share has made just 3.3%.

Performance of indices over YTD

Source: FE Analytics

“A key tail risk we see as problematic is the gap between the US deficit and unemployment rate, risking heightened US bond market volatility, which could spill over into the gilt market. It is also worth noting, albeit cautiously, volatility on average tends to be higher in US election years,” Onuekwusi said.

The chief investment officer has also softened on emerging markets. Although the firm remains overweight, this has come down slightly.

Source: St James’s Place

Here the purchasing managers’ index (PMI) remains “higher than the developed market aggregate”, while “lower inflation and upcoming US rate cuts should continue to support overall emerging market growth”.

In particular, there are moves being made in the largest emerging market – China – where the government is adding stimulus, although he had concerns about the accuracy of the data coming from the country.

“The Chinese authorities recently confirmed the 5% GDP target and 3% inflation target. Given the absence of consistent data, we face challenges in accurately measuring China's GDP,” he said.

“This means we may never know whether the target has been achieved. Nevertheless, the focus is moving away from the traditional manufacturing sector and more towards high end tech and artificial intelligence. This is likely to be a big structural theme in coming years.”

Yet he has toned down his optimism, preferring to diversify across other global developed equities (ex-US) such as Japan, Europe and the UK.

“Although emerging market equities have the highest mean expected return over a medium-term horizon, the range of outcomes is wide and exposure to idiosyncratic risks relatively high,” said Onuekwusi.

“Given all major developed equity markets offer a significant valuation discount to the US, it is prudent from a diversification perspective to spread our active risk.”

He has also reduced a previously overweight position in high yield after reducing global developed equities (ex-US).

“Following a contraction in global high yield credit spreads, we propose closing the overweight position in this asset class, which is funded by a modest underweight to global equities,” the CIO said.

“Although the yield-to-worst of the high yield market relative to equities appears attractive, this is driven by rising sovereign bond yields. The reward for assuming lower quality credit risk at this junction does appear slight.”

A final major change has been on the economic front, where Onuekwusi is more bullish based on improving economic data.

Previously, the SJP chief investment officer believed GDP and unemployment  would be flat, while inflation would fall to below 2% and interest rates would sit around 4% - the ‘muddling through’ part of the table below.

However, this has been changed to the ‘soft landing/Goldilocks’ part of the table, with GDP growing (albeit slowly), unemployment flat – or potentially slightly dipping – inflation between 2% and 3% and only mild rate cuts.

Source: St James’s Place

“Our base case is that the economy moves broadly sideways (around trend growth). Central banks have some work left to do on inflation but once rate cuts begin, they should be able to be more aggressive. Further ahead, elections this year keep uncertainty high, especially on fiscal policy,” he said.

“The US economy has continued to perform well, and recession risks have receded further. As such, we believe the base case is now a more positive ‘soft landing’ where growth moves broadly sideways, unemployment stays low, and inflation gradually moves closer to target. This is in line with consensus.”

While this could be viewed as positive for equities, there is some concern around the  market cycle, which he believes we are in the latter stages of.

Source: St James’s Place

“Investing late cycle is always difficult. Historically, risky assets perform well in this period, however, volatility can increase as markets assess the likelihood of a recession.  We have a neutral view on equity risk but have a bias away from richly-valued US assets,” he concluded.

The market is “marching towards potential overheated territory” but investors should continue to ride the momentum trade for as long as they can because now is a “nirvana” for diversified portfolios, according to TAM Asset Management’s UK chief investment officer James Penny.

Equities have been on a tear to start the year, with the asset class providing strong returns for investors, but there are concerns that this momentum could ultimately lead to its downfall.

Some of the problems are being “masked” by the interest rates debate – with too much emphasis placed on the words uttered by central bankers at their meetings – a term Penny called ‘Fed speak’.

“People’s obsession with Fed speak is potentially overshadowing some things in the market which, if Fed speak wasn’t around, would have caused more volatility. But they haven’t,” he said.

This includes geopolitical uncertainty around the US and China, two wars (one in Ukraine and the other in the Middle East) and questions over economic growth, which are on top of the concerns surrounding inflation and interest rates.

Yet it is only the latter that the market is concerned about. Even inflation, which is yet to get down to central banks’ targets, has largely been ignored, he argued.

However, investors seem unconcerned, highlighted by the fact that every major equity market is up so far this year.

Performance of indices over YTD

Source: FE Analytics

“It definitely feels like this market is accelerating, and it is doing so in the face of geopolitical or macro uncertainties that haven’t gone anywhere,” said Penny.

The S&P 500 set a new record high earlier this year, with some analysts having to re-evaluate their forecasts for the year because they have already been hit in the first quarter, the CIO said. Meanwhile the UK and some European markets are teetering near their all-time highs as well.

“If that keeps happening and if the market keeps rallying all year without taking into account inflation or the trajectory of interest rates or economic uncertainty, you’re going to find yourself in a more expensive market,” he said.

“So, if we are talking about that carrying on all year we could be in a spot where price reconciliation needs to happen.”

However, he noted that he does not want to “scaremonger” investors because now is the first time in more than 18 months where diversified portfolios can make good returns.

Many model portfolio services (MPS) were hit hard last year as the market rally centred almost solely around the ‘Magnificent Seven’ technology stocks, but this positivity has broadened out to other parts now as well.

“It is no longer just the Magnificent Seven, you are starting to see [market performance] broaden out to the other sectors and areas such as Europe, the UK, value and cyclical investing,” said Penny.

“People are coming back to areas they wouldn’t have allocated to last year. That is nirvana for a diversified portfolio manager because the bull market is still here but it is no longer oscillating around seven stocks.”

As such, he said he is “moving with the market” in his portfolios. When it becomes more bullish, he is being positive and when there are signs of people becoming overly bearish, he is taking risk off the table ahead of time.

In equities, he is confident on the US, but is focusing on “the other 493 stocks in the S&P 500”, as well as smaller companies, where his fund selection – Pacific US Smaller Companies – made a 9% gain in February alone. This is another sign that the market could be heating up, he noted.

Elsewhere, Europe is “starting to look really good”, he continued. “There are some phenomenal companies there – especially value which hasn’t had a great time so far but that could be primed for some real positivity.”

Japan is another on the rise, although this has been well-documented. He said there is “a bit of concentration risk there” but noted that with conditions improving the bull market could become “more ingrained and more momentum-driven”.

Emerging markets too could benefit this year from dollar weakness, which should occur when the Federal Reserve starts to reduce interest rates.

In the bond space returns have been more muted as they “can’t get out from underneath this inflation-is-here-to-stay cloud”. However, there are pockets performing well, particularly in the high yield and credit markets, where Penny has a higher allocation at present.

Performance of indices over 1yr

Source: FE Analytics

“The positivity in the market continues to be in the corporate space and high yield areas. That’s why spreads are so tight. No one wants to be in the government space,” he said.

“We have a much bigger position in the corporate part than the sovereign part,” Penny added, but he noted that investors will need to move quickly if conditions change and there is a pullback later in the year.

“Should we hit a recession that part of the market is under owned and oversold. So, if you start to see economic weakness coming through you will have to be quick to move from one to the other as corporates will suffer under economic strain and the sovereigns will be exactly what you want to own in that environment,” he added.

Despite the strong markets, he also said there are compelling reasons to hold alternatives – typically viewed as must-haves when equities and bonds are going sideways, but which investors tend to shun when  traditional asset classes are rising.

“You should always have alternatives,” he said, noting that his main holdings in this area are Amundi Volatility – a hedge against the market selling off – and Ruffer, which had a tough time last year but is “primed for volatility”.

“Much like government bonds, if you can switch into more defensive alternatives at the right time I think that will do very well,” he said.

Jupiter Gold And Silver – which plays into under-owned miners as well as the burgeoning gold price – is another holding, although this is more of an alpha story in the current market.

In late 2023, Edward McQuarrie put out some brilliant research showing that whilst stocks typically have delivered higher returns than bonds, they don’t always.

The one question it didn’t answer however, is under what circumstances bonds are more likely to beat stocks, or is it just random? So I took 150 years of data across the G4 economies (U.S, UK, Germany, Japan) from the Macrohistory dataset, to try and answer this question.

The returns data consists of regional stock indices (e.g. USA = S&P 500) and long-term government bonds (e.g. UK = perpetuals and 15-20 year composite) and I have focused on yearly returns because not everyone has a 10 year + investment horizon.

So to begin, how often do bonds beat stocks for these major economies? On average 36%, or about one in three years. So now we’ve got a baseline number, can we find circumstances where the odds change noticeably?

Source: Author's own calculations

When GDP is low

When we’re in a recession (years when GDP growth is less than 0%) you can see the percentage of years where bonds beat stocks goes to 48%, or almost one in two. That’s a 12% increase from our baseline.

Source: Author's own calculations

Whereas when we have high growth (3% or more), then stocks have a clear advantage. You could argue forecasting a recession is difficult, however with advances in real-time data you can get better estimates than a few years ago.

When yield curves are inverted

When you have an inverted yield curve at the start of the year (e.g. when a three month treasury bill yields more than a 10 year government bond), the percentage of times bonds beat stocks increases to 46% (again almost one in two), 10% higher than our baseline.

Source: Author's own calculations

Yield curves inversions often happen before recessions, so you could argue that this indicator and real GDP are looking at the same thing. However, GDP is an economic indicator and the yield curve is a financial market indicator.

Therefore by using both together, you’re able to combine economic fundamentals and market pricing, which should lead to better decision making overall.

When outright yields are high

Surprisingly, this is actually the least useful of the three. When yields on long-term bonds are north of 6% (which hasn’t happened in more than two decades in the G4 countries).

Source: Author's own calculations

The percentage of years bonds beat stocks goes to 40%, or four in 10 years, 4% higher than our baseline.

Conclusion

In summary, government bonds have a better chance of beating stocks when: there is low or negative real GDP growth; the yield curve is negative/inverted; and when bond yields are more than 6%.

That said, none of the three indicators covered ever produced greater than 50% odds of bonds beating stocks. Therefore, small 5-10% changes in asset allocation to bonds/stocks accordingly, seems more logical than completely abandoning one asset class for another.

Chris Barter is a manager in the investment office at Scottish Widows. The views expressed above are the author's own, not those of Scottish Widows and should not be taken as investment advice.

AJ Bell dropped the £3.2bn Fidelity Global Special Situations fund from its Favourite Funds list at the end of March.

This followed veteran manager Jeremy Podger’s retirement, originally announced in September 2023, as well as the departure of Jamie Harvey, the fund’s co-manager, in May 2023.

With these exits, the fund has lost “significant experience”, according to Ryan Hughes, interim managing director at AJ Bell Investments.

Fidelity International hired Christine Baalham and Tom Record from Ninety One and Liontrust Asset Management, respectively, to replace Podger and Harvey.

“A new team was needed and that made us uncomfortable,” Hughes said. “Fidelity is usually strong at succession planning using their analyst base, so this process has not been as well managed as it could have been.”

Baalham and Record have never worked together at Fidelity or elsewhere and therefore will take some time to properly bed in and to establish a working relationship with Fidelity’s analysts, who are core to the investment process, Hughes said.

“Given these points, and that we have a number of alternative global options on the Favourite Funds list, we felt it was appropriate to remove the fund,” he concluded.

Launched in 2006, the fund’s aim is to outperform the broader market by 4% per annum over rolling three-year periods. To achieve that, it takes an unconstrained investment approach centred around Fidelity’s team of global analysts, which act as the starting point for idea generation.

The process has proved successful and at the beginning of March 2024, the fund featured among the most popular funds held by AJ Bell’s ISA millionaires.

In the past three years, the fund has performed in line with the rest of its peer group, but lagged the MSCI All Country World index by 10 percentage points, as the chart below illustrates.

Performance of fund against sector and index over 3yrs

Source: FE Analytics

For this reason, it was included in Bestinvest’s Spot the Dog report, which names and shames the funds that have underperformed a relevant benchmark by more than 5% for the past three years, as well as in each of the three years individually.

Beyond AJ Bell, Rayner Spencer Mills Research (RSMR) analysts have also placed Fidelity Global Special Situations ‘under review’ due to the manager changes.

In the IA Global sector, the other Fidelity strategy highlighted by AJ Bell is the passive Fidelity Index World fund.

Economics students the world over learn about the law of competition, which suggests that companies making supernormal profits attract competitors, forcing down their returns on capital.

The market, believing this rule, assumes that for many high-returning businesses a downward trajectory of returns will begin at some future point. This is what gets factored into the share price, said Lazard Asset Management’s Barnaby Wilson and Louis Florentin-Lee, who have been managing the £413.6m Mid Wynd International Investment Trust since October 2023.

But the truth is that this rule gets broken all the time.

“This economic law is very often wrong, and that’s a good thing that actually allows us to have this job. Some companies in the real world are able to build sufficiently strong competitive advantages or economic moats around them that will insulate them from the competition,” Wilson explained.

“Microsoft's been doing it for 40 years, Coca-Cola for probably double that and Louis Vuitton for double Coca-Cola. If the law of competition really worked everywhere, their success should never have been possible.”

Despite these businesses’ track records, the market continues to price them as if they will correct downwards at some point in the near future.

Microsoft is Mid Wynd’s largest holding, making up 5.4% of the trust’s portfolio.

Another example of a ‘rule breaker’, where there is a mispricing opportunity, is Accenture, which the managers have held since its inception in Feb 2011. 

“The market is assuming that Accenture’s current level of returns at around 40% CFORI [cashflow return on investment] will only last for six years before it starts to fade, but we believe its competitive advantages will enable it to sustain those returns for much longer than six years,” Wilson continued.

“Finding companies that are going to maintain their high level of returns on capital for longer than the market expects is in a nutshell what we do.”

Accenture’s financial productivity

Source: Lazard

Wilson summarises this approach as “invest in compounders exploiting the market misconception that all high returns fade over time.”

It is a tactic he and Florentin-Lee have introduced to Mid Wynd, which was previously a thematic strategy under the management of Artemis’ Simon Edelsten and Alex Illingworth.

Wilson and Florentin-Lee inherited the trust’s leadership in October 2023 and have maintained only six of the original names, including Microsoft; the rest of the portfolio has been completely overhauled, its exposure to US-based financials, industrials and technology increased and European healthcare and consumer staples cut.

“In less than a week's time, we transitioned the old thematic, top-down portfolio to our bottom-up global quality growth strategy, with a total of 40 to 50 stocks with great conviction behind them,” Wilson said.

One of the stocks with most conviction, as already mentioned, is Accenture, which the managers see as “extremely well positioned to take advantage of the fundamental technology rewiring” that almost all global companies around the world are going to have to go through.

“Decisions around tech are moving away from the realm of operating efficiency and landing squarely on the desk of CEOs around the globe. Artificial intelligence, cloud, cybersecurity and digital marketing are all becoming of strategic importance,” said Wilson.

“Accenture's heritage back in its consulting days puts it really in pole position to be able to advise on these massive transformational projects. That’s its competitive advantage and its moat”.

Performance of fund against sector and index since Lazard’s leadership

Source: FE Analytics

Away from large caps like Microsoft and Accenture, the new managers also invest in smaller companies in nicher areas, where it’s even more difficult that competitors come in to compete for profits.

It’s one of the main differences between Mid Wynd and Terry Smith’s Fundsmith.

“Smith’s motto is to buy great businesses and then do nothing. We're in that camp, but there's plenty of difference in the way we express that and in the names that we own, even if the overall philosophical approach might be reasonably similar,” the manager explained.

“One of the big differences is that Smith’s exposure is much more towards the mega-cap stocks, whereas we feel that we can find very interesting and compelling small and mid-cap opportunities as well.”

One such example is the “world's leading anime company”, Toei Animation in Japan, whose intellectual property contains shows such as Dragon Ball and One Piece.

“It is a wonderful business that dominates a niche industry and makes great returns on capital. Obviously it’s well established in Japan, but still a tiny part of the media industry and growing very quickly in markets such as the US and China.

“It’s unbelievably unlikely that platforms such as Netflix, Amazon or Disney should decide to make their own content in this space, because the best animators are attracted to Toei, which is very broadly broadcast in Japan and a good launch pad for anime shows. Also, Toei’s biggest shareholders are the Japanese broadcasters, so it's quite a cosy shareholder arrangement.”

Under the new management since the end of 2023, the trust has returned 9.9%, as shown in the chart above. It narrowed its 12-month average discount of -2.08% to the current -0.64%.

It is indisputable that our lives are becoming increasingly entwined in – and reliant on – technology, for everything ranging from day-to-day tasks and interactions to medical diagnoses, procedures and treatments.

Simultaneously, businesses are actively integrating technology into their operations, supply chains, marketing and sales, and back offices.

The artificial intelligence industry alone is projected to grow from 2022 to 2030 by a compound annual growth rate (CAGR) of 21.6%. Over the same period, cloud computing is projected to grow at a similar CAGR of 20%.

These are just two of 20 distinct areas highlighting how technology is the epitome of growth and opportunity in the 21st century.

How can technology’s investment potential be captured? While difficult to give a definitive answer, we believe it is not by investing in a passive vehicle that tracks the GICS Information Technology (IT) sector.

The issues with the GICS classification system are three-fold.

First, many of the leading companies of today span multiple industry verticals. Amazon started as an online bookseller before evolving into the e-commerce giant, but it is also the world’s leading cloud computing vendor.

The difficulty in categorizing multi-industry businesses under one sector becomes immediately apparent when you consider that four of the seven companies that make up the ‘Magnificent Seven’ mega-cap technology stocks – Alphabet, Meta (both in Communication Services) Amazon and Tesla (both in Consumer Discretionary) – are not in the IT sector.

Second, technology permeates virtually every industry in today’s economy. Consequently, it can be challenging to determine which criteria should dictate a company’s categorization.

For instance, in May 2023, GICS reclassified eight payment processing companies – including Mastercard, Visa and PayPal – from IT to Financials. It did the same thing in 2018, with Meta, Alphabet and Netflix moved out of IT into the newly created Communication Services sector. With these companies and many others, while the bedrock of their business is technology, their end markets are not.

Lastly, as a result of the 2023 GICS reclassification, just three stocks – Apple, Microsoft and NVIDIA – now comprise more than two-thirds of the IT sector by weight. This lopsided weighting means that an investment in a passive fund tracking the IT sector is essentially a bet on these three stocks.

Technology should be seen as broader than just the IT sector. Technology-driven businesses are not just found in IT, but rather across virtually every sector.

There are a wide range of different industries that are technology driven. In addition to companies like Alphabet, Meta and Tesla, names like Equinix, a data centre company, and CoStar, a technology-enabled real estate service, both in the Real Estate sector, fit within the broader technology universe.

In Healthcare, Intuitive Surgical, maker of the da Vinci robotic surgical system, also falls within the technology rubric. In the Industrials sector, Space Exploration Technologies Corporation (SpaceX) manufactures reusable rockets, operates the satellite-based internet service Starlink, and has the ultimate goal of enabling people to live on other planets. While GICS does not include them within the IT sector, for all these companies and many more, technological innovation is at the core of their business.

A broader, more encompassing definition of technology companies requires an active investment approach because these stocks must be researched simply to be identified. The wide dispersion of returns is another reason the technology space favours active investing.

Results just within the IT sector over the past 10 years illustrate this point. IT stocks that performed in the top 10th percentile returned almost 40% on an annualised basis; stocks in the bottom 10th percentile lost more than 40% annualised.

Put simply, the performance of the companies within this sector varied significantly. This dispersion dynamic existed in nearly every sub-industry within IT, from application and system software companies to internet services to semiconductors and hardware.

The disruptive impact of the rapid pace of innovation and significant breakthroughs in technology is, in large part, responsible for this dispersion. Technology innovation has powered some of the biggest winners in stock market history and driven more upside than any other segment of the market. At the lower end, disruption has caused a significant loss of market share and some outright business failures.

There is little doubt that technology disruption will continue for many years. Generative AI (GenAI) is a case in point. GenAI, which was introduced to the public via ChatGPT in November 2022, is such a transformative technology it was the subject of a key negotiating point in the 148-day strike by the Writers Guild of America in 2023. Many industry experts consider GenAI to be the most revolutionary technology in decades and it is just getting started.

It is increasingly clear that durable secular trends will be the predominant underpinning of market leadership over the long term for both individual businesses and industries. The leading companies driving or riding these trends are finding better, more efficient and cost-effective ways to deliver goods and services. They are leveraging advances in technology – or developing technologies themselves – to disrupt their industries.

These trends include cloud computing software as a service (SaaS) and vertical software and services; artificial intelligence; cybersecurity; e-commerce and electronic payments; digital media, advertising and entertainment; electric vehicles and autonomous driving; and genomics, genetic medicine and modern surgery.

A broader approach to investing in technology can and does capture opportunities that a passive product tracking the IT sector will miss out on. This gap will only grow larger as innovations such as GenAI expand the scope of what technology can do.

For investors, the challenge lies in pinpointing the defining characteristics of the likely winners as a result of technological advancements. In addition to a strong moat and effective capital allocation, businesses must be willing and able to innovate and disrupt themselves to keep up with the rapid pace of technological change. Companies with these attributes are well positioned to maintain their existing success and leverage their competitive edge to expand into new areas, products and services, growing existing markets and even establishing entirely new ones.

Michael Lippert is a portfolio manager and head of technology research at Baron Capital. The views expressed above should not be taken as investment advice.

The Vanguard LifeStrategy 60% Equity has been a success since its launch in June 2011, outperforming the IA Mixed Investment 40-85% Shares sector by more than 30 percentage points over the past 13 years.

The recipe of the £14.9bn fund’s success has arguably been simple: offering investors a low-cost balanced portfolio mixing diversified assets, underpinned by the traditional negative correlation between equity and bond markets.

Mohneet Dhir, head of multi-asset product specialism at Vanguard, Europe, said: “The equity sleeve of the fund is designed to do the heavy lifting regarding generating returns, while the primary purpose of the fixed income allocation is to act as a hedge against equity market volatility.

“By holding a balanced portfolio, you are therefore looking to protect yourself against the fluctuations of the market, without having to second guess it. Nobody can see around corners, after all.”

While the fund has delivered on its objectives, experts stressed that the Vanguard LifeStrategy 60% Equity is not foolproof either. Below, they discuss the strengths and weaknesses of this fund of index funds.

Performance of fund since launch and over 5yrs vs sector

Source: FE Analytics

Tom Poulter, head of quantitative research at Square Mile Investment Consulting and Research, likes the low costs of the Vanguard LifeStrategy 60% Equity and highlighted the fact it is one of the cheapest offerings in its sector.

He said: “This cost advantage means that, over the long term, the fund has a good chance of outperforming peers net of fees.”

However, he warned this passive approach and the “static” asset allocation mean that there is no manager to divest when an asset class looks extremely overvalued or, conversely, to take benefit of an excessively undervalued asset class.

Furthermore, Poulter stressed that the nature of the fund also means it is unlikely to be the best performing portfolio in the IA Mixed Investment 40-85% Shares sector.

He added: “We should not expect this fund to be top of the pile unless active managers have seriously underperformed, nor should we expect it to be bottom of the pile unless active managers have seriously outperformed.”

For Gavin Haynes, co-founder of Fairview Investing, the Vanguard LifeStrategy 60% Equity should be a good long-term “all-weather” holding, but noted that the negative correlation between equities and bonds as broken down in recent years, especially in 2022.

This hurt the fund’s performance as it could not seek refuge in any other asset class, unlike many of its competitors.  As a result, the Vanguard LifeStrategy 60% sat in the third quartile of its sector in 2022, falling 11.2%.

Performance of fund over 2yrs vs sector

Source: FE Analytics

Dhir acknowledged the recent years of simultaneous decline for stocks and bonds but stressed that the usual relationship between the two asset classes is starting to reestablish itself.

He said: “It’s worth remembering that the death knell of the 60/40 portfolio has been rung many times before. The first 60/40 style balanced fund  was launched in 1929. It has seen a great depression, a world war, bear markets, bull markets, periods of much higher inflation than we have today, rising rates, declining rates, and yet the approach continues to deliver for investors. It is a time-tested strategy.”

Alex Watts, investment data analyst at interactive investor, added that the outlook for 60/40 portfolios is positive.

Although bonds have been slow to recover from the market rout of 2022, he explained yields remain high as strong economic data has pushed back monetary easing. Moreover, inflation hasn’t met central bank’s targets in most developed markets, although it is trending down.

He said: “In all, suppressed bond prices and high yields offer an attractive outlook for investors in fixed income securities.

“Outlooks for equities – the main growth driver in a 60/40 portfolio – are looking improved versus last year, meaning the risk return characteristics of the 60/40 portfolio is attractive.”

Another thing Haynes  pointed out is the ‘home bias’ in the equity sleeve of the portfolio, where the UK accounts for 15%.

He said: “The fund has a structural bias towards UK equities as it is designed for the UK adviser market but this has been a headwind over the past decade. More active asset allocation would have helped.”

However, Watts argued that this home bias may prove beneficial if UK valuations revert towards historic norms or serve as a buffer if the US market experiences a correction.

Dhir concluded: “Financial markets are difficult to predict. Often, a stock market that is in favour today, may not be tomorrow. The catalyst of changes in markets are even harder to predict. For investors, the best approach to tackle this is diversification.”

With equity markets knocking up against all-time highs, could their next move be downwards? James Harries, who manages the £825m Troy Global Income fund, thinks this is a distinct possibility and believes an economic slowdown could be triggered by a couple of factors.

The first is the “long variable lag” after which interest rate hikes feed into the broader economy through higher mortgage rates and borrowing costs.

The second would be a dent in the sky-high expectations for US mega-cap technology stocks, if other companies do not adopt their artificial intelligence-related products and services as quickly as markets have priced in. “Maybe the expression ‘trees don’t grow to the sky’ at some point might be right,” he mused.

The ‘Magnificent Seven’ have become such a large component of global stock markets that if their valuations dip, it would have a knock-on impact on equity indices, he added.

Harries is preparing for a potential downturn in the “incredibly fully-valued equity markets” by researching which companies he would buy if their valuations were more reasonable. He wants to increase exposure to three areas: consumer cyclicals, non-bank financials and industrial cyclicals.

One consumer-facing business he would love to own is Starbucks, which has a “long growth runway” in China. “Coffee is less controversial than [computer] chips”, he said, so he does not expect Starbucks’ expansion plans in China to invite the same level of scrutiny that tech companies are facing.

If the global economy slows, cash-strapped consumers would be less likely to pay for expensive coffee, which would depress Starbucks’ share price, providing a buying opportunity.

Rentokil Initial – “a high quality global operation” – is also on Harries’ radar. It acquired Terminix in the US in 2022 and has just snapped up HiCare Services Private, the second-largest pest control company in India.

Climate change and warmer summers are causing pests to become more of a problem, increasing demand for Rentokil’s services. Rentokil is also a play on wealth creation in emerging markets; “one thing you do as you move up the income ladder is have effective pest control,” he said.

Harries is also keen to increase his exposure to non-bank financials that are not highly levered, such as BlackRock. He described the asset management giant as “a high-quality proxy on capital markets”.

In industrials, Harries has his eye on Fastenal, which distributes nuts and bolts in the US. Industrials tend to fall out of favour during economic slowdowns, which might present an opportunity to add exposure, he said.

As well as compiling his wish list, Harries has been adding to his portfolio in real time.

In the past few weeks, he started building a position in Pernod Ricard, the second-largest spirits business in the world and the owner of Jameson Irish Whiskey and Absolut Vodka. Pernod has a significant emerging market footprint and a “huge runway for growth,” he said. Whiskey is popular in India and Chinese consumers are developing a taste for cognac.

Demand for spirits soared during the Covid lockdowns and slumped thereafter, causing Pernod Ricard’s share price to tail off, providing a buying opportunity.

Harries also added Canadian National Railway Company (CN) to the fund in October 2023. In North America, rail is primarily used to move commercial goods and is a lower carbon alternative to road transport – a significant advantage as companies increasingly build the cost of carbon into their forecasts, he explained.

Consumer healthcare company Kenvue, whose portfolio of brands includes Tylenol, Calpol and Band-Aid, is another new entrant. It was spun out of Johnson & Johnson (which the fund also owns) in May 2023 in an exchange offer, whereby Johnson & Johnson shareholders received Kenvue shares – which many of them sold, causing Kenvue’s share price to plummet.

Following the spinout, Kenvue has benefitted from greater focus and productivity, and more prominence for its brands. Kenvue has an average 6% free cash flow yield and a 4% dividend yield.

Kenvue share price performance over 1yr

Source: Google Finance

The Troy Global Income fund treads a cautious path, with Harries aiming to deliver a reliable income to his investors, many of whom are retired, while avoiding capital losses.

As such he owns a lot of “dull but worthy” branded consumer goods powerhouses and has avoided the Magnificent Seven – except for Microsoft, which he has owned since 2013 – because they do not pay sufficient dividends. “We are the ying to that yang. People can get Magnificent Seven exposure from lots of places – not from us,” he said.

The flipside to this steady eddy approach is that during “optimistic” markets such as the present environment, “we look quite pedestrian” and the fund has underperformed. “We’re in optimism squared at the moment because we’ve got a very expensive late cycle market with an AI cherry on top,” he observed.

Performance of fund vs sector over 5yrs

Source: FE Analytics

Harries argues that investors in or approaching retirement should consider taking some of the exponential gains they have made from large-cap equities, especially US tech stocks, and reinvesting that wealth to secure a long-term income stream. “The better the markets perform, the less focussed on income people are,” he lamented.

The overall emerging markets index has experienced some challenging times in the recent past; but most of the major markets barring China have done reasonably well. China has remained the only major market which has disappointed.

Its ageing demographics and declining population poses longer-term structural challenges to domestic consumption growth. There are concerns about China’s slow consumption recovery and geopolitical tensions between China and the West. There have also been property sector woes, which have weighed on consumer sentiment and local investor sentiment.

These have overshadowed early signals of China’s recovery. While government policy has become more supportive, we are cognisant that more substantive policies and a rebound in consumer activity is required for a sustained improvement in Chinese equities.

However, it’s not all doom and gloom. The country has not experienced the hiking of interest rates and inflation like the US and Europe, and there has been some improvement in business confidence with some companies undertaking share buybacks.

There are new growth drivers that can replace China’s traditional sectors including electrification of transportation and growth in its supply chain, import substitution of advanced technology hardware and green energy solutions.

Supply chain disruptions, triggered by the Covid-19 pandemic, geopolitical tensions, and export restrictions on cutting-edge semiconductor and artificial intelligence (AI) technology have led companies to re-consider their reliance on China as the manufacturing base for the world.

Chinese companies, however, remain technology leaders in many of the new emerging sectors of electric vehicles and renewable energy and reliance on them cannot be completely cut out. Many of these Chinese companies are working on setting up international manufacturing bases, to alleviate some of these concerns.

China’s sizeable domestic consumer market, albeit not growing, also provides these companies with a customer base that is too large to ignore – China today is the largest electric vehicle market in the world, for example.

There’s been quite some noise about the Magnificent Seven in the US, which have driven the rally in the US market. However, many of them are facing challenges in China and many of the domestic Chinese companies have come forward with competing products.

For example, Apple is being replaced in China by Huawei and Tesla is starting to see competition come through from other electric car companies. Chinese companies certainly have a competitive edge in the electric vehicle sector.

Chinese internet platforms such as Alibaba and Tencent remain strong technology companies with large international presence. Bytedance has also emerged as a leading short video platform globally. In fact, a meaningful part of China e-commerce is now going through Douyin, Bytedance's short-form video offering in China. These are just a few of the companies in China that are leading the way in their sectors.

Current valuations reflect many of the challenges being faced by China. We do see upside; in particular in the internet sector, which has adjusted to the new operating environment as China has eased its regulatory crackdown on the sector.

The large internet platforms remain technology leaders and best placed to leverage the benefits of AI. The growth for these companies is likely to be slower but we expect returns to be supported by efficiencies, strong cash flow generation and corporate actions.

We remain hopeful that this year China will re-emerge, the market is not looking for foreign investors to invest but for the locals. The locals remain cash rich following the pandemic, they have the savings and China hasn’t experienced a spike in interest rates therefore leaving cash in savings accounts is not beneficial due to the very low returns.

The assets in China are currently looking reasonable and cheap, and we’ve witnessed companies buying back shares. China has a good chance of returning to higher earnings per share (EPS) growth this year, which in turn will lead to a good prospect of it returning to positive returns in the current year on an absolute basis.

While some investors have voiced concerns about the level of volatility in the Chinese equity market, as a longer-term investor, we believe that this provides a good opportunity to build positions in companies that we favour but are being unfairly punished alongside the broader market.

This is particularly the case now where valuations have come off their longer-term averages and expectations are not high.

Overall, China’s economic outlook remains challenging. While a swift rebound in growth is unlikely, clear signs of a bottoming in the country’s economic growth will be welcomed. We believe that select China-based companies have been oversold, although their fundamentals remain strong.

Chetan Sehgal is lead portfolio manager of Templeton Emerging Markets Investment Trust. The views expressed above should not be taken as investment advice.

When everything looks cheap, how do you decide what to buy? This is a dilemma facing investment trust buyers, with more than 30% of trusts trading at a double-digit discount.

The answer, according to Charlotte Cuthbertson, co-manager of the MIGO Opportunities Trust, is to look for investment trusts whose discounts are likely to narrow for idiosyncratic reasons, such as Georgia Capital and Chrysalis Investment, and whose underlying assets should perform strongly.

“That’s a really powerful combination and that’s where you get quite explosive returns,” she explained.

MIGO was established in 2004 to take advantage of investment trusts trading at a discount to their net asset value. In normal market conditions, 40-50% of investment trusts might fall into MIGO’s remit but currently it feels closer to 90%, Cuthbertson said. “It would have been quite easy to be a child in a sweet shop but we have been very selective.”

The average discount of MIGO’s top 10 holdings is about 34%, which is “pretty unheard of”, she noted. “In general, it does feel like a moment in time. We will look back on this period and think, gosh, it was just so cheap. It feels like there’s an incredible opportunity in the sector.”

Performance of trust vs sector over 5yrs

Source: FE Analytics

Below she highlights trusts that look particularly compelling on their current valuations.

Frontier and emerging markets

Cuthbertson’s highest conviction investment is Georgia Capital. It has a large holding in the Bank of Georgia, which has performed well, and also invests in several companies with exposure to Georgia’s growing middle class, such as insurers, healthcare providers and private education.

The trust’s underlying assets are performing well and Georgia’s economy is buoyant, but the trust has been hampered by negative sentiment due to concerns over the war in Ukraine, so at one point it was trading on a 60% discount, which has narrowed to 50%. MIGO topped up its exposure when shares were trading at £6; they have risen since to £13.

Performance of trust’s share price over 5yrs

Source: Google Finance

MIGO’s second largest holding is VinaCapital Vietnam Opportunity. Vietnam is benefitting from industrialisation and urbanisation and it has not become embroiled in the trade wars between China and the US. The trust is trading at a 22% discount.

Performance of trust vs FTSE Vietnam index over 5yrs

Source: FE Analytics

Georgia and Vietnam are frontier markets but she expects them to become more mainstream destinations for investors. The latter is on the Russell Investments Watch List for a possible reclassification from frontier to secondary emerging market status.

JPMorgan Indian is also in MIGO’s top 10 holdings. The trust had been underperforming but it changed managers in 2022 and Cuthbertson has more conviction in the new team of Amit Mehta and Sandip Patodia, under whom returns have improved.

She has a favourable view of Indian large-caps but thinks mid-caps look overpriced after recent gains. Indian mid and small-caps have been “incredibly hot and have gone up an awful lot.”

Private equity

Another theme in MIGO’s portfolio is private equity. These trusts have been hit harder than other investment companies by concerns about debt and over-gearing in a higher rate environment as well as fee disclosure rules, which make private equity trusts look expensive due to their higher ongoing charges figures (OCF).

Oakley Capital Investment, for instance, is performing well but its OCF is very high, Cuthbertson said. She also likes NB Private Equity Partners. Both trusts have visible underlying portfolios and are trading on wide discounts. 

“If we get some resolution on the OCF front, and there is a huge lobby within our industry pushing for this, that should be incredibly supportive for investment trusts. We've been caught in a perfect storm over the past year or so,” Cuthbertson said.

Performance of trusts vs sector over 5yrs

Source: FE Analytics

MIGO also owns Augmentum Fintech and Chrysalis Investment. There is a lingering perception that they invest in young companies but the trusts have evolved since inception and their holdings are approaching profitability – something the wider market has yet to appreciate, Cuthbertson said.

MIGO does not get involved in many initial public offerings (IPO), but the trust did support Chrysalis when it launched in November 2018 because of its compelling investment thesis, backing innovative businesses with the potential to disrupt markets and achieve long-term growth. Then a lot of “hot” money poured into the trust, which began to look overvalued, so MIGO sold the majority of its holding.

Cuthbertson has been rebuilding the position during the past year at a discount. Chrysalis is set to profit from the anticipated IPO of Klarna, the Swedish buy now, pay later firm, which is expected to list at a valuation of $18-20bn. The trust also owns Starling Bank, which is performing well.

Chrysalis was widely criticised for awarding £112m in performance fees to its managers Nick Williamson and Richard Watts in 2011 – a year when its net asset value rose 57%, only to nosedive the following year. The trust’s performance fees have since been reduced and Cuthbertson said its corporate governance has improved.

“There are a few war wounds from Chrysalis but thankfully we managed to miss much of the pain on the way down,” she said. “It’s been a noisy trust.” The underlying portfolio now looks interesting at a sensible valuation, she added.

Performance of trust vs sector since inception

Source: FE Analytics

Bond managers have been navigating through stormy waters in the past few years, as interest rates were hiked rapidly and yields rose to record levels, making it difficult to generate alpha.

Among all global bond funds with at least a five-year track record, those in the IA Global Mixed Bond sector were most successful at beating their benchmarks. But even here, only 18 out of the 34 funds in consideration consistently outperformed their ­benchmarks and just six had an alpha greater than 1, meaning that the managers generated 1% of excess returns or more.

Alpha scores were even lower for global government bond funds and global high-yield funds, as the Trustnet study below shows.

For this research, we used data from FinXL and looked at average alpha scores across 61 year-long periods measured monthly since 2018.

We begin with the IA Global Mixed Bond sector, where managers can flexibly allocate resources across credit type and currency spectrums.

The first vehicle to stand out was Dodge & Cox Global Bond fund, which not only achieved an average alpha of 5.25, but also kept a positive alpha for most of the past five years (95% of the time) – meaning that it outperformed its benchmark in almost all market conditions.

The fund invests with a total-return mindset that is consistent with long-term capital preservation. Regarding the asset allocation, the investment committee currently has a preference for corporate bonds (41.5%) and government bonds (31.4%), while credit quality is mostly AA (27.9%) and BBB (27.8%).

Source: FinXL

At 3.01 of average alpha, Morgan Stanley Global Fixed Income Opportunities took the second place on the podium while also achieving the second-best frequency of average alpha, maintaining a positive score in 47 of the 61 year-long periods.

The $4bn fund is a five FE fundinfo Crown-rated strategy managed by Michael Kushma since 2011. He was joined by Utkarsh Sharma in 2020 and FE fundinfo Alpha Manager Leon Grenyer in 2022.

The team takes top-down macroeconomic views to determine the portfolio’s beta positioning, but also conducts bottom-up analysis for taking active decisions.

Assets are splits between credit (39.1%), securitized assets (35.9%) and government bonds (18.3%).

M&G Global Macro Bond was another fund to stand out with its average alpha of 1.46 and sizable portfolio of £1.1bn. FE Investments analysts highlighted manager Jim Leaviss’ success in calling macroeconomic movements.

“The fund offers attractive diversification characteristics and has proven effective at preserving capital during periods of market stress, such as March 2020,” they said.

“Leaviss benefits from working closely with other portfolio managers that hold niche expertise in emerging markets and currencies, while the credit research team is deep and experienced.”

We continue with the IA Global Corporate Bond sector, where the only fund that consistently maintained an alpha above 1 was the $1bn Vanguard Global Credit Bond, averaging at 1.33.

Renowned for passive investing, Vanguard has also achieved  success within its range of active funds, which includes this strategy.

Analysts at Rayner Spencer Mills Research (RSMR) described it as a core global credit fund, designed to provide “quality exposure” to global credit markets.

“It can draw on the research and expertise one of the largest fixed income teams around, aiming to add incremental value through stock selection rather than taking big bets,” they said.

“This is a high quality core offering, backed by one of the largest credit analyst teams in the world, providing a sustainable and diversified income stream.”

The price is a mere 0.35% and in the past five rolling years, it had a positive alpha in 54 of the 61 periods considered.

Just half a point above zero, JPM Global Corporate Bond was the only other fund with a positive average alpha. With $5.9bn of assets under management (AUM), this sizable strategy focuses on investment-grade bonds issued primarily in the US, which make up 59.1% of the portfolio.

The remaining funds in the sector didn’t hit positive territory, with the lowest alpha being that of the Robeco Global Credits fund, which stood at -1.61.

Source: FinXL

In the IA Global High Yield Bond sector, more funds managed an encouraging alpha track record.

The top vehicle was the $1.7bn Barings Global Senior Secured Bond fund, which combines a regional allocation strategy with fundamental selection of credits in the US (which make up 48.9% of the portfolio) and Europe (41.6%).

Its average alpha was 1.89.

Another sizable fund that proved its ability to outperform a benchmark was the $3.8bn Aviva Investors Global High Yield Bond fund, achieving an average alpha of 1.04.

It has a much higher allocation to the US (60%) compared to the Barings fund, which it outperformed between 2022 and 2023 only to fall behind again, as the chart below shows. The two vehicles are just 33% correlated.

Performance of fund against sector and index over 5yrs

Source: FE Analytics

The rest of the sector remained predominantly in positive territory, albeit with unimpressive numbers.

FE fundinfo Alpha Manager Konstantin Leidman, who has taken over the sole leadership of the Wellington Global High Yield Bond fund after his co-manager Christopher Jones retired in June 2023, has generated an average alpha for the fund of 0.34.

Three vehicles were in negative territory: PIMCO US Short-Term High Yield Corporate Bond Index UCITS ETF (-0.22), FTGF Western Asset Global High Yield (-1.10) and GS Global High Yield Portfolio  (-1.13).

Source: FinXL

IA sectors previously in this series: UK Equity Income, UK All Companies, Global, Global Equity Income, Sterling bonds, smaller companies.

We have spent the past few years trying to demonstrate how cheap the UK equity market is, both in absolute terms but particularly when compared to the US equity market.

MSCI UK Index vs MSCI World Index

Source: Morgan Stanley, 31 Dec 2023

When we highlight the very low valuations on offer in the UK equity market, however, the first question we are asked is ‘what is going to change this?’ and that is a very fair question since I personally find it hard to see a scenario where all the money that has departed the UK suddenly comes back in this direction.

We can see two mechanisms that could potentially realise this value in UK equities without the need for large money flows into the market: corporate takeovers and share buybacks.

Corporate takeovers

The relentless selling of UK equities has driven valuations to such low levels that overseas corporates have spotted an opportunity to acquire UK assets at prices that offer serious potential to achieve an attractive return.

The chart below shows the numbers of takeovers in the UK market and the fact that this picked up significantly in 2023.

This momentum has accelerated in 2024. By the end of February, we had already seen offers for Currys, Direct Line, Wincanton, Redrow, LXI REIT and Spirent.

Number of takeovers in the UK market

Sources: Redwheel, Factset, 31 Dec 2023

Share buybacks

Meeting the chief executive officers of the companies we invest in has been quite a depressing experience in recent years since many feel that they are doing a very good job of running their companies and yet continue to watch their share prices fall.

Our advice has been to not take the low share price personally but rather to use it to the advantage of the company’s shareholders by buying shares back at lower valuations as this will be value accretive in most cases.

The chart below suggests that this message is finally starting to hit home as 50% of UK companies within the MSCI UK index have bought back shares in the past 12 months, the highest percentage of any market in the world.

Number of companies with buyback over 1% of total market cap/total number of companies

Source: Morgan Stanley, ‘The Land of Equity Yield’, 31 Dec 2023

How share buybacks add value: The theory

To show how share buybacks can add value, we have created three scenarios below. To keep the maths simple, in all cases we are using a fictional company with a market capitalisation of £1bn that is generating £100m of free cash flow per annum, i.e. cash generated after interest, tax and capital expenditure that is free to return to shareholders. This company would be valued on a 10% free cash flow yield (£100m/£1000m).

Company one pays a £50m dividend (5%) and buys back £50m of shares. The share buyback will reduce the share count by 5% meaning that for a constant level of earnings and dividends, the earnings per share and dividends per share will rise by 5%. This 5% dividend and 5% buyback will thus produce a total return of 10% per annum and will continue to do so even if the free cash flow remains unchanged.

Company two is identical with the exception that the free cash flow grows at 5% per annum and this produces a total return of 14% a year.

Company three is the same as company two but in this case, we have assumed that investors warm to the company over the five-year period and place a higher valuation on the business. In this case we assume the shares re-rate from a 10% free cash flow yield to a 6% free cash flow yield. This produces a total return of 24% per annum which I believe would be more than acceptable for most investors.

How share buybacks can add value

Source: Redwheel, 29 Feb 2024

Share buybacks in practice

The poster child for a successful capital allocation policy that uses share buybacks is Next plc. It has bought back two-thirds of its shares in issue since 2000 and hence produced a total return for investors of 16% per annum and seen its share price rise from £5 to £80 over that time, despite only growing sales at 5% a year.

Share buybacks in practice: Next

Sources: Bloomberg, Redwheel, data from 1 Jan 2000 to 31 Dec 2023

Perhaps an even more spectacular example of the power of share buybacks has been British American Tobacco. Investors were right to identify in 2000 that it had poor growth prospects due to declining numbers of people smoking. Between 2000 and 2016, its sales only grew by 2% a year and yet it gave its shareholders a 22% per annum total return and saw its share price rise from £3 to £50.

Share buybacks in practice: British American Tobacco

Sources: Bloomberg, Redwheel, data from 1 Jan 2000 to 31 Dec 2023

The return of the total return kings?

We believe that the conditions today are reminiscent of those that existed in 2000; once more investors are focusing on the growth prospects of technology companies and are paying very high valuations for them in our view.

Conversely, they have seemingly little interest in investing in old economy sectors such as energy, financials and autos and have driven the valuations of these parts of the market to lower levels.

So which companies today are in a similar situation to Next and British American Tobacco and thus have the potential to reward their investors with attractive total returns in the future?

The table below contains some of the companies we hold in our portfolios which we think could produce attractive total returns for investors.

It’s important to note that share buybacks are more powerful when valuations are low, simply because for every £1 used, you are able to buyback more shares. We would argue that US technology companies who buy back highly valued shares are making a bad capital allocation decision.

Company earnings as a percentage of current market capitalisation

Sources: Redwheel, company report & accounts, 29 Feb 2024

We hope it should be fairly obvious that if these companies continue to buy back shares at the rate of the past two years, it seems likely that their share prices will eventually respond since their earnings per share and dividends per share could increase significantly. If the share price does not rise, then the price-to-earnings ratios and dividend yields will eventually reach ridiculous levels.

We believe that the market is currently offering up some incredible opportunities for investors not because there is anything fundamentally wrong with these businesses but rather because of neglect.

As US fund manager David Einhorn has said, valuation has become almost irrelevant for most market participants: “The market is still dominated by investors that either will not (index funds), cannot (untrained novice investors) or choose to not (valuation-indifferent professional investors) have valuation as a cornerstone of their investment process.”

What we have hopefully demonstrated, however, is that companies have the ability to use this low valuation to change the fundamentals of their business, i.e. increase their earnings per share and dividends per share and that eventually the market will take notice of this.

Just as in 2000, investors are so entranced with the potential growth being offered by US technology companies that they are ignoring some of the real bargains to be found in the new ‘total return kings’.

Ian Lance is co-head of Redwheel’s value and income team and co-portfolio managers of the Temple Bar Investment Trust. The views expressed above should not be taken as investment advice.

Now could be a good time to start building an allocation to fixed income, as central banks are expected to cut interest rates this year. However, it might be daunting for investors to build an exposure to the asset class given its complexity.

Therefore, Trustnet has asked experts to build comprehensive bond portfolios that should hopefully do well once the time will come for central banks to lower rates.

They all included government bonds and investment grade corporate credits in their respective portfolio as a starting point, but more adventurous investors might also want to look at high yield and emerging markets debts to try to get even higher returns.

Vanguard UK Government Bond Index, TwentyFour Absolute Return Credit and Artemis Corporate Bond

Jason Hollands, managing director at Bestinvest, built an exposure to fixed income aiming to provide attractive yields but with relatively defensive positioning that would suit a more cautious investor. This bond allocation should also act as a ballast to the equity exposure in the overall portfolio.  

The funds he picked to achieve those goals are Vanguard UK Government Bond Index, TwentyFour Absolute Return Credit and Artemis Corporate Bond.

Vanguard UK Government Bond Index is a low-cost option to access 82 gilts across the maturity spectrum. Hollands said it is the fund he would prioritise in the list.

He explained: “Gilt yields are compelling in real terms given the diminishing inflation outlook, but have been in retreat since their peaks last autumn given growing expectations of interest rate cuts.

“Unless there is a surprise renewed uptick in inflation (which is unlikely given the new energy price cap), the window to lock in current attractive yields is therefore probably quite limited.“

Performance of funds over 5yrs

Source: FE Analytics

TwentyFour Absolute Return Credit, managed by Chris Bowie, aims to provide a defensive allocation to short-dated credits.

The fund invests a minimum of two thirds of the portfolio in investment grade bonds with less than five years until maturity.

Hollands said: ”Unlike many funds that carry ‘absolute return’ in their names and deploy derivatives as part of their strategies, this fund has a simple but effective strategy of focusing on short-dated bonds to minimise volatility.”

Performance of fund since launch vs sector

Source: FE Analytics

Finally, Hollands chose Artemis Corporate Bond, run by Stephen Snowden and Grace Le, to get exposure to corporate bonds from high quality issuers.

iShares UK Gilts ETF, Artemis Corporate Bond, Invesco High Yield and M&G Emerging Markets Bond

Paul Angell, head of investment research at AJ Bell, suggested to build the core of a fixed income portfolio with both a government and a corporate bond fund. Investors may then want to add high yield and emerging markets bond funds as satellites to boost the overall level of income.

The exposure to UK government bonds is gained through iShares Core UK Gilts ETF, which is another low-cost option investing across the maturity spectrum.

Performance of fund since launch vs sector and benchmark

Source: FE Analytics

For corporate bonds, Angell also picked Artemis Corporate Bond. He said: “The fund is typically run with a higher beta than the index, with tracking error contribution fluctuating between duration and credit positioning.

“That said, the managers have kept the fund’s duration within 1.5 years of the index since launch, ensuring its return profile has remained equivalent to that of wider fixed income markets.”

Moving on to the satellite part of the portfolio, Angell chose Invesco High Yield to get exposure to higher risk bonds.

The manager, Tom Moore, invests across a combination of higher quality bonds, subordinated financials and more speculative special situations.

Angell explained: “Given the volatility of the latter two components, the fund is typically at the higher beta end of its market. Moore’s positioning in financials has been particularly beneficial to relative returns over the years, and he continues to seek good opportunities in the sector.”

Finally, Angell selected M&G Emerging Markets Bond to get access to the emerging market debt space. 

He said: “The neutral split across emerging markets government (two third) and emerging markets corporate (one third), alongside developed market currency (two third) and emerging markets currency (one third), results in a nicely diversified portfolio of risk factors.

“The team’s bottom-up credit selection typically generates a higher yield than the index, given the team’s preference for both high yield issuers, as well as peripheral country bonds.”

Performance of funds over 5yrs vs sectors

Source: FE Analytics

Colchester Global Bond, M&G Corporate Bond and JPM Global High Yield Bond

To get an exposure to government bonds from developed markets, Tom Stevenson, investment director at Fidelity International, picked Colchester Global Bond, which should provide “useful insurance against global crises or recession risk”.

He explained: “The purest interest rate play is a government bond because these have almost no credit or default risk. A developed world government is extremely unlikely to default on its obligations to bondholders.”

To get a higher income, investors can add an exposure to corporate bonds in their portfolios. However, it comes with greater risk, as companies are more likely to default than governments, which is why investors get a better compensation.

Performance of funds over 10yrs vs sectors

Source: FE Analytics

As a result, Stevenson suggested M&G Corporate Bond for more risk-averse investors, as this fund focuses on lower-risk companies.

For investors prepared to take on even more credit risk in the pursuit of an even higher income, he also pointed to JPM Global High Yield Bond.

“The investment team is based in the US, where the majority of high yield bond issuers are located,” Stevenson added.

Performance of fund vs sector and benchmark over 5yrs

Source: FE Analytics

Finally, Stevenson also mentioned M&G Global Macro Bond for investors who would rather hand over all the decision making to an expert.

He concluded: “This is a flexible fund that can invest across multiple regions and lend to a range of borrowers across the risk spectrum. It is run by one of M&G’s most experienced managers who is supported by a strong team of analysts.”