Fund tips for 2013

CHINA:

A key concern this year has been a possible slowdown in China. Along with the rest of Asia and emerging markets China failed to decouple from the west during the financial crisis and has fallen significantly from year-on-year double-digit gross domestic product (GDP) growth to strong single-digit growth. The drop in the rate of growth in China caused fears that the bubble would burst.

However, opinions are now changing as China has completed a leadership reshuffle and economic data are starting to show signs of improvement, for example the HSBC purchasing managers' index recently showed a reading of 50.4 and anything over 50 suggests growth in manufacturing in the country. China is also now transitioning from being a manufacturing exporter to a more developed consumer economy, a process which was never likely to be smooth.

Analysts at private bank Coutts argue that the Chinese growth story is not over, setting out 10 reasons why. These are:

■ An exports revival.

■ Higher government infrastructure investment.

■ Easier corporate borrowing.

■ Resilient consumption.

■ A re-rating of Hong Kong share prices.

■ Accelerating earnings growth.

■ Renewed investor inflows supporting prices.

■ Cyclical sectors such as consumer and energy expected to do better.

■ Stable politics following the leadership transition.

■ Expected economic reforms.

There is a general slowing in the rate of decline in growth in China and although it will remain sensitive to growth in the west it has adjusted to this. "With valuations at historic lows this looks like a good entry point," says Adrian Lowcock, senior investment manager at Hargreaves Lansdown.

Due to the recent loss of confidence, Chinese equities, which were highly valued, have fallen massively. In October 2007, just before the financial crisis, the Chinese stock market was trading on a price/earnings ratio (PE) of over 30 and the Shenzhen was at 1551. Today, the PE ratio for China is 8 and the Shenzhen has fallen by 55.4 per cent. China has lagged behind all the major stock markets over the past three years. Before the crisis, China was expensively valued but it is now looking more favourable compared with other Asian markets, and provides a great entry point for those not yet invested or wishing to top up.

"It is what happens over the next few years that is important, not whether China reaches its 7.5 per cent annual growth target this year," adds Brian Dennehy, managing director at Dennehy Weller. "Although we are more optimistic than most, don't expect the new leadership to turn around China's fortunes quickly. If in doubt drip-feed into a China fund month on month to gain exposure."

Of the active China funds available the onshore ones generally do not have strong performance records with the exception of First State Greater China Growth, but this is currently 'soft-closed' meaning it is expensive to buy in. Offshore funds tend to have high charges.

Adventurous choice

But there are a number of low-cost exchange traded funds (ETF) and these include db X-trackers CSI300 Index ETF (XCHA) which has an all-in fee of 0.5 per cent and uses a swap to get its returns. It offers exposure to shares listed in mainland China and the index is the most representative of this equity market, but also the most expensive and probably the most illiquid in a crisis.

Read more on China ETFs

Defensive choice

Single-country funds, in particular those offering exposure to emerging markets are very high risk. So if you want exposure to this area a lower-risk way to do this would be via a regional Asia fund that includes exposure to China.

"While China looks cheap investors are still shunning it at the moment, so it may get cheaper still," says Mr Lowcock. "We like the valuations for China but there is little choice for pure China funds and we prefer to offer a diversified approach to investing. We like First State Asia Pacific Leaders (GB0033874214) [also an IC Top 100 Fund] which has over 20 per cent of its portfolio invested in China and Hong Kong."

Source: Morningstar as at 18 December

BONDS:

Developed market government bond yields are too low, with 10-year government bonds in the US, UK and Germany likely to yield well below 2 per cent and in Japan well below 1 per cent, according to analysts at investment bank Investec. Government bonds offer negative real yields so investment analysts and advisers suggest you steer clear of these, including UK gilts. Legal & General Investment Management (LGIM) believes core government bonds are in bubble territory and that "there is nothing safe haven about this asset class just now".

Corporate bonds have had a strong 2012, returning 13 per cent to date by the end of November, but as a result the income yields have come down significantly over the past 12 months from 5.96 per cent to 4.11 per cent. "Investors should consider locking in some profits from gilts and corporate bonds, before the market does it for them," says Mr Lowcock.

However, while the picture is not great for bonds, balanced portfolios still need to maintain an allocation to this area, while those approaching retirement may be looking to shift their pension pots away from equities.

A number of institutional investors favour high-yield bonds as they offer much better returns. "US investment-grade corporate bonds are likely to offer scant returns of 1.6 per cent in the year ahead, but high-yield bonds could return up to 7 per cent and emerging market bonds could return 10.1 per cent," says investment bank BofA Merrill Lynch.

But these kinds of bonds are of a high-risk level comparable with equities, as is the case with emerging market bonds. Choosing and allocating to bonds is generally more difficult than choosing equities because there is so much macroeconomic research needed, as well as scrutiny of company fundamentals. While a bond fund may have a named lead manager, in reality there is a team behind it that will include an economist and maybe tens of analysts, because of the volume of research needed to put together a fixed-income portfolio. For this reason most advisers suggest a strategic bond fund which has the ability to allocate across all areas of the fixed-income spectrum. It means their managers can move in and out of opportunities as well as getting out of problem areas, and hold a range of fixed-income securities diversifying risk.

Adventurous choice

Good funds in this area include Jupiter Strategic Bond (GB00B2RBCS16), which is only four years old but has built up a good track record. It invests in assets including high-yield bonds, investment-grade bonds, government bonds, preference shares and convertible bonds, and its manager seeks investments offering value and good risk/reward positions, considering both the bond issuer's credentials and macroeconomic considerations.

Read our tip on Jupiter Strategic

Defensive choice

For those with a cautious risk appetite, strategic bond funds are not the right choice given that at times they can be heavily invested in higher-risk areas such as high-yield debt and emerging markets, and use derivatives. Given that these funds have the flexibility to shift allocations, what seems like a cautious fund could have a very different portfolio in the space of months. If you are cautious you should avoid this area.

But if you can take some risk a slightly lower-risk option in this sector is the conservatively managed Fidelity Strategic Bond (GB00B05NC857). This has delivered positive returns over the past four years, and only fell 3.08 per cent in 2008 when some equity markets fell 30 per cent or more.

Fidelity Strategic Bond because has lower volatility than other similar funds because it is run via a cautious approach with no single bond holding dominating returns. The investment process is supplemented by a layered approach to risk control.

Source: Morningstar as at 18 December

EQUITY INCOME:

Corporate bonds have experienced great inflows as investors try to avoid the downside in choppy markets and get income in a low-interest-rate environment. However, this has caused the yields on these to fall so in many cases equities issued by the same company yield more than their bonds. Companies that pay dividends in the UK also tend to be less sensitive to economic conditions as they are more defensive in nature, covering sectors such as utilities and healthcare where there is good cash flow and constant demand, thus dividends are more reliable.

Overseas companies also offer opportunities. "We see genuine value in many large-capitalisation stocks across the globe and we are confident that long-term global equity investors will be rewarded by focusing their investments on high-quality blue-chip stocks that have impressive track records of creating shareholder value, growing dividends in challenging operating environments, maintaining strong balance sheets and are well positioned competitively in their respective industries," says Jing Sun, co-manager of PSigma Global Equity Fund.

Reasonable valuations, earnings growth and support from dividend yields also point to global equities being an attractive place to invest, according to Philip Saunders and Max King of Investec Asset Management's Multi-Asset Team.

Equities have a very different profile to bonds so you cannot necessarily substitute one for the other, especially in terms of risk. But Alan Higgins, chief investment officer at Coutts, says this is an option in the case of longer-term investments such as pensions. "If you have a 10 to 20-year time horizon why not sell some gilts and buy equities," he says.

Adventurous choice

Fund options include IC Top 100 Fund Unicorn UK Income (GB00B00Z1S94), which is the top UK equity income open-ended fund over one, three and five years, and yields more than 4 per cent. It makes its excellent total returns by having a bias towards smaller companies, which currently account for over 90 per cent of its assets, according to Morningstar, rather than the usual defensive large-caps. But as a result of this its shorter term returns can be fairly volatile.

Defensive choice

If you want a smoother ride, consider Invesco Perpetual High Income (GB0033054015) run by highly regarded fund manager Neil Woodford. This fund is among the UK equity income funds which lost least in difficult markets such as 2007 and 2008, and yields 4.19 per cent. While Mr Woodford has made strong long-term returns, however, his defensive investment approach means his funds can get left behind in market rallies.

Source: Morningstar as at 18 December

EUROPE:

Europe may seem the last place an investor wants to be but it has provided some of the best stock market returns of 2012. Valuations reached depressed levels before action taken by the new head of the European Central Bank, Mario Draghi, heralded a turnaround in sentiment in the summer.

"European equities look enticing," says wealth manager Whitechurch Securities. "If the more stable political backdrop and undertaking to save the euro at all costs remains in place then these markets offer potential for further recovery. While political uncertainty will remain at the forefront of investors' minds (with a forthcoming German general election a focal point), there are excellent contrarian opportunities in Europe for investors with a longer-term perspective who can tolerate the volatile environment."

Valuations are also compelling relative to some other developed markets. "European equities look cheaper than US equities on every measure, including both price to current earnings and price to long-term trend earnings," says Robert Farago, head of asset allocation at Schroders Private Banking. "In particular, Europe offers a higher yield at a time when the US is considering dividend tax increases.

A euro break-up remains the biggest single threat not just to owners of European assets but also to the world economy. However, if Europe can continue to muddle through, we expect investors in European equities to be well rewarded for taking this risk."

Some of the world's most successful multinationals are listed on continental European markets. Their earnings are not necessarily related to where they are listed, for example with many having good emerging markets growth exposure.

From a fund perspective, some of the best fund managers run European funds and they have delivered excellent results with their stock picks regardless of the economic picture.

Adventurous choice

One of the best Europe funds is IC Top 100 Fund Jupiter European Opportunities Trust (JEO) (read our tip), which over the past five years has made excellent positive returns regardless of problems in Europe. So, not surprisingly, it trades at a premium to NAV. The trust's manager, Alex Darwall, also runs a unit trust, Jupiter European (ISIN: (GB0006664683), again a top performer. However, the unit trust has a total expense ratio of 1.79 per cent against 1.19 per cent for the investment trust, and a slight premium can be worth paying for strong outperformance.

Defensive choice

Henderson Eurotrust (HNE) has not done as well as Jupiter European Opportunities, but beats the benchmark and most of its other peers over three and five years. It can be picked up on a discount to NAV of around 10 per cent. It also makes good positive returns and in down years such as 2008 is one of the trusts that lost the least.

Henderson Eurotrust targets large and medium-sized companies that are perceived to be undervalued in view of their growth prospects or on account of significant changes in management or structure, and manager Tim Stevenson favours quality consistent shares, which he holds for the long term. Read our interview with him