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Fund tips for 2016

We set out our sector and fund recommendations for 2016
January 7, 2016 and Leonora Walters

This year is shaping up to be volatile and choosing areas for low-risk investing has become a more difficult task. Fears of a global slowdown and the impact of rising interest rates in the US are affecting equities around the world as well as causing bond yields to spike. For this reason we are including some targeted absolute return funds among our suggestions.

However enthusiasm for Japanese and European equities is still strong. Both areas are being boosted by central bank stimulus measures and are on the path to economic recovery. We are also tipping funds from some more volatile areas - emerging markets and Asia-Pacific. This is because the pessimism and gloom surrounding those markets has rarely been lower, and discounts, valuations and the potential for a re-rating could make now a good time to re-enter these markets.

JAPAN

Of all the regions to allocate to in 2016, Japan is by far the most popular among analysts. Since the election of Prime Minister Shinzo Abe in December 2012 the investment narrative surrounding Japan has been strong, and a new focus on shareholder returns and corporate governance could mean solid returns for investors in 2016. Mr Abe's first of three 'arrows' of reform focused on quantitative easing (QE) and currency devaluation sent markets soaring in 2014. Even when the country moved into recession in 2015 it remained the best performing of the major developed stock markets and the continued support of the country's central bank will give equities a safety net this year.

Equities tanked in the summer on the back of the Chinese crash and over fears of a slowdown in growth. But that means you can now access Japanese stocks at lower valuations, just as Mr Abe's reforms aimed at corporate governance begin to take hold.

Wealth manager Brewin Dolphin says: "We have a favourable view on Japanese equities heading into 2016. Initially our positive stance was predicated on the aggressive monetary policy pursued by the Bank of Japan, which weakened the currency and propelled the equity market higher. More recently, our positive opinion has increasingly relied on the government's third arrow of structural reforms and the renewed focus on corporate governance and profitability."

Adrian Lowcock, head of investing at AXA Wealth, says: "Japan's dip in growth was expected, although revised figures showed the country avoided a recession in 2015. We expect the country to continue to recover and show growth in 2016."

CF Morant Wright Nippon Yield Fund (GB00B2R83B20) offers a play on the growing importance of dividends in Japan. The fund is small, at £291.7m, but offers a good yield of 2.3 per cent due to its screening process, which identifies stocks in a position to grow dividends. It differs from the majority of funds in the market due to its focus on mid and small caps - it is 38.4 per cent invested in mid caps and 37.4 per cent in small caps - which tend to outperform over the long term. Its small cap focus provides exposure to the domestic economy, but the fund's income will provide a benefit if the domestic economy stalls and capital growth wanes.

The fund has outperformed the Investment Association (IA) Japan sector average over one, three and five years and is in the top quartile of the sector in terms of performance over these periods. It is a bet on the growing importance placed on return on equity, dividend payments from Japanese companies and the wider recovery.

For a broader, larger fund look to Baillie Gifford Japanese (GB0006011133), available for an ongoing charge of just 0.68 per cent. It is one of the oldest Japan funds in the sector and has delivered strong returns even in difficult market conditions. The fund is run by highly regarded manager Sarah Whitley, who has been at the helm since 2007. Ms Whitley also manages IC Top 100 Fund Baillie Gifford Japan Trust (BGFD) which has an excellent performance record but is trading on a relatively high premium net asset value (NAV) and has a higher ongoing charge.

Ms Whitley and her six-strong team seek out businesses with strong balance sheets and competitive advantages at good prices. The fund currently has 60 holdings and has proved itself over the long term. Over three and five years it has returned 60 per cent and 59 per cent compared with just 45 per cent and 33 per cent for the IA Japan sector average.

We have not chosen a fund that offers a hedged share class despite the Japanese central bank's easing policies. In the past we have tipped hedged share classes as a result of central bank stimulus policies, however we believe this effect has now run its course and there will enough downward pressures on sterling in 2016 to undermine the case for currency hedging.

 1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)10-year cumulative total return (%)Ongoing charge (%)
CF Morant Wright Nippon Yield 20.8552.7065.58na1.19
Baillie Gifford Japanese11.6360.1459.0251.960.68
IA Japan sector average14.6345.3032.7916.84
Topix Index TR JPY16.0148.5134.2127.60

Source: Morningstar

Performance data as at 30 December 2015

 

EUROPE

Europe was a popular bet in 2015, and remains popular with analysts due to strong central bank support for equities combined with the steady improvement in the region's economies. A weaker currency as a result of the latest injection of QE this year and low oil prices have been good for European companies. Meanwhile shoots of recovery are appearing in peripheral nations such as France and Spain, despite major tensions in the form of a potential Greek exit from the eurozone and terrorist attacks in Paris.

Even if the recovery does stall, continued central bank support should boost European equities. And European stocks remain cheap in relation to comparable equity markets.

Michael Stanes, investment director at Heartwood Investment Management, says: "We continue to believe that these markets will retain the support of the corporate earnings recovery cycle, which remains at an early stage versus the US, as well as ongoing central bank stimulus."

Brian Dennehy, managing director of research hub FundExpert.co.uk, says we are at an "inflection point" in Europe and have the "ingredients of a cyclical recovery". He says investors should back cyclical stocks, which have been out of favour and are now cheaper than they have been since the millennium. He thinks European consumer confidence is on the brink of a comeback and is now the area to back.

Schroder European Alpha Income (GB00B7FHV230) is a concentrated portfolio skewed to the European consumer. The fund is run by James Sym who uses a business cycle investment philosophy, which involves analysing the sensitivity of companies' earnings to the business cycle. He allocates each company to one of seven style groups and after using a range of indicators to determine what stage the cycle is at, adjusts the portfolio accordingly. The fund is currently largely overweight cheap consumer stocks and financials.

Despite the fact these have not been popular recently, the fund has been very successful over five years as well as offering a yield of 3.8 per cent. If analysts are correct and a European recovery does take hold, stimulating more consumer spending and instigating a turnaround in stock performance, this fund could benefit. And in the meantime it pays out a healthy income.

However if you do not want to take a bet on a particular style, Jupiter European Fund (GB00B5STJW84) is one to back in all market conditions. Highly regarded manager Alexander Darwall has proven his stock-picking abilities in a wide range of market conditions and looks for successful, proven business models to put together this concentrated portfolio.

The fund has a low ongoing charge of 1.03 per cent and has been run by Mr Darwall for 14 years, over which time he has built a formidable track record. He largely ignores the benchmark and is unconstrained in his ability to roam over market cap and region, which can lead to short periods of underperformance. But for a fund which delivers over the long term, this is a solid bet.

 1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)10-year cumulative total return (%)Ongoing charge (%)
Schroder European Alpha Income 13.2960.06nana0.94
Jupiter European22.6864.0378.51211.781.03
IA Europe Excluding UK sector average8.8136.2237.7383.32
FTSE World Europe Ex UK TR GBP4.6132.7233.0179.15

Source: Morningstar

Performance data as at 30 December 2015

 

EMERGING MARKETS

Emerging markets have plummeted in recent years and sunk to new levels of unpopularity in 2015. But the sheer depth of that gloom could make it the time to think about returning - albeit cautiously - to this area. A slowdown in Chinese growth is weighing on demand, a commodities rout has sparked fear among many nations and the strong dollar is weighing on their debts. But there are also reasons to feel more positive about selected areas.

Many Asian nations in particular are beneficiaries of a weak oil price and have demographics on their side. They are also less reliant on foreign capital and, with the exceptions of India and Indonesia, have low inflation, meaning policymakers have room to offset deflation with easing. India has also seen a strong rally on the back of the expectation of new prime minister Narendra Modi's reforms which have made the market more expensive but look set to continue spurring stocks upwards.

Analysts were perhaps most bearish on the impact of the US interest rate rise on emerging economies but there are signs that this pessimism could have been overdone. The first rate rise finally took place last month and several emerging market currencies rallied on the news, with investors taking heart from the statement that future rises would be slow and steady. Risk appetite was most in evidence in Asia's emerging markets, where the Indonesian rupiah added 0.1 per cent against the dollar and India's rupee added 0.2 per cent.

All the negativity surrounding these markets could also now be priced in - emerging markets are trading at low levels. In December the MSCI Emerging Markets Index was trading at around a 30 per cent discount to MSCI World Index. Mick Gilligan, head of fund research at stockbroker Killik & Co, says: "On a cyclically adjusted price-to-earnings basis the region trades at levels comparable to those seen during the global financial crisis. Given this outlook we believe allocations to emerging markets should be reviewed within portfolios."

The region remains high risk. But one fund to dip a toe back in with is Newton Global Emerging Markets (GB00BVRZK937). It is a small and nimble fund which takes very high conviction bets, dynamically switching between areas it thinks will outperform. That makes it high-risk but manager Rob Marshall-Lee, who also heads up Newton's Asian and Emerging Markets team, has delivered strong performance in recent years and the fund has substantially outperformed its sector average over one and three years. Newton Global Emerging Markets was originally only available to institutional investors until offered to private investors in mid 2015.

Mr Dennehy says: "The fund seems to have the temperature of the market and is prepared to move where its managers see an attraction, which is possible with a small, agile fund."

Newton Global Emerging Markets has outperformed recently due to a very high weighting in India - 28 per cent of the fund is invested in the region - and having nothing in Brazil. Jason Hollands, managing director at Tilney Bestinvest, says: "Although Mr Lee's fund management track record only extends to a few years, he is a highly experienced investment specialist, having spent around 20 years in the industry. All in all, we believe the manager is capable of adding value over the investment cycle, providing investors with robust risk-adjusted returns."

1-year total return (%)3-year cumulative total return (%)Ongoing charge (%)
Newton Global Emerging Markets -1.6417.280.95
Index : MSCI Emerging Markets TR in GB-10.29-10.87

Performance data: FE Analytics as at 30 December 2015

 

Another option focused on Asian equities, is Pacific Assets Trust (PAC), currently trading at a wider discount than usual. This IC Top 100 Fund has performed well since it was taken over by its current managers in 2010, returning 44.2 per cent and 55.5 per cent over three and five years, against 7.4 per cent and 4.8 per cent for MSCI AC Asia Ex Japan Index.

The trust aims for capital growth through investing in companies in Asia Pacific and the Indian sub-continent, and it also includes environmental, social and governance considerations in its investment strategy. It has a third of its assets in India but also offers significant exposure to Taiwan and the Philippines. The trust had an ongoing charge plus performance fee of 2.11 per cent, but after scrapping its performance fee and revising its management fee in February 2015 this could fall.

  1-year share price return (%)3-year cumulative share price return (%)5-year cumulative share price return (%)*Ongoing charge (minus any performance fee)  (%)
Pacific Assets4.044.255.51.3
MSCI AC Asia Ex Japan NR USD-4.57.44.8
AIC Asia Pacific - Excluding Japan sector average-5.0-4.9-15.9

Source: Morningstar as at 29 December 2015, *Stewart Investors

 

DOWNSIDE MITIGATION

While 2016 brings a number of opportunities these are accompanied by a number of risks and perhaps an even harder challenge for investors - uncertainties. Analysts also anticipate periods of volatility: for example, there could be volatility in UK markets in the run-up to an expected referendum on leaving the European Union (EU) - regardless of how well individual companies or the domestic economy is doing.

"Stock dispersions will continue to rise and ones which disappoint will be punished," adds David Coombs, head of multi-asset investments at Rathbones.

And regardless of the economic climate it is always wise to have some kind of portfolio protection to mitigate downside should there be unforeseen events.

Traditionally bonds were held as diversifiers, but with increased risks and concerns about liquidity, low returns, and rising inflation and interest rates, investors now need to look elsewhere for diversification and downside mitigation. An alternative option is funds which aim to deliver positive returns in any market conditions.

Targeted Absolute Return funds may also aim to achieve a return that is more demanding than a greater than zero after fees objective, so can replicate the fixed income attributes of low volatility and capital preservation. Options include Henderson UK Absolute Return (GB00B5KKCX12) which we count among our IC Top 100 Funds. It aims for a positive return over the long term whether markets go up or down via a long/short strategy on UK company shares, which could be particularly useful if this market experiences volatility around a referendum on leaving the EU. The fund also uses derivatives to achieve its objective.

Henderson UK Absolute Return has delivered positive returns in every calendar year between 2010 and 2014, and strong cumulative returns over one, three and five years, putting it among the top few performers in the Targeted Absolute Return sector.

Standard Life Investments GARS (GB00B7K3T226), also an IC Top 100 Fund, aims for positive returns in all market conditions over the medium to long term. It has largely succeeded in doing this making positive returns in every calendar year between 2009 and 2014, as well as reasonable cumulative returns over one, three and five years.

It targets a level of return over rolling three-year periods equivalent to cash plus 5 per cent a year, gross of fees.

Standard Life Investments GARS uses traditional assets such as equities and bonds, and investment strategies based on advanced derivative techniques, resulting in a highly diversified portfolio. It can take long and short positions in markets, securities and groups of securities via derivative contracts.

 1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)
Henderson UK Absolute Return7.5532.8439.411.06
SLI Global Absolute Return Strategies2.6715.7427.220.89
FTSE All Share TR GBP1.2224.2533.27

Source: Morningstar

Performance data as at 30 December 2015