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Fund tips for 2017

The Big Theme

Fund tips for 2017

The flight to safety that defined 2016 is giving way to a hunt for higher-yielding stocks and markets at cheaper valuations. Bonds have finally lost their allure, inflation is up and rates are starting to rise. A risk-hungry attitude is spreading throughout markets, reflected in the surging prices of assets such as high-yield bonds and buoyant banking stocks. So we have selected a medium- to high-risk basket of funds, which should outperform in this climate.

These funds reflect themes such as the return of value investing and US equities. Spiking bond yields sent investors out of inflated bond-like stocks towards cheaper cyclicals at the end of 2016, and controversial incoming US president Donald Trump has pledged to stimulate growth.

 

The US

There is a clear consensus among analysts and commentators that US president-elect Trump's 'America First' policies will result in domestic US growth and better prospects for domestically-facing US corporates. In the run-up to his election, Mr Trump pledged enormous reflationary fiscal stimulus and spending plans aimed at kick-starting the US economy. If put into action, these could result in higher profits for US companies and a more accommodative environment for their goods in the US.

Markets rose sharply following Mr Trump's election, with the Dow Jones, S&P 500 and Nasdaq all up at the end of the year. Industrials, infrastructure and banking stocks in particular rose due to Mr Trump's plans to increase spending on major projects. Asset manager Fidelity forecasts aggregate US earnings growth of 11.2 per cent in 2017 - up from a decline of 0.9 per cent in 2016 - and a return on equity of 16.2 per cent. Those figures put the region at the global forefront of corporate earnings and growth, adds Fidelity.

US markets' strong rise at the end of 2016 makes this a risky market, as it is arguably expensive and might not have further to go. But it could also deliver big gains throughout the year.

The two funds we are suggesting are focused on small- and mid-cap stocks, which should benefit from any domestic growth.

Schroder US Mid Cap (GB00B7LDLV43) invests at least 70 per cent of its assets in medium-sized US companies and focuses on three types of company: growth stocks with improving cash levels, dependable stocks generating consistent earnings and revenues, and recovery stories not yet recognised by the market. It is run by experienced manager Jenny Jones who takes a more cautious approach than some of her peers, meaning the fund will not fully take part in bull runs but is likely to protect losses if equities hit a bumpy road.

Schroder US Mid Cap is among the top 10 funds in the Investment Association (IA) North America sector over one and five years in terms of performance. It has also comfortably beaten its benchmark, the Russell 2500 TR Lagged GBP index, over 10 years, having returned 269.2 per cent against 220.2 per cent for the index and 164.8 per cent for the North America sector.

But other than exceptions such as this fund, active fund managers investing in the US have struggled to beat the indices in recent years, so a low-cost passive fund has been one of the best ways to invest there. iShares S&P SmallCap 600 UCITS ETF (ISP6) tracks the small-cap segment of the US market via a basket of stocks with a median market cap of $1.1bn. This exchange traded fund (ETF) has beaten the returns of those tracking the well-known Russell 2000 small-cap index over three and five years, as well as the S&P 500.

The index it tracks excludes stocks that posted negative earnings in the past four quarters added together, giving an added quality screen.

Although US small-caps look set to rise, this is a high-risk area and could experience falls if Mr Trump's policies are not enacted or have unintended consequences on the wider market. There is also a key distinction between the impact of a Trump presidency on the global market and US companies set to benefit from domestic growth, the reason why we are backing the latter.

Shaun Port, chief investment officer at wealth manager Nutmeg, says: "Developments in the US tend to drive global markets and we expect this to hold firm in 2017. I expect Trump will bring growth to America, but instability to global markets and trade."

 

Japan

Japanese equities have soared in recent years as a result of Prime Minister Shinzo Abe's 'three arrows' reform package aimed at the domestic economy. Despite a brief dip in 2016 new policies, improving corporate governance and low valuations mean it still looks like a good investment destination.

The year 2016 was not as strong as investors had hoped for Japanese stocks, when the central bank's move to negative rates caused confidence to waver. The start to 2016 was slow and only turned with Donald Trump's election victory. The Japanese market has rallied significantly since the result of the US election due to the relationship between rising US rates, and the interplay between the dollar and the yen - a trend likely to continue throughout 2017. Asset manager WisdomTree says: "We believe that Japan's recent performance is not just a one-off adjustment, but has the potential to develop into a broad-based rally throughout the next 12 to 18 months."

But there is a much stronger structural case for Japanese equities in the improving nature of the Japanese economy and Mr Abe's reform policies. Darius McDermott, managing director at Chelsea Financial Services, says: "Mr Abe's policies have delivered a degree of price stability and a number of other good things along the way: improving corporate profits [earnings have risen each year since Abenomics started], increased dividends and better corporate governance, to name a few."

Central bank policy focused on keeping yields steady and the yen weak, and good valuations also make Japanese equities seem appealing. In summer 2016, Mr Abe won a sweeping victory in Japan's upper house elections so now holds a supermajority, affording him unprecedented power to push through further change.

Baillie Gifford Shin Nippon (BGS) is a concentrated investment trust that invests in small-cap companies offering exposure to the most disruptive, high-growth stocks in the market. The trust is a standout performer over the long term, having returned 192.9 per cent over 10 years, compared with the Association of Investment Companies (AIC) Japanese Smaller Companies' sector average of 39.6 per cent. In December 2015, longstanding lead manager John MacDougall left the fund and handed the reins to Praveen Kumar. However, the trust is still well ahead of all its peers in the AIC Japanese Smaller Companies sector over one year, returning 30.2 per cent against nearest rival Fidelity Japanese Values ' (FJV) 6 per cent.

This trust invests in small, under-researched stocks which gives it an edge. The stocks favoured tend to be technology companies with creatively destructive business models, such as online legal services company Bengo4.com (6027:TYO) or Nippon Ceramic (TOK:6929), a company with the majority of the global market in crash sensors. If this trust continues to perform, it should do so regardless of any volatility in the Japanese economy or stock market.

We tipped Baillie Gifford Japanese (GB0006011133) last year and it was one of our top performers. This year we are backing Baillie Gifford Japan Trust (BGFD), also managed by Sarah Whitley. The trust has outperformed the open-ended fund over the long term, but was trading at a premium to net asset value (NAV) in December 2015, and has a higher ongoing charge of 0.88 per cent against 0.68 per cent for its open-ended equivalent. However, it is now trading at a discount to NAV. Over 10 years, the trust has returned 154.2 per cent compared with 131.4 per cent for the open-ended fund and 80.7 per cent for the Topix index.

Ms Whitley has an unconstrained mandate and invests in growth-focused Japanese companies. Recently she has been adding to smaller companies by deploying gearing (taking on debt).

 

Value investing

A move away from growth investing towards value-style investing appears to be under way. A value approach - investing in unloved stocks at low prices - has had a tough time in recent years. A bond bull market and low interest rates have kept money flowing into bond-like stocks with predictable earnings streams and steady growth profiles, pushing up the prices of growth stocks grouped in sectors such as consumer staples to exorbitant levels.

But rising bond yields, an uptick in inflation and higher interest rates have all burst that bubble and made cheaper, cyclical value stocks appealing again. Wealth manager Whitechurch Securities says: "High-quality global businesses that can increase profits in a harsh economic backdrop have been the darlings of the stock market over the past decade. However, with optimism over higher economic growth and a return of inflation, there are signs that undervalued cyclical stocks could be returning to favour."

In 2016, the MSCI AC World Value index outperformed the MSCI World Growth index for the first time in 10 years, and by a significant margin (not counting 2011 when the value index fell by 6.7 per cent, just 0.02 per cent less than the MSCI World Growth). With plenty of reasons for this trend to continue, now looks like a good time for investors with a high risk appetite to allocate to a global value fund.

Sam Lees, head of research at dealing and research site FundExpert.co.uk, says: "This style has underperformed for 10 years, so there may be opportunities in 2017 if more fiscal stimulus starts to flow - something we are seeing the beginnings of in the UK with the infrastructure spend announced in the Autumn statement. Trump's stated objectives also point towards more government spending."

Three of the analysts we spoke to, including Mr Lees, tipped Schroder Global Recovery (GB00BYRJXP30), managed by Nick Kirrage, Kevin Murphy and Andrew Lyddon. This fund is managed via the same approach as Schroder Recovery (GB00BDD2F315), also run by Mr Kirrage and Mr Murphy since 2006.

Schroder Global Recovery's managers take a highly disciplined approach, screening for companies valued at low cyclically adjusted price/earnings ratios (CAPE). The fund is overweight financials, where 32.4 per cent of its assets are invested, underweight US equities and overweight European equities. Its largest holdings are Citigroup (C:NYQ), Barclays (BARC) and American International Group (AIG:NYQ).

"The fund managers deliver growth by investing in companies that have suffered severe short-term setbacks but will not take unnecessary risks," says Adrian Lowcock, investment director at Architas. "The fund has a deep value strategy."

Schroder Global Recovery has been available as an offshore vehicle since 2013, but an onshore version was launched in November 2015.

 

Emerging markets and Asia Pacific

Emerging markets were strong performers in 2016 after a significant bounceback in investor sentiment. That particular rally might have run its course, but emerging markets and Asia are still the regions likely to offer the best prospects for long-term growth due to their favourable demographics, growing middle classes and structural economic improvements.

The disparity between emerging market countries and companies is likely to deepen in 2017, making selective positioning a key priority. Central and South American markets were hit by the election of Mr Trump in 2016 due to fears about trade tariffs and protectionist policies hurting countries such as Mexico. Meanwhile, China's mounting debt and slowing growth could destabilise markets again as they did in January 2015.

Good active managers should be able to steer away from the most vulnerable areas and home in on the markets and companies with the best growth prospects, while the Trump-induced fall in MSCI Emerging Markets at the end of 2016 may turn out to have been overdone if his proposed policies prove hard to push through. Due to the recent pullback, emerging markets are now trading on valuations of 1.45 price-to-book multiples, according to investment bank UBS, a level close to the crisis lows of 2001 and 2008-09, making them one of the most appealing regions on a valuation basis.

Templeton Emerging Markets Investment Trust (TEM) has undergone a significant change since Carlos Hardenberg became its manager in October 2015. Mr Hardenberg increased its weighting to younger companies focused on technological disruption, and themes like the internet and biotechnology, via holdings such as Indian generics company Dr.Reddy's Laboratories (DRREDDY:NSI). He has also increased the number of holdings from 56 in September 2015 to 97.

Performance in 2016 was strong: the trust returned 47.4 per cent outpacing MSCI Emerging Markets index's 33.4 per cent.

"Following a number of years of underperformance, Templeton Emerging Markets has significantly outperformed since Carlos Hardenberg took over as lead manager on 1 October 2015, with the NAV up 48.1 per cent versus a 34.5 per cent gain in the benchmark (to November)," say analysts at broker Numis. "Although his investment approach remains focused on value through bottom-up stockpicking, the definition of value is now much broader and seeks to factor in companies with long-term competitive advantages, as well as strong balance sheets and good corporate governance."

Schroder Asian Income (GB00B559X853) is a lower risk option focused on Asian equities with income potential. A gradual shift in corporate governance across Asia is taking place, with more corporates paying out income and dividend yields gradually rising.

Schroder Asian Income is managed by stalwart Asian equity manager Richard Sennitt and gives investors exposure to companies offering attractive dividends, including ones listed in Australia and New Zealand. Its income focus makes it less volatile than other funds focused on this area and it has performed strongly over the long term, returning 193.7 per cent against 128.6 per cent for MSCI AC Asia ex Japan index. Mr Sennitt has a strong value discipline and runs a concentrated portfolio of 60 to 80 stocks on an unconstrained basis.

 

Higher-yielding bonds

Fixed income remains an important part of income portfolios, but the bond market is likely to continue to be a tricky place to invest. Government and long-dated bonds lost their sheen in 2016 as interest rates rose in the US, and inflation started to tick up in the US and UK. Higher inflation is bad news for long-dated bonds and higher rates mean investors need a higher yield for bonds to remain appealing.

So income investors should seek exposure to higher-yielding parts of the bond market and look further down the quality spectrum, where valuations are lower and yields are higher.

The high-yield market is concentrated in the US and the majority of issuance is from the energy and infrastructure sectors, likely to benefit from Mr Trump's expected reflationary policies. Yields are high due to the higher risk of loaning to these corporates, but company defaults seem unlikely to spike dramatically even if interest rates start to rise, meaning that the risk you take on these bonds should be acceptable and the income earned decidedly higher.

Investing in a high-yield bond fund is highly risky, so a good alternative could be Henderson Strategic Bond (GB0007502080), managed by John Pattullo and Jenna Barnard. This is a strategic bond fund that can move between fixed-interest asset classes depending on its managers' view of the market. It has over a third of its assets in high-yield bonds, and in terms of its geographic breakdown about 40 per cent of its assets are in the US. But the fund also holds securities such as secured loans, which benefit from low volatility and higher yields.

Henderson Strategic Bond has not outperformed over the short term due to a focus on investment-grade credit and longer-duration bonds. However, its managers have recently changed tack and so could be in line for strong performance in 2017 at a lower risk than a high-yield bond fund.

 

Suggested funds' performance

Fund/benchmark 1-month /total return (%) 3-month total return (%)  6-month total return (%)   1-year total return (%)  3-year cumulative total return (%)  5-year cumulative total return (%)  10-year cumulative total return (%)  
Schroder US Mid Cap3.211.324.342.681.0152.2266.1
iShares S&P SmallCap 600 UCITS ETF5.5719.3334.5649.1874.59162.15
Russell 2500 TR Lagged GBP index 4.3913.9427.3539.6964.05142.65222.49
IA North America sector average3.4810.3219.9729.0859.23123.28162.66
Schroder Asian Income 0.70.716.130.343.980.8192.5
MSCI AC Pacific ex Japan index0.6-0.517.629.333.457.3129.3
IA Asia Pacific ex Japan sector average-0.5-1.012.425.833.157.3124.4
Templeton Emerging Markets 4.72.719.946.318.417.0117.5
MSCI Emerging Markets index 2.60.216.833.024.933.891.2
AIC Global Emerging Markets sector average0.7-0.510.326.914.429.9
Baillie Gifford Shin Nippon -1.7-0.4-1.224.983.0258.7192.7
Baillie Gifford Japan -2.33.417.916.651.2202.4152.2
AIC Japanese Smaller Companies sector average-0.9-2.31.711.440.2118.339.4
MSCI Japan Small Cap index 3.33.216.630.768.4108.1118.7
AIC Japan sector average1.84.415.115.249.6149.6105.7
Topix index2.74.919.925.952.296.180.4
Schroder Global Recovery 4.510.530.336.7
IA Global sector average3.45.915.823.036.081.192.6
MSCI World index4.68.619.628.551.6107.6133.2
Henderson Strategic Bond 0.8-2.02.24.314.141.471.2
IA Sterling Strategic Bond sector average1.2-0.93.47.113.632.353.6

Source: FE Analytics, as at 30.12.16

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By Kate Beioley ,
05 January 2017

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