Fund tips for 2019

The past year has confirmed that the raging equity bull market between 2016 and 2017 is over. This means that all types of portfolios should have some protection via assets that could mitigate losses if volatility continues.

The decision on whether to allocate to risk assets such as equities should be based on when the next global recession is likely to occur. Last year there were signs of slowing global growth, which suggest there could be a recession sooner than many thought at the end of 2017. But even if global growth is slowing, equity markets could have further to run. So continuing to allocate to equities is fine – just remember it's not a good idea to buy at the top of the market. So despite the fact the global economy is being driven by US economic growth, we would not suggest putting new money into a US equity fund at this point, as valuations in this market are stretched. However, some equities outside the US do offer value.

Rory McPherson, head of strategy at Psigma Investment Management, says investors should take note of the causes of equity market volatility in 2018.One cause of this was significant sales in the US funds market as US private and professional investors became increasingly nervous. This was in part because of the Federal Reserve's comments on how close the US economy is to overheating and entering recession. Many US investors are unsure as to whether the Federal Reserve, the US central bank, has acted quickly enough in raising interest rates, or has done this too soon and stifled economic growth.

“Equities look like the best place to do well in 2019, but the downturn in markets could continue just because US investors keep selling," says Mr McPherson. "US funds own about 40 per cent of the market and can drive it down. We would want to see softness in US data or dovish comments from the Federal Reserve before we committed to equity markets generally. If the Federal Reserve makes a policy error, for example tightening into a falling economy or lowering inflation, it could temper excitement. We want to reallocate to equities, but will wait until we see a stabilisation of fund flows and a better indication of what the Federal Reserve will actually do."

UK equities

There is an area much closer to home where poor sentiment among international investors and uncertainty among domestic investors have left a valuation gap, and that is UK equities. This is because of increasing uncertainty over this country’s relationship with the European Union (EU) and weak sterling hampering the returns of international investors. Valuations, particularly of domestic-focused stocks, are now as low as they were at the end of the financial crisis.

Ben Seager-Scott, director of investment strategy at wealth manager Tilney Group, says earnings expectations for UK companies have actually grown, yet the market keeps trending downwards. “The UK is in an especially attractive position," he says. "Most other markets are down 10 per cent on valuation, but UK earnings remain robust."

Charles Younes, research manager at data company FE, says it’s difficult to see how valuations for UK equities could get any worse. And Mr McPherson says UK equities are the most attractive asset globally in terms of valuation, so could make a good contrarian investment, although how they play out will depend on how the UK leaves the EU.

All three of these analysts believe the broader UK equity market will rally if a deal with the EU is approved, and in these circumstances funds focused on megacap FTSE 100 stocks should do well. More domestically-focused mid-cap funds could offer greater returns as the valuations of such stocks are more depressed, so investors may be best placed if they hold both.

If you want exposure to the possibility of a rise in the overall UK market rather than to specific stocks you can get broad exposure very cheaply via passive funds. Options include iShares Core FTSE 100 UCITS ETF (ISF), which is one of the cheapest and most liquid UK large-cap equity funds. This is a simple core exchange traded fund (ETF) that’s good value for money both in terms of its charges and spread.

If you prefer an active fund, a good option for large-cap income is City of London Investment Trust (CTY). It has been run by Job Curtis since 1991 and over the long term he has proved more than adept at picking stable large-cap income stocks and managing downside risk. However, recent relative performance has been lacklustre due to exposure to housebuilders such as Persimmon (PSN) and Taylor Wimpey (TW.), and a relatively large holding in British American Tobacco (BATS). This means the trust could benefit from a change in sentiment towards UK stocks and improving fundamentals of the companies it holds.

The trust's share price underperformed the FTSE 100 over 2018 with a fall of 8.73 per cent versus a fall of 7.88 per cent for the index, although was in line with the FTSE All-Share index. And over 10 years the trust has made a share price cumulative total return of 183 per cent versus 133 per cent for the FTSE 100. City of London Investment Trust has also increased its dividend every year for the past 52 years.

For more domestic exposure, options include Merian UK Mid Cap Fund (GB00B1XG9482), previously called Old Mutual UK Mid Cap. This fund has been run by Richard Watts since 2008, over which period he has made substantial returns by picking small and mid-cap companies that have become big growth names. Following the recent market rout Mr Watts has been buying into companies he thinks are too cheap to ignore. The fund has no major sector bias and is focused on high-growth stocks, so looks well placed to ride any market return to form. Mr Watts has a good record of being in the right names at the right time. In 2018 the fund fell 22.62 per cent versus a fall of 13.08 per cent for the FTSE 250 index, making this a contrarian bet. But over five years the fund has returned 47.65 per cent, almost double the FTSE 250's 25.81 per cent.

UK equity funds

Source: FE Analytics, as at 31/12/2018

Capital preservation

Given the volatile nature of 2018 many investors will be thinking about defence. The idea of giving away returns from equity markets to protect against possible downside may have seemed overly cautious 12 months ago, but we are now in different times.

Capital preservation, or absolute return, is a difficult nut to crack. It can often mean buying assets that are likely to lose you money in the short term but mitigate downside in the long term. Good managers try to limit the time spent in the former, but working out the right time to buy an asset is difficult. Many absolute return funds, which aim not to lose capital over any three-year period, have failed to live up to expectations. Many were set for a market downturn but lost capital as markets continued to rise.

Jupiter Absolute Return Fund (GB00B6Q84T67) is a global equity long/short fund. Its manager, James Clunie, buys companies whose share prices he expects to rise and also takes bets on companies’ share prices falling. Doing this can provide positive returns in falling markets, depending on how well Mr Clunie has picked 'long' and 'short' options. The fund currently has a net exposure of -8.2 per cent, which means most of its assets are being used to short stocks in anticipation of a rough market. This has detracted from the fund's recent performance, but could prove to be the right strategy if there are market falls ahead. Mr Younes says the fund is shorting 'bond proxies' – companies that are defensive and high yielding – because their valuations have increased a good deal. This could be useful in an environment where inflation and interest rates rise – which is likely in 2019. Mr Clunie aims to provide a positive return above cash over a three-year period, and had returned 7.6 per cent over the three years to 31 December 2018.

JPMorgan Global Macro Opportunities Fund (GB00B4WKYF80), unlike Jupiter Absolute Return, invests in a broad range of assets including stocks, bonds, currencies and commodities, and uses derivatives to manage its long and short exposures with the aim of providing a positive return. The fund's lead manager, Talib Sheikh, left last year, but the two co-managers – James Elliot and Shrenick Shah – remain. They are managing the fund in anticipation of an overly bearish market in 2019, so if you are very concerned about how things will go it could be a good option. The managers invest along the lines of global risk themes, and take both long and short positions. Currently 25 per cent of the fund's assets are invested to try to mitigate the risk of a maturing US economic cycle. Over three years to 31 December 2018 the fund had returned 11.15 per cent.

Capital preservation funds

Source: FE Analytics, as at 31/12/2018

Strategic bonds

Portfolio diversification is always necessary, but even more so when market volatility is likely. Bonds are one of the main areas investors have traditionally turned to for diversification, however rising interest rates and inflation are not a good environment in which to buy safe-haven bonds such as UK government bonds. US government bond yields have risen above 3 per cent, so arguably offer better value, but neither these nor UK government bonds are likely to offer much capital growth. And as the Federal Reserve and the Bank of England are reducing the amount of bonds they hold, markets could be volatile.

However, a good active manager will aim to invest a bond fund in the best parts of this market at the right time. A manager with a good record of doing this is Craig Veysey, who runs Man GLG Strategic Bond Fund (E00B7VMRN51). Mr Veysey recently moved from Sanlam Asset Management to Man GLG and took the fund he ran with him. Mr Younes says he differs from some other bond managers because he has never simply relied on high yield exposure for returns, but rather remained cautious of downside risk. The fund has a lot of exposure to investment-grade credit and Mr Veysey  manages the risk of this by controlling the duration of the fund, ensuring risks are kept in check on a daily basis. Duration is how sensitive a bond portfolio is to rising interest rates, and a high duration in the current environment could result in a capital loss. Over three years this fund has returned 23.1 per cent, more than double the IA Sterling Strategic Bond sector average of 10 per cent. The fund has an attractive yield of 4.1 per cent.

Allianz Strategic Bond Fund (GB00B06T9362) is more defensive than Man GLG Strategic Bond. Its manager, Mike Riddell, cut his teeth as part of the well-respected M&G bond team, but moved to Allianz Global Investors in 2015 and took over this fund. Mr Riddell has performed well in the past 12 months, returning 2.5 per cent versus the IA Sterling Strategic Bond sector average – a 2.5 cent fall. Mr Riddell is particularly focused on currency risk and ensures that the majority of the fund's assets are hedged back into sterling. He also has greater exposure to government bonds than most other strategic bond managers, and invests in safe-haven markets, rather than just relying on duration and credit spreads.

Strategic bond funds

Source: FE Analytics, as at 31/12/2018

Emerging markets

The headwinds that emerging markets have faced in 2018, such as dollar strength, rising oil prices, and trade tensions between the US and China, may not have disappeared. Oil prices are falling and the dollar is predicted to weaken in 2019, but things could change and global trade remains an unknown. Should the US and Chinese tit-for-tat sanctions be withdrawn emerging markets could receive a boost. However, emerging market fundamentals have worsened due to slowing global growth, and the dollar strength is making debt and foreign purchases more expensive for emerging market companies. However, if you put money into emerging markets it should be for the long term rather than just the next few years, so 2019 could be an attractive entry point into an asset that could make strong returns in five or more years.

We recommend funds run by good emerging markets stockpickers who focus on company fundamentals and valuations, value long-term growth, and diversify well across the different regions. Hermes Global Emerging Markets Fund (IE00B3DJ5K90), managed by Gary Greenberg, is one such option. This fund has suffered recently due to its exposure to Chinese tech companies and industrials, but Mr Greenberg remains confident that the businesses the fund owns will do well over the long term. He has recently reduced Chinese bank exposure in case these are forced to help stimulate the Chinese economy, and added to consumer-facing businesses such as insurance companies. Over the long term the fund has a good record with a return of 67 per cent over five years versus the IA Global Emerging Markets sector average of 34 per cent and a 41 per cent rise for MSCI Emerging Markets index.

Recent negative sentiment has affected the share prices of emerging market investment trusts so a number of them are trading on discounts to net asset value (NAV). These include JPMorgan Global Emerging Markets Income Trust (JEMI) whose NAV return has beaten the MSCI Emerging Markets index over one and three years, but is trading around par. This has recently narrowed from as wide as 5.3 per cent, but as the trust sometimes trades on a premium this still looks like a good entry point. The trust is managed by Omar Negyal, Amit Mehta and Jeffery Roskell, and key sector exposures include financials, consumer stocks and tech companies. Over three years its share price total return has beaten the index and the Association of Investment Companies (AIC) Global Emerging Markets sector average.

Emerging market funds

Source: FE Analytics, as at  31/12/2018