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Fund tips for 2018

Europe, Japan, Asia and emerging markets look set to deliver some of the best gains of 2018
January 4, 2018

2017 was characterised by strong economic and market performance as for the first time in many years most major global stock markets posted positive returns. Volatility skirted historical lows and valuations in many asset classes grew increasingly rich, with US tech stocks leading the way.

This has left some investors questioning the sustainability of current trends. But many investment analysts believe the bull market, particularly in equities, has further to run.

The fixed-income outlook, however, is more mixed, clouded by a maturing credit cycle, low yields and some monetary tightening, notably in the US. Therefore, we have selected a medium to high risk basket of equity funds and more defensively positioned bond funds, which should perform well in the current environment.

 

Europe

Europe experienced strong growth last year and this looks set to continue, with unemployment falling and business and investor confidence returning to the region. Europe's political outlook, meanwhile, is more stable after far right candidates failed to come to power in France, Germany and the Netherlands in elections last year.

And European Central Bank (ECB) policies are keeping financial conditions loose. The bank recently extended its quantitative easing (QE) programme until at least September 2018, although it will begin cutting the amount of bonds it buys each month from €60bn (£53.42bn) to €30bn from this month. Analysts believe the recovery in economic activity and accommodative monetary policy have further to run. And this supportive economic backdrop is expected to feed into corporate earnings, with analysts at Columbia Threadneedle Investments predicting earnings growth of up to 15 per cent in 2018. 

Europe is also at an earlier stage in the economic cycle and equity valuations are not as high as in other developed markets, such as the US.

"The region is a treasure trove of excellent companies that will benefit from the ongoing global pick-up in activity," adds Tom Stevenson, investment director for personal investing at asset manager Fidelity International.

Small and mid-cap stocks should benefit from the domestic recovery in Europe and a fund that has exposure to these assets is Marlborough European Multi-Cap (GB00B90VHJ34). Almost half of this fund's assets are invested in small and micro-sized companies, with 14 per cent in mid-caps. Over three years the fund was the best performer out of more than 80 funds in the Investment Association (IA) Europe excluding UK sector, and second-best over five years. It is managed by David Walton and Will Searle.

Another strong performer in the IA Europe excluding UK sector is Jupiter European (GB00B5STJW84), which we count among the  IC Top 100 Funds. The fund has been managed by Alexander Darwall since 2001 and he has built an impressive track record over this period. Jupiter European beats FTSE World Europe ex UK index over one, three and five years, and is the top performer in its sector over one year. The fund invests in high-quality European companies meaning it typically has a defensive performance profile which often gives it a degree of protection in falling markets.

 

Japan

Last year saw fiscal stimulus, quantitative easing (QE) and structural reform that Japan's Prime Minister, Shinzo Abe, initiated in 2013 really start to bear fruit. And a win for Mr Abe's Liberal Democratic party in an election last October means he should be able to continue his policies.

"Japan's economy continues to respond positively to structural reform," say analysts at asset manager WisdomTree. "Demographics, including a shortage of labour, are forcing a structural shift from part-time to full-time employment and placing steady upward pressure on wages and income. We expect this structural improvement in employment quality to create a strong foundation for rising household spending."

2017 was also a good year for Japanese equities as companies are benefiting from record-low interest rates and record-high cash balances. An increasing number of them are returning capital to shareholders through dividends and share buybacks, as policies to improve corporate culture take hold.

But Japan is still one of the cheaper developed equity markets. "Although the Nikkei 225 has performed well [in 2017], it's still around 40 per cent below its long-term peak," says Darius McDermott, managing director of research company FundCalibre.

A good fund to play this could be Legg Mason IF Japan Equity (GB00B8JYLC77), which has been managed by Hideo Shiozumi since its launch in 1996. It is the best performing fund in the IA Japan sector over one, three and five years, over which time it is also far ahead of the TOPIX index.

Analysts at Tilney Group say: "During his career [Mr Shiozumi] has had periods of considerable outperformance. This is due to his investment style, which seeks primarily small-cap companies that generate most of their revenues domestically. These stocks tend to exhibit significant volatility, and therefore this strategy should be regarded as relatively high-risk. The portfolio is concentrated and has little resemblance to any benchmark."

A less racy option is Baillie Gifford Japanese (GB0006011133), which aims to invest in growing Japanese businesses that deliver consistently strong returns for shareholders. The fund is well ahead of the TOPIX index over one, three and five years, and in the top quartile of its sector in terms of performance over those periods.

It is managed by Matthew Brett and veteran Japanese manager Sarah Whitley. However, Ms Whitley is retiring in April, and Mr Brett will become the lead manager, while Praveen Kumar, who also manages Baillie Gifford Japanese Smaller Companies Fund (GB0006014921), will become his deputy.

However, Ben Gutteridge, head of fund research at wealth manager Brewin Dolphin, says: "Baillie Gifford Japanese fund looks well positioned to perform strongly in 2018, despite the imminent retirement of Sarah Whitley as the head of Baillie Gifford's Japanese equity team. Ms Whitley has built up a relatively large team well versed in the Baillie Gifford investment philosophy of long-term, patient, benchmark agnostic investing in companies with above-average growth prospects. As such we do not expect much to change. The portfolio will continue to be made up of companies with attractive industry backgrounds, strong competitive positions, high-quality earnings and managements with favourable attitudes towards minority shareholders."

 

Asia

Asia Pacific equities were among the best performing equity markets in 2017, and could continue to impress in 2018. This is because Asia has some of the most dynamic economies and arguably the best growth potential of all geographic regions. It includes China and India, the countries with the world's largest populations, where growing affluence is driving areas such as consumer and financial services.

And as well as a positive macroeconomic backdrop, forecasts for corporate earnings in Asian markets have recently been revised upwards. Although valuations rose in 2017, Asian stock markets are still not expensive compared to their long-term average, given the lows to which they fell three years ago. The region also looks attractively valued compared with other global markets.

"China's five-year plan focuses on the level and quality of growth, and should act as an anchor for economic growth and investment confidence in the region," says Jonathan Sparks, head of investment strategy at HSBC Private Banking. "This coincides with Japanese growth, an economic rebound we expect to see in India and buoyant regional trade, which all create opportunities for investors."

Old Mutual Asia Pacific Fund (GB00B1XG9607), run by Ian Heslop, Amadeo Alentorn and Mike Servent, is a well-diversified way of getting exposure to Asia's fast-growing markets. The fund has more than 240 holdings in companies across the Asia Pacific excluding Japan region. China is its largest single country exposure, accounting for a quarter of assets, Australia accounts for 15.4 per cent, South Korea for 14.9 per cent, Hong Kong for 9.3 per cent and Taiwan for 8.6 per cent. It also has exposure to India and Singapore.

The fund beats MSCI AC Asia ex Japan index over one, three and five years and is among the top performers in the IA Asia Pacific excluding Japan sector over these periods.

"The fund has done well over the past couple of years, helped by holdings in Tencent (700:HKG) and Alibaba (BABA:NYQ)," says Mr Stevenson. "With sentiment likely to be more volatile [in 2018], I like the managers' ability to move in an agile way between stocks and sectors as the market mood shifts."

Schroder Asian Alpha Plus (GB00BDD27J12) also has a good performance record. This fund has been run since launch in 2007 by Matthew Dobbs who has more than 30 years' investment experience. Mr Dobbs believes long-term returns are driven by valuation, but is willing to exploit other opportunities if the investment case is strong enough. 

Analysts at FundCalibre say: "Schroders' global scale and high-quality team of analysts provide it with an important competitive advantage when investing in Asia. Matthew Dobbs has demonstrated he can deliver real returns without taking undue risk. The blended investment strategy means the fund should hold up well in most market conditions."

 

Emerging markets

Emerging markets were one of the best performing equity markets last year, and low inflation, the pick-up in global trade and weak US dollar suggest this strong performance is likely to continue in 2018. And China, the largest emerging market, has continued to grow robustly and is making progress in transitioning from an export-led to consumer-focused economy.

"China looks set to lead emerging markets as the underlying economic data is supportive of strong single-digit growth and valuations remain attractive," says Adrian Lowcock, investment director at Architas. "While debt in the country continues to rise this is currently offset by the foreign reserves and continued economic growth. China continues to make progress in shifting from being more of a global exporter to a domestic consumer, and there has been a shift from 'made in China' to 'innovated in China' as the country has emerged as a global leader in technology. We believe emerging markets closest to China will benefit from a halo effect so prefer Asian emerging markets."

Dean Newman, head of emerging market equities at asset manager Invesco Perpetual, likes Asian tech hardware companies because of their ability to generate significant free cash flow and also rates Chinese internet businesses for their strong growth potential.

"While we envisage earnings growth will increase at a faster pace in Asia, for example from Korean and Chinese tech firms, we are confident that companies in Brazil, South Africa and Russia will also deliver," he says.

Emerging market commodity producers also look particularly attractive amid a bullish outlook for materials prices. Luca Paolini, chief strategist at Pictet Asset Management, says: "Russia in particular is likely to benefit from the rebound in oil prices. Russian equities look cheap, as does the currency, and the central bank is supportively cutting rates."

Fidelity Emerging Markets Fund (GB00B9SMK778) favours companies that serve the nascent emerging markets consumer, so its largest sector exposures are consumer and financial stocks. China, South Africa and Hong Kong are its three largest geographic exposures. The fund is in the first quartile of the IA Global Emerging Markets sector in terms of performance over one and five years, over which periods it also beats the MSCI Emerging markets index.

Mr Lowcock says: "This fund invests in companies with superior business models that demonstrate strong and sustainable profitability, and a consistent track record over time. Manager Nick Price is looking for confirmation of quality through a superior and sustainable return on assets, strong and unleveraged balance sheets, track record and valuation. He prefers self-funding businesses that treat shareholders fairly. He is also interested in companies with long-term growth potential where reinvestment in growth delivers a high rate of return."

Baillie Gifford Emerging Markets Leading Companies (GB00B06HZN29) is among the 10 best performers out of more than 60 funds in the IA Global Emerging Markets sector over one, three and five years. It is run by Will Sutcliffe and invests in larger and more liquid emerging market stocks.

China is its biggest country exposure, accounting for nearly a third of assets, followed by South Korea at 15.1 per cent, Taiwan at 13.8 per cent and India at 13.3 per cent.

 

Strategic bond funds

After years of QE by global central banks, which has kept financial conditions loose and pushed bond prices up, the fixed-income environment is starting to turn. Last year the US Federal Reserve (Fed) raised interest rates three times and more rate rises are expected this year. The Fed also started unwinding its $4.5 trillion (£3.32 trillion) QE programme, reducing the amount of bonds it buys by $10bn each month, and it will reduce this further over the coming months. The Bank of England also raised interest rates for the first time in a decade last year.

Given the shifting fixed-income environment, strategic bond funds continue to look like the best way to get exposure to this asset class, as their managers can invest across the fixed-income spectrum in an unconstrained way. This means they can invest in the areas that look best and avoid less desirable ones, moving around as required.

Floating rate bonds could be an effective way of mitigating interest rate risk if rates rise faster than expected. Unlike bonds which pay a fixed rate of interest, floating rate bonds have a variable rate that resets based on interest rate changes. 

A strategic bond fund with a good performance record and substantial exposure to floating rate bonds is GAM Star Credit Opportunities (IE00BYZXFP13), run by Anthony Smouha. It has 43.3 per cent of its assets in fixed-to-floater bonds. These provide a fixed interest for a specified period and then float at a spread over a specified benchmark, which is regularly re-set and can move in line with interest rates. This fund is the best performer in the IA Sterling Strategic Bond sector over three and five years, and second over one year. It has a yield of 4.2 per cent.

Mr McDermott says: "[This is a] safety first fund with very low turnover, as its managers look for bonds they can buy and hold for 10 years. Very little of what they own yields less than 6 per cent at the initial purchase point and this gives the fund far less interest rate sensitivity than many of its peers, which is particularly valuable in the current environment."

Jupiter Strategic Bond (GB00B544HM32) also has a history of investing in floating rate bonds, although at present has only 5 per cent of its assets in this area. Over half of its assets are in corporate bonds, with 36.8 per cent in government bonds. The fund aims for a high income with the prospect of capital growth and has a yield of 3.4 per cent.

"This is a highly flexible bond fund run by a talented manager," say analysts at Hargreaves Lansdown. "Ariel Bezalel generally seeks to achieve the highest returns possible for investors through a combination of income and capital growth. He also has a range of options that allow him to try to shelter the portfolio during tougher times."

Performance of suggested funds

Fund/benchmark1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)Yield (%)
Asia Pacific ex Japan     
Old Mutual Asia Pacific 35.276.9114.61.001.34
Schroder Asian Alpha Plus35.170.284.20.880.92
IA Asia Pacific ex Japan sector average23.752.766.4  
MSCI AC Asia ex Japan index27.457.873.1  
Emerging markets     
Baillie Gifford Emerging Markets Leading Companies*36.666.875.80.790.60
Fidelity Emerging Markets 27.952.074.30.990.00
IA Global Emerging Markets sector average23.346.242.7  
MSCI Emerging Markets index24.152.246.2  
Europe ex UK     
Jupiter European 32.365.5116.51.030.40
Marlborough European Multi-Cap25.1108.2142.10.901.00
IA Europe ex UK sector average20.848.685.3  
FTSE World Europe ex UK index20.551.185.7  
Japan     
Legg Mason IF Japan Equity46.5168.5328.31.020.00
Baillie Gifford Japanese27.491.9176.60.630.71
IA Japan sector average18.770.4119.8  
TSE TOPIX index16.470.5122.3  
Strategic bonds     
GAM Star Credit Opportunities*15.332.571.91.224.24
Jupiter Strategic Bond*5.214.427.90.733.40
IA Sterling Strategic Bond sector average6.213.223.7  
Bloomberg Barclays Sterling Aggregate Corporate index7.519.036.6  
Source: FE as at 15/12/17. *Performance shown is for a different share class to that mentioned in the text.