US small-cap manager The Royce Funds has moved to back more established and stable businesses it believes can outperform, as interest rate rises usher in a “higher-risk environment” in equities.
With the US Federal Reserve (Fed) widely expected to raise its base interest rate later this year, managers at Royce, an affiliate of US fund giant Legg Mason, have prepared their portfolios for the end of the “easy-money” environment.
Since the financial crisis the money pouring into the US financial system from quantitative easing and low rates has led the S&P 500 index to rise 236 per cent, while the mid-cap Russell 2000 index has risen 286 per cent.
But Chuck Royce, chief executive of Royce, said the onset of higher rates could herald a “hinge period”, leading to uncertainty, higher risks and lower equity returns.
Mr Royce said a focus on quality companies should outperform in such an environment, although this direction has been a headwind for him in recent years.
Royce’s portfolios of smaller companies have struggled at times since the financial crisis, as the firm’s dogged adherence to quality companies has meant it has missed out on the rocket-fuelled gains in more risky, growth areas of the market.
“The Fed’s policies made it easier for low quality to do well because there were few, if any, penalties to taking on more debt or not being profitable,” Mr Royce said. “In contrast, there were few of the traditional advantages that usually accrue to high quality.
“We feel confident this era is over. We expect lower returns for stocks as a whole, but relatively better returns for both high-quality companies and more cyclical, less defensive sectors.”
Francis Gannon, co-chief investment officer at Royce, said a higher-risk environment “tends to benefit quality companies”, such as those that are “conservatively capitalised, profitable businesses with high returns on invested capital and effective, shareholder-friendly management”.
Mr Royce said his funds’ focus on quality had served the firm well during the ‘taper tantrum’ of 2013, when markets fell following signs that the Fed was about to end its easing policies.
In the past five years, Royce’s US small- and mid-cap equity funds, both domiciled in the US and those sold in the UK, have underperformed the Russell 2000 index.
The two vehicles available in the UK – Legg Mason IF Royce US Smaller Companies and Royce US Small Cap Opportunity funds – have continued to underperform and lag their benchmark in the past year, according to data from FE Analytics.
With an interest rate rise on the horizon, Mr Royce said he had been looking to buy into financial stocks, which are expected to perform well in a higher-rate environment.
The manager, who typically has not invested much in the sector, said he was now “looking around for interesting opportunities in bank stocks”.
The Royce funds also have overweight positions within the energy sector, as well as materials and industrials, but admitted their calls had not yet paid off.
Mr Gannon said: “It’s been challenging for us waiting for many of our highest-confidence holdings to turn around.
“Transitions are never easy, and to be sure the shift we’ve been anticipating has taken longer than any of us initially thought it would.”
