Multi-assetAug 11 2016

Fund Selector: Playing the ‘quality trade’

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Fund Selector: Playing the ‘quality trade’

Investors always need to be careful with their stock or fund selection, but rarely has it been so critical in a world where extreme monetary policy is distorting the norm.

Long-established investment principles and fundamentals are being cast aside in favour of a potentially dangerous momentum trade, otherwise known as the ‘quality trade’.

Investment committees, wealth managers and model portfolio selectors are all in danger of being consumed by the idea that in a very low interest rate/bond yield environment, the only logical place left to invest in the equity market is in highly dependable quality bond proxies, which apparently provide a low-risk solution and a yield that still gives a real return.

Quality has become a popular investment strategy or theme, and it seems all types of investors are scrambling to get more of it. But they are forgetting once again the basic and simple rules of engagement espoused by Sir John Templeton in his 10 investment maxims.

History doesn’t repeat, but it does rhyme. Many of these bond proxy-hungry investors would do well to recall the experience of the late 1990s when technology stocks were the only game in town.

In some cases, managers were forced to own expensive technology investments, for fear that if they didn’t they would continue to underperform or even get sacked. But then technology underperformed massively and buying into an expensive trend proved very costly.

Based on recent experience, stock or fund selectors would do well to remember Mr Templeton’s words of wisdom. He said: “To sell when others are greedily buying requires the greatest fortitude and pays the greatest reward, [and] if a particular industry or type of security becomes popular with investors, that popularity will always prove temporary, and when lost may not return for many years”.

He also advised that investors should learn from their mistakes, that “the time of maximum optimism is the best time to sell”, and that “this time is different” are perhaps the four most costly words in market history.

To return to the quality trade theme, a recent piece of research from RWC concludes that “nearly all the outperformance of the quality strategy has come from rising valuations”.

There would appear little or no evidence that quality as a factor earns excess return in the long run, and in more recent times quality stocks or bond proxies have only earned a premium as a result of becoming more expensive.

There is no crystal ball that can tell investors when this fashionable trade will abate or reverse. Perhaps we are approaching a period where governments reverse fiscal austerity in favour of more expansionary policies, and this might just be the trigger for a meaningful reversal in the types of stocks that have driven the market.

In any event, now arguably more than ever selectors of stocks or funds had better make sure they understand exactly what type of portfolio or equity they are selecting, because the price paid for any asset ultimately determines how successful they are.

Investors seem to want to pay an ever-inflating price for these expensive quality stocks that appear to offer some certainty. This might just be the completely wrong strategy for the medium to long term.

Gary Potter is co-head of multi-manager at F&C Investments