Ian Heslop, who runs the £2.4bn Old Mutual North American Equity fund, expects volatility to rise in the US stock market, and has been looking to small and mid caps for protection.
Mr Heslop, who is also head of global equities at Old Mutual Global Investors, said the valuation gap between large caps and the rest of the market “has never been wide”.
His fund is the absolute top performer in the IA North America sector over the past half decade, returning 179 per cent, compared with 126 per cent for the average fund in the sector in the five years to 7 December.
Mr Heslop said the rise in popularity of ETFs has contributed to this trend, as those passive investment funds buy stocks in proportion to their weighting in the index, and as a result keep buying the largest companies, pushing the valuations higher.
He said he expects volatility to rise central banks' quantitative easing is unwound, and cautioned that the current situation in markets, where equities keep rising and volatility is low, is highly unusual.
He said there is a very strong correlation between the increase in the size of the US Federal Reserve’s balance sheet and the rise in the US stock market.
Mr Heslop said this has helped to keep volatility lower even as equities have risen, but said, “it is rational to think that if the market went up a lot when quantitative easing was in place, then that might reverse as interest rates rise and the Fed shrinks its balance sheet, and would lead to more volatility”.
Quantitative easing pushes up equity valuations in two ways. The first is that bond yields move downwards, making the yields on equities relatively more attractive. The second is low interest rates have created extra liquidity in the global economy, cash that finds its way into all asset classes.
Mr Heslop said he does not attempt to forecast macro-economic changes, as he thinks there are too many variables.
"The problem with trying to forecast economic events is, even if you are right about what happens in the economy, which is hard enough, you then have to be right about how the market reacts.
"If you had predicted Brexit, you would have been right for seven days, if you were right about Trump [winning] you would have been right for about seven hours."
He said his view is buying stocks based on the valuations, and particularly in the mid and small cap part of the market, is the prudent approach.
This is because, if the impact of the ending of quantitative easing is negative for the economy and markets, then it is possible the parts of the market that are relatively cheapest will fall least, representing value for investors.
In contrast, if the US economy and market perform well even as monetary policy is being tightened, then the outlook for the US economy and market will be considerably brighter, with the effect that more economically stocks, many of which are mid and small caps, but also in sectors such as banks, which have underperformed.
David Jane, who runs £811m across three multi-asset funds, said he thinks the US technology giants, which have been among the best performing stocks on the US market in recent years, could suffer as interest rates rise.
He said one of the reasons the shares have done so well is that in a world of low growth and low bond yields, the income one sacrifices by owning shares that pay little or no dividend is reduced.
In a world of little economic growth, companies such as those in the technology sector that are growing, attract a premium valuation.
If the economy is growing, which it should be for policy makers to tighten monetary policy, then more companies should be growing, and capital won’t all go to a small number of businesses.
Tom Slater, who jointly runs the £6.6bn Scottish Mortgage investment trust, said throughout the history of the US stock market, a tiny number of stocks have driven the performance of the market, meaning the current surge in a small number of stocks is not unusual.
Brian Dennehy, who runs the IFA firm Dennehy Weller in London, said the valuations at which US equities trade is so inflated that it will prompt a correction, which will spread to other markets within five years.
David.Thorpe@ft.com
