Portfolio picksDec 17 2018

Two funds to offer protection in a falling market

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Two funds to offer protection in a falling market

The big question that investors are trying to address is whether the correction seen in October was just a correction, or the beginning of a longer term bear market.

The argument for it being just a correction is centred on the fact that, after the correction in the first quarter, it was only the US market that managed to drive successfully above, and stay above, for more than a few days.

As Mark Twain was reputed to have said: “History doesn’t repeat itself but it often rhymes.” 

The run-up in the FAANGs (Facebook, Apple, Amazon, Netflix and Google) stocks in the summer were very much rhyming with events in 1999. At that time we had the technology, media and telecommunications (TMT) mania.

While everybody recalls the TMT rise and fall, many investors forget that at the same time passive investments were all the rage.

Those believing that October was just a correction console themselves that the over exuberance in the summer of this year required a correction for markets to move upwards and onwards.

Even the regulators were jumping on the bandwagon, suggesting that due to their low fees, these should be an investor’s first port of call. In the UK the most tracked index was the FTSE 100.

In November 1999, Vodafone, one of the larger FTSE 100 companies, announced a hostile bid for Mannesmann, a German industrial group. When the deal finally got clearance in February 2000, the combined group became more than 10 per cent of the index.

This caused a problem for index trackers as, in those days, most of them were open ended investment companies and not exchange-traded funds (ETFs), which were not allowed to hold more than 10 per cent in any one company.

They needn’t have worried, the company now represents just 2.5 per cent of the index.

Apart from index tracking mania, the other main similarity was that back then Vodafone represented a company that would ‘take over the world’ and in the summer the same was true of the likes of Apple.

The principles of capitalism, it seems, had been forgotten by the markets. Where there is growth and profit, others will move in.

Those believing that October was just a correction console themselves that the over exuberance in the summer of this year required a correction for markets to move upwards and onwards.

Additionally, many investment houses point out that a bear market requires a recession and the US, which drives markets, shows no sign of a recession imminently. Although many recognise that a slowdown is likely.

This recognition was helped by Jerome Powell, chairman of the Federal Reserve, who moved from the hawkish view that we were a long way from neutral interest rates, to a dovish view that we were just below the neutral rate.

As ever with markets, the first reaction was positive in that it meant there would be fewer rate rises going forward, but the markets were soon wondering why he had changed his view. Markets have started to wonder what the Fed knows that they do not.

The list of factors that could mean that October was the beginning of a bear market is a lot longer. We have US President Donald Trump versus China and the imposition of tariffs and a continuing trade war.

Then there is Brexit, Italy facing down the EU, the rise of populism politics around the world and all the uncertainty that that creates.

Then, of course, we have the ending of one of the biggest financial experiments the world has ever seen. Quantitative easing (QE) is slowly turning into quantitative tightening (QT), with only the Bank of Japan being the last one going. Some irony, since they were the ones that started it.

Whatever your view, it seems likely that markets will be volatile in the future.

Fixed interest markets no longer look the safe haven that they have been since central banks got inflation under control in the 1980s.

We had one fixed interest fund manager tell us he would rather buy equities then corporate debt. Maybe that’s not surprising, since in Europe 73 per cent of equities yield more than their corporate debt.

One investment style that has been out of favour since the global financial crisis has been value investing. One of the things that we have been hearing from equity fund managers of varying styles is that they are now finding individual shares representing excellent value.

The good thing about holding a share that is cheap now is that it has less far to fall if markets do maintain a downward trend. Additionally, you have the consolation of an income stream.

Two funds we have tucked away in our portfolios are the Schroder Income Maximiser and the RWC Enhanced Income fund.

The Schroder fund has the underlying portfolio of the Schroder Income fund, managed by Kevin Murphy, Nick Kirrage and the value team.

The RWC fund is managed by John Teahan, Ian Lance and Nick Purves, all three of whom were previously at Schroders.

These funds enhance the underlying dividend yield by selling call options for which they get a paid premium.

Both of these funds will participate in a rising market, although not to the full extent if the market is rising rapidly and the call options are called.

In a flat market they will benefit as the calls will lapse, and in a falling market these funds offer some protection.

Paul Warner is head of portfolio management at Miton Optimal