Raising the stakes for demanding investors

In the near future, returns are likely to be lower than investors are accustomed to, says William Russell, and many fund managers are responding by launching aggressive focus funds which reward greater risk with greater returns.

Market volatility always helps to concentrate the mind. When everything is moving steadily upward, the average investor works on the sound principle: “If it’s not broken, don’t fix it.” The problem, with markets as they are, is that too many investors are thinking in terms of the quick fix. If you do not know what is broken, how can you start to fix it? There are two main problems in addressing current market volatility. One is that, despite (or perhaps because of) analysts’ best efforts, factors that generate volatility seem to be coming from all directions at once. The other problem lies in coming to terms with the likelihood that stock market returns going forward may be lower than those to which investors have become accustomed in recent years. “I’m afraid we all got a little spoiled in the 1980s and 1990s,” says Mike Felton, lead manager of Royal & SunAlliance Investments’ (R&SA) UK Equity and UK Prime Fund. “Markets seemed to go up in almost straight lines so investors could rely on making double-digit returns every year.” But, he says: “In today’s low inflation/low growth environment, many investors either will have to get used to single digit returns – we forecast equity returns of only around 8 per cent for this year – or will need their independent financial advisers (IFAs) to show them some new approaches. “Low to medium-risk corporate bond funds are now returning around 8 per cent a year, while equity funds, which are naturally more risky than bond funds, are only forecast to return about the same over the short-term. Investors should be considering all their options. “Managing a private portfolio these days is all about absolute returns,” says Mr Felton. In other words, it means disregarding whether a fund’s returns are generated as income or growth and concentrating on whether the savings are delivering the best level of return for the risk. History suggests that equities are more likely to deliver outperformance over the long-term but a mainstream equity fund will require investors to spend more of their finite risk budget in exchange for this potential. Playing safe In terms of getting the best returns, corporate bond funds have the most to offer private investors. Looking at the returns from such funds on a risk-adjusted basis (that is, the level of return received for the amount of risk spent) will make for interesting reading. James Foster, director of credit strategy and research at R&SA Investments, says: “The measurement of an asset’s return for each unit of risk expended is called the Sharpe Ratio. It is still a little known fact but the Sharpe Ratios for corporate bonds – whether investment grade or high-yield – are head and shoulders above those for other asset classes [see figure 1]. This means that investors get more return for less risk than with any other type of asset.” Picking winners As far as both corporate bonds and equities are concerned, picking worthwhile sectors is likely to be hard going in the next year or two and picking individual winners will be even harder. Any worthwhile gains that managers make in 2002 will be hard won and, most probably, the result of close attention to stock picking rather than a purely top down approach. That said, the Bank of England has recently confirmed clear signs of an economic recovery. Leading US and European indicators also suggest that recession has been avoided. And there is one investment sector that still has cast-iron top-down credentials: the high-yield bond market. The high-yield segment of the bond market is always the first to benefit from improving economic fundamentals. The main concern for high-yield bond investors is always default rates but, as economic conditions improve, the risk of defaults naturally lessens. Now, market factors have conspired to make high-yield the closest thing to a win-win proposition that this year’s murky investment market has to offer. Borrowed ideas Companies have been working feverishly to reduce debt levels, following the long bull run of the 1990s and commentator speculation that much of the period’s supposed growth was illusory. For some companies, the focus has been on reducing debt levels. Examples are ICI, with its recent Ł800m rights issue, and BT, which is explicitly asking its shareholders for more money. Other heavily indebted large caps, such as British Airways, Invensys and Vodafone, have had little choice but to follow suit for fear of the new proactive stance taken by credit rating agencies in the wake of the Enron debacle. After all, it was a credit downgrade that spelled disaster for Enron. Although it could survive with a BBB rating, the cost of a downgrade meant that its earnings were threatened by the additional cost of servicing its debts. The market as a whole has suffered as a result of the Enron collapse. Companies such as Tyco have already endured severe bouts of ‘Enronitis’ because investors have all but ceased to accept balance sheets at face value. “The most notable result of the Enron affair has been to create a much more challenging environment for highly geared companies,” says Fatima Luis, fund manager of the R&SA Maximum Income Bond Fund. “A major impact, besides the increased need for transparency in accounting practices, has been that short-term access to liquidity for companies now has a major effect on their long-term credit rating.” This is what lies behind the efforts being made across the market to pull credit ratings up. “You can see how the price of Tyco’s sterling debt accurately followed the stock’s credit re-rating. It will be the same story for any company that doesn’t start to put the fortunes of its bond holders before that of its shareholders,” says Ms Luis. This way of thinking is a departure for most corporates. Management culture has so far targeted factors such as earnings, market share or dividend growth. Now a company’s credit rating is starting to take precedence. Mr Foster says: “With this in mind, we can expect a wave of volatility in the investment grade bond market as balance sheets come under ever closer scrutiny. The same is true for genuine high-yield companies; transparent accounting could make the difference between success or failure.” Despite this recent turmoil, the fundamentals have not changed, according to Ms Luis. “For high-yield bonds, it still comes down to taking a view on the issuing company’s ability to repay its IOUs.” The crucial aspect is cash flow, she says. “So long as a company continues to generate enough cash to repay its debts, the value of the bonds will be sustained. Equity prices, in contrast, are far more geared to short-term changes in profit outlooks.” Making the grade Fund managers who have confidence in their research capabilities should have a field day in the coming year, says Ms Luis. “We are convinced that, with the early stirrings of economic recovery already being felt, 2002 will be the year for the high-yield bond market.” “History demonstrates that the peak in default rates has always been a lagging indicator. That means that the best time to buy high-yield is at this stage of the cycle, as defaults slowly tick towards their forecast peak. The last time the market was this depressed, it bounced back with a 44 per cent return the following year,” she says. Ms Luis’s forecasts for high-yield returns of anywhere between 10 per cent and 14 per cent this year compare favourably with consensus forecasts on equities of around 8 per cent for 2002. “It is difficult to see why investors would want the additional risk of investing in equities when forecast returns for the year clearly show that they won’t soon be rewarded for taking the risk,” she says. The only remaining question, it seems, is when to make the move to high-yield. Ms Luis says: “If you’re still here in a year’s time wondering whether to get your feet wet, then don’t worry – you will already have missed the boat!” Going for broke According to Mr Felton, it is the recognition of the lower return outlook for equity funds that has prompted so many fund managers to launch a new generation of aggressive focus funds. These employ more concentrated portfolios to reward greater investment risk with greater investment returns. “In this environment the only way to generate equity returns above and beyond those of a given index is to concentrate,” he says. “That means concentrated portfolios that deliberately have a low correlation to the index in question.” This might not sound like the most worthwhile advice for investors who are anxious to diversify their investments and so reduce the overall risk to their savings. But, as Michael Lynch, director of sales at R&SA Investments, says: “In a market where most portfolios are heavily skewed toward the UK and the FTSE Index, grasping the nettle and investing in funds with a low correlation to the market is one of the best ways to reduce total investment risk.” Mr Felton says: “We find that we are dealing an awful lot more often than we do when managing our mainstream UK equity fund. But we are also free to engage stocks in a way that is simply not open to us with more conventional portfolio structures. “For example, by putting the emphasis on stock picking, we are freed from having to find attractive long-term strategic investment stories in stocks. Instead, if we see an attractive tactical opportunity to make money on a stock we can make it work for the portfolio, even if we do not particularly fancy the long-term story,” he says. “The same is true with valuations. Whereas we might be restricted to looking for value with a mainstream equity fund, with a focus fund we only need to know that the stock is going to go up in the short-term. Whether the stock justifies its subsequently increased valuation is not really a concern because we will have sold out when the stock made our target price,” he says. A good example of this type of cut and thrust is provided by the troubled telecom stock Cordiant. As the chart shows, the nimbleness of a focused portfolio means that managers can make strong returns even on poorly performing stocks. “We were not fans of the stock because the fundamentals left a lot to be desired. But I also knew that the stock must be worth more than just 57p,” says Mr Felton. “We bought in at the start of October and, by the month’s end, we were starting to feel that we had already had a good ride. We sold a part of our holding then and banked close to a 70 per cent gain on the stock. Having secured a result, we held the remainder of the stock for another fortnight and sold the rest at 108p, banking a 90 per cent profit.” Relative values This approach undoubtedly has a higher risk than mainstream ones but the point to remember is that it is only high risk relative to market risk. “Do not mistake market risk for low risk. Any investors in a FTSE tracker over the last couple of years will have learned this lesson the hard way,” says Mr Felton. “Focus funds are high risk only in relative terms. When you consider that the All-Share has volatility of around 16.5 per cent a year and that a fund like UK Prime has volatility of only around 17.5 per cent a year, you start to get a clearer picture.” Most mature investors will look at the focus fund story as an opportunity to establish an aggressive satellite to their existing portfolio. The attractiveness of the high-yield bond market at this stage of the economic cycle could also make it the ideal accompaniment to such a holding, especially because it is likely to be less of a bumpy ride than even a low cost index tracking fund. But Mr Lynch says: “The real point for advisers to pick up on is that it is time for serious investment clients to manage their portfolios in the same way as institutions now do. For true ‘instividuals’, investment will no longer be about how much money they have spent; it will be about how much risk they have spent.” William Russell is retail fund director at R&SA Investments

Features of focus funds

• Undiluted exposure to the expertise of top fund managers
• An aggressively managed concentrated portfolio, typically around 30 stocks
• Stocks held on their own merit, not because of their size in the index
• Rigorous stock selection by an experienced research team
• A pragmatic investment style, which provides the flexibility to trade rapidly in a fast changing environment
• The ability to take advantage of market volatility to enhance returns
• Sophisticated risk management analysis for identifying the optimal risk/reward mix
• A high risk/return fund for sophisticated investors
• An adventurous satellite to add to lower risk core portfolios