All is not quiet in equity markets, and investors need to be aware of hidden risks.
In the six months until the correction of early February, many had remarked on the quietness and placidity of equity markets, but to those looking beneath the surface a more varied and uncertain picture had long been apparent. The recent sharp move downwards in equities should be seen in the context of a series of tremors beneath the surface over several months. The selloff follows a period of protracted low volatility in markets. The MSCI World had not posted a negative month, in dollar terms, since January 2016. This may have lulled some into a false sense of security; but signs of instability were there to be seen.
For example, in November and December 2017 there was a sharp sector rotation: the US market’s best performing sector of the year, information technology, gave up some of its gains, and the telecoms sector, which had performed poorly, advanced. This may have been profit taking, and the rotation reversed again in January 2018, but it illustrated how rapidly sectors could turn.
The low volatility prior to the selloff was, on the other hand, an unreliable signal. It seems likely that volatility has for some time failed to capture the uncertainty in markets in the way it normally would. The use of volatility as an asset, for instance in the sale of options to create yield (the so-called covered call strategy) may have degraded its usefulness as a reliable signal. Rather, volatility may have been driven by supply and demand drivers in the derivatives market.
Other, less studied, measures than volatility tell a different story. We already mentioned an example of sector rotation; but there has been a notable decline in the rolling correlation between all sectors. Different sectors have been diverging from each other. There has also been a decline in the correlation between different pairs of stocks. In principle, this should be good for stockpicking, and our process selects stocks according to their individual characteristics.
We do not forecast macro events, but the macro picture reflects the uncertainties we have been observing in markets. On the one hand, the US economy has been humming along nicely. President Donald Trump’s signature tax policy is positive for future corporate profit growth, and his attack on regulation could in theory lead to further expansion: these initiatives may be thought of as positive for equity markets. On the other hand, if the effect of stimulating an already-strong economy eventually leads to the US Federal Reserve increasing the speed of the monetary tightening it has already embarked upon, that could bring about a distinctly chillier environment for equities.
A MATTER OF STYLE
What matters vitally to the returns of funds over time is their style across different market environments. For example (see Figure 1), many US equity income funds are biased toward a value style, which means preferring shares whose prices are relatively low compared to the book value of their equity, or their earnings per share. Sometimes a value style is what is needed, but this is by no means always the case. In 2017, a growth style – investing in faster-growing companies like tech – strongly outperformed a value style. In fact, over the decade since the global financial crisis, growth has outperformed value.
Of course, this year could be different: investors could come to feel that cheaper stocks deserve to catch up. The last value rally was in the second half of 2016, when the reflationary trade was very beneficial
for the likes of the Russell 2000, the oil price, and financials; but there was then a significant value drawdown in the first half of 2017. The drawdown in the value style was particularly aggressive in North America. The lesson to draw is that one style does not work in all market environments. That’s why we seek to flex the style of our funds to suit market conditions.
Style bias is not the only risk to which US equity income funds are exposed. They are also biased towards or away from certain sectors. For example (see Figure 2), the top five US equity income funds by assets under management have on average only 15% in information technology (which as mentioned was the best performing US sector in 2017) compared to a 25% allocation by the MSCI USA Net Return Index.
Another risk is stock concentration (see Figure 3). The five largest US equity income funds have, on average, 29.0% of assets in their top ten stocks. Heavy weightings, or concentrations, can expose a fund to reversals in a small number of stocks, potentially increasing volatility. We believe in a more balanced stock allocation, increasing diversification.
There is a need for an alternative approach that avoids concentration and bias. Our approach is to be diversified, sector agnostic and flexible in style. When investing for income, we look beyond the more traditional dividend-generating sectors and adopt an unconstrained, total return approach. We believe our process offers genuine diversification from concentrated, sector-biased and style-biased funds.