What’s the outlook for absolute return and UK equity funds in 2017?
Cautious investors fled UK equity funds and piled into absolute return last year, but those that did missed out on double-digit returns in the index, particularly as sterling weakness boosted large caps.
Investment Association figures released earlier this year showed equity funds lost £8.2bn over 2016, a trend that picked up immediately following Brexit, compared to sales of £7.8bn a year earlier.
In contrast, the FTSE All Share delivered 16.8 per cent in 2016, partially boosted by sterling weakness following the UK’s vote to leave the European Union, compared to 1 per cent in 2015 and 1.2 per cent in 2014.
On the other hand, Targeted Absolute Return was the best-selling sector with inflows totalling £5.1bn as investors took a cautious approach to allocation amid political and market uncertainty. The sector returned just 1.1 per cent over the period, significantly underperforming the FTSE.
“The main trend was a consistent pattern of shunning UK equities and a preference for absolute return funds. This undoubtedly reflects the diet of doom and gloom investors endured,” says Tilney Group managing director Jason Hollands.
But those bearish bets backfired as the FTSE delivered returns that “don’t come along often”, Hollands says.
Furthermore, money market fund assets grew 40 per cent over 2016 as investors allocated to cash, IA data shows.
“In 2016 we saw substantial evidence that uncertainty was causing investors to sit on cash,” says Chelsea Financial Services managing director Darius McDermott. “However, stock markets rose over the course of the year and those who did sit on the sidelines missed out.”
Fergus McCarthy, head of UK intermediary distribution at BNY Mellon, says clients remain nervous that markets have risen “too high, too quickly” and the investment industry could face another difficult year if spooked investors sit on the sidelines.
Last year was one of the worst in decades for asset managers, McCarthy says. January volumes at the multi-boutique asset manager were down on where they should be, he adds.
People that choose to enter the market are likely to favour absolute return or multi asset products, McCarthy suggests.
Ryan Hughes, head of fund selection at AJ Bell, agrees that despite a poor run of performance absolute returns could benefit from persistent uncertainty.
“Absolute return has had a poor run of performance recently but could continue to benefit from flows if people are concerned about any volatility that may result from the uncertainty that the triggering of Article 50 will likely bring,” Hughes says.
Some investors may see no alternative, says Darius McDermott. “Investors are tired of cash returning nothing, perhaps don’t want to add to much more to equities when markets are very high, and bond funds look less attractive in a rising rate environment.”
Laith Khalaf defends the role of absolute returns funds, pointing out that there have been several years of late when cautious funds have provided superior returns.
“Conservative funds can provide some useful ballast in a portfolio that is otherwise orientated towards the equity markets,” Laith Khalaf says, adding this is particularly so at times of low government bond yields.
“Whether you invest in equities, absolute return, or both ultimately comes down to your investment horizon, attitude to risk, and the make-up of your portfolio.”
The political, monetary, fiscal and macro uncertainties that are prompting investors to take a more cautious approach are unlikely to cease anytime soon, says James Ashley, head of international market strategy, strategic advisory solutions at Goldman Sachs Asset Management.
Analysis conducted by the asset manager and Bloomberg shows that the number of times ‘uncertainty’ appears in articles has reached an all time high.
But uncertainty should be seen as a finely balanced backdrop of opportunities and risks, rather than something to be feared outright, Ashley says.
Uncertainty mentioned in news articles reaches record levels
“For investors seeking downside protection in this environment, cash may be king; but to make that switch onto the side-lines is to perceive the potential risk perhaps without perceiving the potential upside created by such conditions,” Ashley says.
Possible stumbling blocks in 2017
Currency could trip investors up this year following inflows into international funds, particularly the US, warns Jason Hollands.
Inflows into the IA North America sector were £244m in the month Trump took the White House in comparison to average net outflows for the previous 12 months of £57m.
Hollands questions if this was a wise move for UK investors who deployed pounds at a point of major weakness against the US dollar to buy into already highly priced US shares.
“Notably sterling has just experienced its strongest month against the dollar in recent years as allies of Trump step up the rhetoric on trade tariffs,” Hollands says.
He says investors may overlook the risk the UK overheats because of excessively loose monetary policy. “A tightening of UK monetary policy would shore up sterling,” Hollands says. “So maybe ignoring UK equities and pouring cash into overseas funds won’t prove such a shrewd move.”
But McDermott says UK All Companies and UK Equity Income funds are the best selling for Isa investors this year and the launch of Neil Woodford’s Higher Income fund is only set to continue this trend.
The Woodford Equity Income and JOHCM UK Equity Income funds were among the most bought on Charles Stanley Direct, although the former was also listed among the most sold.
At FundsNetwork the Lindsell Train UK Equity fund was among the most bought by Isa investors, but the top five was topped by Fundsmith Equity and followed by real asset funds.
If the Trump trade pans out that could benefit UK equities, AJ Bell’s Hughes says.
“According to consensus forecasts, half of aggregate FTSE 100 profits and three-quarters of aggregate profits growth are due to come from just four sectors – banks, insurers, oils and miners. All are potential beneficiaries of the Trump trade,” Hughes says.
Cyclical earnings growth could support performance and therefore flows into UK equity funds, Hughes says, but he warns that Brexit and global politics “could throw us a curve ball at any stage”.