An aversion to volatility is an “intellectual virus that has hijacked the global investment community”, according to M&G Investment Management’s Eric Lonergan (pictured), who says it is pushing swathes of investors into assets that are guaranteed to lose them money
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Lonergan, who manages the M&G Episode Growth fund, said that one of the biggest challenges faced by top-down investors is reducing an intrinsically complex system into some sort of insight that will allow them to outperform.
However, he said that rather than trying to make forecasts, it can be more productive to look at the widespread denial of established facts.
“You can have an edge in macro, not by forecasting but by recognising how other people are anchored and biased to beliefs that are clearly invalid,” he explained.
According to Lonergan, the most blatant example of this trend is the huge risk premium being paid to investors willing to hold equities over “safe” assets such as government bonds and cash.
The manager said that while economic forecasts and five-year views should be automatically ignored, valuations have “an awful lot of power” – and that towards the end of last year, numerous equity markets were trading on multiples associated with events such as the eurozone crisis, the Asian crisis of the late 1990s or the financial crisis.
Performance of indices (price only, local currencies) over 20yrs
Source: FE Analytics
“They were at those levels at the end of December and many of those have rebounded, but they are still on levels where you are getting paid much higher returns than history,” he explained.
“So, I can buy a basket of global equities that is priced to deliver me a 7 to 10 per cent real return.”
While this would be a relatively high return in any market, Lonergan said that compared with the return currently expected from cash and bonds, it is “extraordinary”.
“It is a very curious thing,” the M&G Episode Growth manager continued. “If I were to launch a fund and said, ‘don’t worry, it will have zero volatility, nominal volatility so it is a no-risk fund, but I am going to guarantee that you lose 2 per cent in real terms per annum’, it is kind of like death by a thousand cuts.
“The irony is that is still the best-selling fund in the world. Because that is cash. And European cash is priced even more aggressively than that.
“It is fascinating to me the premium people are willing to pay for a low level of volatility.”
This echoes the view of AJ Bell chief investment officer Kevin Doran, who towards the end of last year begged financial advisers not to put cautious clients into government bonds, warning they would “absolutely” lose money after inflation.
Lonergan said that whenever you are faced with a valuation opportunity such as the one he believes has presented itself in equities, it is vital to ask yourself whether it is justified based on fundamentals or whether it is due to behavioural bias.
This begs the question, is this a world in which it is dangerous to own capital?
There has been much fretting about the rise of populism over the past couple of years and its potential to destabilise developed economies. However, Lonergan said that as with any type of bias, you can make politics “impossibly complicated” by trying to predict what is going to happen with issues such as Brexit, the US election result or protectionism, or you can reduce it to a relatively simple observation, which is what the asset markets care about: interest rates, inflation and profits.
“What is very interesting to me about populism for want of a better term is that actually there is no coherent economic policy associated with it,” he added.
“If anything, the pendulum globally has continued to move in favour of capital and that may change, but I would have to say that I haven’t observed that populism has manifested itself in a coherent way [economically]: it’s largely been about attitudes towards migrants, which distasteful though that inherently is, doesn’t actually bear on the price of bonds, equities or exchange rates.”
One of the biggest concerns for equity investors is that the US is now in the final stages of the market cycle, however Lonergan pointed out that many economic models have proved to be flawed.
Source: M&G
The manager added that in a globally integrated world and with China beginning to ease monetary policy and Europe capable of going either way, it could be argued that we are at the beginning of a new cycle rather than the end of an old one.
“It is statistically very difficult to measure US output and there are lots and lots of problems around it,” he continued.
“But corporate profitability has been ballistically strong in the US since the crisis and that wasn’t people’s prior [conception]. People’s prior [conception] was that profits had been inflated by the financial sector and a load of unsustainable activities. So, actually, people have been hugely surprised by the profitability outcome.”
Regardless, the manager said that “the one thing and one thing only” that the Federal Reserve is terrified of is a recession, which helps to explain the high risk premium on equities. However, the final stage of the economic cycle tends to be characterised by a period of exuberance and so the manager said that if everyone is fretting about a recession, the likelihood is low.
Lonergan said this leads him to an obvious investment conclusion.
“That is you should own equities. Then you have a difficult question as to which equities. But it is pretty clear that as you extend your time horizon, equities are priced to annihilate cash and bonds,” he finished.
Data from FE Analytics shows M&G Episode Growth has made 60.19 per cent since Lonergan joined in January 2011, compared with 58.84 per cent from its IA Mixed Investment 40-85% Shares sector and 84.42 per cent from its benchmark, split 67/33 between the MSCI AC World and Bloomberg Barclays Global Aggregate Bond indices.
Performance of fund vs sector and benchmark under manager tenure
Source: FE Analytics
The £860m fund has ongoing charges of 0.96 per cent.