Smaller companies, investment trusts and high yield bonds are all popular areas for managers and investors, but there are reasons to think each one could be close to the top of the cycle.Investors buying now on a medium-term view are taking a bigger risk than they realise, warns Chris Mayo, investment director at Wellian Investment Solutions.
“Private investors often invest on the back of past performance,” he said.
“Just because one area of the market has done well over the past five years, it doesn’t mean it will perform just as well over the next five.”
One area of the market that has proved very popular with investors over the last few months has been UK smaller companies.
Small caps have had a stellar run since the period after the financial crash.
Our data shows that the FTSE Small Cap index has returned more than 200 per cent over five years, nearly doubling the returns of the FTSE 100.
Performance of indices over 5yrs
Source: FE Analytics
However, while it has tended to be an area that many investors steer clear of due to its perceived riskiness, IMA UK Smaller Companies has been one of the bestselling sectors so far in 2014.
Unicorn UK Income, CF Miton UK Smaller Companies and R&M UK Smaller Companies – along with the now soft-closed Cazenove and Fidelity UK small cap funds – are the five funds with the highest number of factsheet impressions on FE Trustnet over the past month.
Chris Spear (pictured), managing director at Spear Financial, says that investors are putting their capital at risk by buying into the sector now.
“Regrettably, it is part of human nature to invest in things that have already done well,” he said.
“That is certainly the case with small caps. I read all these articles from people saying that the rally still has legs, but they have had a phenomenal run. Yes, economic conditions are improving, which has tended to benefit smaller companies, but I have a healthy level of scepticism.”
Spear added: “That’s not me saying, 'don’t buy smaller companies funds', but instead I am saying 'think about it'. What could happen to your money if you buy them now after they have performed so well?”
The last time smaller companies had a strong rally was during the boom years prior to the financial crash.
Performance of indices Mar 2002 to Mar 2007
Source: FE Analytics
Our data shows that the FTSE Small Cap index made 76.75 per cent between March 2002 and March 2007, which was again around twice the return of the FTSE 100 over that time.
However, if investors had started buying up small caps for their ISA at this point in time in 2007 then they would have had a disastrous five years.
Between March 2007 and March 2011 – which incorporates the falling markets of 2007, 2008 and 2011 – investors would have lost close to 10 per cent.
Performance of indices Mar 2007 to Mar 2012
Source: FE Analytics
While certain fund managers – such as Simon Evan-Cook and FE Alpha Manager Bill McQuaker – have started to rotate out of smaller companies, there are a number of others who say that the rally can continue.
Andy Merricks, head of investments at Skerritts Wealth Management, agrees with them.
“Yes, the easy money has been made. Are investors now too late to get in? I’m not convinced,” Merricks said.
“I don’t think they can be expecting the same level of returns over the next five years, but they can possibly expect the same sort of outperformance.”
“There is that thought that when everyone is talking about an asset class, you should probably be edging towards the exit. However, what we haven’t seen before is such a prolonged low interest rate environment.”
“If you think that is going to carry on for some time to come, then smaller companies will benefit from lower debt prices and the proportion of profits will be greater for them. Also, a lot of larger companies are sitting on a lot of cash, but we haven’t seen that M&A activity yet. If they do start spending, that is going to help small caps.”
However, Spear says that long-term investors should be using this opportunity to buy into funds that have been out of favour.
“Things like emerging markets, Far East equities, gold and other commodities have fallen very heavily. However, if you are a long-term investor you know that these are the sort of things that will come back into favour.”
“I’m not saying that time is now, but why not put your money in something that has scope to bounce back in the future instead of buying something that has done very well of late?” Spear said.
While Spear and Merricks disagree on the outlook for small caps, they both say that investors need to tread carefully if they are looking to add investment trusts to their ISAs this year.
Since the implementation of RDR last year, closed-ended funds have become increasingly popular with private investors.
However, they have also been some of the major beneficiaries of the recent rally, which has led to discounts tightening across the majority of investment trust sectors.
FE Alpha Manager James Henderson told FE Trustnet recently that he would buy his open-ended income fund over his trust – even though the two are effectively mirror portfolios – as the latter is trading on a premium to its NAV.
“They will go back to discounts one day, they always do. I love investment trusts dearly, but they are expensive,” Henderson said.
Spear says that investors need to think very carefully if they wish to use closed-ended funds over their open-ended rivals in the current environment.
“I have used trusts in my own portfolio in the past, but I don’t tend to use them for my clients,” Spear said.
“There have been many studies in the past and whether or not this is true, the way I look at it is that trusts will outperform in rising markets but then I would expect them to do worse when the market falls.”
He added: “We have had a few very good years for equities and, for me, there are too many other factors with trusts such as discount movements and leverage.”
Outside of equities, Chris Mayo says investors should be careful when it comes to deciding upon their fixed income exposure.
For example, high-yield bond funds have had a stellar run over the last five years, especially compared with other areas of the bond market.
Performance of sectors over 5yrs
Source: FE Analytics
The likes of Hermes’ Fraser Lundie have warned that the high yield rally doesn’t have much further to run as it is over-owned and very expensive and therefore he is looking further up the credit quality spectrum for opportunities.
Mayo says that investors should not be putting all of their bond allocation into a high yield fund and instead should be more diversified.
“Fixed income is a complete minefield at the moment anyway, but high yield has performed very well but tends to be highly correlated with equities,” Mayo said.
