Investors are often told that diversification is the key to long-term success and that they should blend asset classes, sectors and regions to make sure their savings are protected from varying risks.
However Conway – who co-manages the PFS Hawksmoor Distribution and PFS Hawskmoor Vanbrugh funds – says cautious investors have never faced a more difficult market backdrop as six years of ultra-low interest rates and copious amounts of money printing via quantitative easing has left all areas of the market expensive and correlated.
“You cannot lose sight of fact that the current environment is unprecedented. These are ridiculous times, absolutely ridiculous,” Conway said.
“This is what happens when the yield curve is so flat and a high proportion of government bonds have negative yields. You have to take a step back and you shouldn’t listen to people who claim they know how markets will perform because no-one knows how it is going to pan-out.”
He added: “It’s never, ever been harder to build a diversified and cautious portfolio.”
One of the manager’s major concerns is that the large majority of private and professional investors have never seen a bear market in fixed income.
Data from FE Analytics shows, for example, that the average fund in the IA UK Gilts and IA Sterling Corporate Bond sectors have returned 334.71 per cent and 364.80 per cent respectively since data began in December 1989.
More pressing, however, is that the average fund in the gilt and corporate bond sectors has had a maximum drawdown, which measures the most an investor could have possibly lost if they had bought and sold at the worst times, of 13.95 per cent and 17.82 per cent over that 25 year-plus period.
Performance of sectors since Dec 1989
Source: FE Analytics
On top of this, given that the likes of the US Federal Reserve and Bank of England have followed extraordinary monetary policies to revive their economies after the financial crisis, Conway says it is concerning that most young analysts and fund managers are now only used to very low interest rates.
However, with 10-year gilts yielding just 1.5 per cent, one-fifth of developed government bond markets having negative yields and nine countries’ two-year bonds on negative yields, he says there isn’t anywhere for yields to go but up.
Another major worry, according to Conway, is that as central banks have forced up valuations in fixed income markets, equity markets have been artificially inflated thanks to the huge amounts of liquidity sloshing around in the system.
According to FE Analytics, the FTSE All Share and the MSCI World indices are up more than 150 per cent since markets bottomed after the financial crisis while the S&P 500 has returned more than 200 per cent over that time.
Conway also says that while he and his team were bullish on Europe and Japan at the start of the year, now that both the ECB and Bank of Japan have initiated full-blown QE, much of the value has already disappeared.
“Areas we did like were Europe and Japan but, that being said, they have already had a great run this year.”
Performance of indices in 2015
Source: FE Analytics
The manager is also wary of emerging markets as, while they may look cheap on a relative valuation basis, he is avoiding them as he thinks those regions will inevitably suffer as the US dollar strengthens and the US Federal Reserve starts to raise rates.
All told, he says the current market is a very difficult one to call – especially as the US Federal Reserve has stated its intention to soon start tightening monetary policy by raising interest rates.
“We don’t want to come across as overly bearish, but we are generally cautious on markets and so we are not chasing returns,” he said.
“We are avoiding beta and focusing on alpha and one way we are doing that is by using absolute return funds, but the problem is there isn’t huge amount of good ones out there.”
As we have mentioned in recent FE Trustnet articles, Conway and his co-managers Daniel Lockyer and Richard Scott have been removing higher beta funds like Artemis Global Income from their portfolios and have been buying absolute return funds such as Henderson UK Absolute Return and BH Macro, along with more esoteric offerings like RWC Global Convertibles and Artemis Strategic Assets.
Conway says he is also happy to hold more of his funds’ assets in cash at this point in time.
“I think if we were to take more money into the funds we wouldn’t be rushing to invest. I don’t think there aren’t any accidents waiting to happen, but everything is quite expensive and nothing is cheap,” he added.
There will be a number of experts who disagree with Conway’s assessment of the current market.
The likes of FE Alpha Manager Ian Spreadbury have said, for example, that bonds can continue to perform well as inflation is set to remain low and as there is still a huge amount of debt in the system which is hindering the likelihood of an economic growth surprise.
On top of that, others have told FE Trustnet that areas of the equity market such as UK smaller companies, Europe and Asia Pacific ex Japan still look attractive for long-term investors.
Nevertheless, Equilibrium’s Mike Deverell (pictured) agrees that the current market is very difficult for cautious investors.
When asked if he thought it had ever been harder to build a diversified portfolio, he said: “Yes, that’s basically true and would be even more so if equities and bonds went up much more.”
“We’ve tackled it by diversifying more into direct commercial property, structured products and lower risk alternative funds like Invesco Perpetual Global Targeted Returns or Old Mutual Global Equity Absolute Return. Our fixed interest holding has never been lower, either.”
Deverell added: “We also hold more cash than usual which we can put to work on a market dip.”
The Invesco Perpetual Global Targeted Returns fund was launched in September 2013 by Dave Jubb, David Millar and Richard Batty, who had previously worked on Standard Life GARS.
Since its launch, it has returned 13.64 per cent, which is greater than that of the FTSE All Share but less than UK gilts. Nevertheless, the fund has been less volatile and had a lower maximum drawdown than both bonds and equities over that time.
The $3.2bn Old Mutual Global Equity Absolute Return fund, which is a long/short fund, is highly rated as it has delivered equity-like returns over the medium term with much lower levels of volatility.
Performance of fund versus index over 5yrs
Source: FE Analytics
Rob Morgan, pensions and investment analyst at Charles Stanley Direct, agrees that with the yield curve so flat and a high proportion of government bond yields in negative territory – plus valuations in equity markets also quite high – that it has never been harder to build a cautious and diversified portfolio.
However, as result, Morgan says shouldn’t be afraid to be ultra-defensive at this point in time.
“Absolutely, though there is always cash and absolute return funds, areas which may become more popular if valuations keep rising,” Morgan said.