Global equity markets have become increasingly susceptible to a correction due to high valuations after years of central bank intervention, according to FE Alpha Manager Charles L. Heenan, who is holding 15 per cent of his Kennox Strategic Value fund in cash to protect his investors.
Investors in equities have certainly witnessed a year of two halves so far in 2015 as early gains have been diluted by significant falls over recent months.
Global equities were driven higher in the first few months of the year thanks to the ECB’s quantitative easing (QE) programme, falling expectations of a US rate rise and developments in China such as added stimulus and the highly anticipated Shanghai-Hong Kong Stock Connect.
However, fears of a US rate hike, the bursting of the China ‘A’ shares bubble and the ongoing Greek debacle have led to major falls. All told, FE data shows the MSCI AC World index is still up 3.81 per cent year-to-date but is down some 8 per cent since its peak in April.
Performance of index in 2015
Source: FE Analytics
The month of August is usually a quieter one for investors as trading volumes fall thanks to the holiday season, but many are expecting the now more than six year rally in equities to continue when market activity picks up in the next few weeks.
Heenan, who heads up his £305m Kennox fund with fellow FE Alpha Manager Geoff Legg, is less optimistic, though.
The managers have kept their cash weighting at a high level for a number of years now and, due to historically high valuations thanks to the rally and huge levels of central bank stimulus which is now being turned off, Heenan says he will continue keep money parked on the sidelines until markets fall.
“Our outlook is that markets have performed very well for a number of years now and there are plenty of question marks out there, such as Greece and China,” Heenan said.
“However, the major problem is that QE is an experiment. We haven’t seen anything like this before and no one knows how it is going to play out. As a backdrop, that does means things are a bit choppy especially as stock markets are at very high levels.”
He added: “It means we are now certainly as concerned, if not more, about the downside rather than upside.”
Historically speaking, September has tended to provide investors with a high level of volatility. According to FE Analytics, for example, the FTSE All Share has (on average) lost 2.12 per cent during the month over the past 15 years.
One source of that potential volatility, according to a number of leading industry experts, is the chances of rate rise in the US. While the exact timing is still highly debated, many still believe that the US Federal Reserve will look to hike for the first time in a decade over the coming months.
Though such an event has been very well telegraphed, even the smallest increase is likely to create at least short-term volatility.
Nevertheless, this isn’t something Heenan is overly concerned about.
“Our view on interest rates is that they have been extremely low for a long-time now that they have to rise at some stage. We are no macroeconomic forecasters but if markets can’t sustain a couple of rate rises then we really are in trouble,” Heenan said.
Heenan has a similar view to Jeremy Grantham, chief global strategist at GMO, who recently told the FT that while markets may continue to grind higher they are heading for a crash in the second half of 2016.
“We agreed with many of things he said and I can see how markets can continue to run, but they are increasingly susceptible to a correction,” Heenan said.
Certainly, Heenan and Legg aren’t alone in holding a high proportion of their portfolio in cash.
Recent Bank of America Merrill Lynch surveys have shown that fund managers have increased their weightings to cash, while FE data shows that there are eight funds in the IA Global sector which have a double-digit weighting to the money market.
Source: FE Analytics
Heenan and Legg have kept their weighting to cash for a number of years now thanks to their value approach and focus on capital preservation, and the FE Alpha Manager says they will reinvest those assets if markets were to fall.
“It is very much a stock-picking fund but we would like to see more volatility. We have, in the past, invested 10 per cent of our cash in a month if we have found stocks which differentiate the risks in our portfolio.”
“We haven’t seen anything like that recently, though, as we have only bought two new stocks over the past year.”
Heenan’s thoughts are echoed by star manager Sebastian Lyon, manager of the Troy Trojan fund and Personal Assets investment trust.
“The present equity bull market has entered its seventh year and is looking rather long-in-the-tooth,” Lyon (pictured) said. 
“Investor and corporate behaviour is suggestive of market euphoria - US corporations have in the last quarter announced record-breaking share repurchase programs. US merger & acquisition activity hit an all-time high in May, surpassing the previous highs seen during the peak of the dot.com bubble and zenith of the debt boom that led to the 2008 financial crisis.”
“Finally, investors seemingly share the confidence sweeping through US boardrooms as witnessed by the increasing amount of record borrowings used to purchase stocks on margin. History has consistently shown that previous peaks in these three activities coincide with subsequent losses.
He added: “Fans of the Game of Thrones television series will know that “winter is coming.””
As a result, Lyon says holding cash is very important in the current environment.
“Rising asset price correlations make it difficult to conventionally protect portfolios through diversification. Cash has an important role to play within the (Trojan) fund. Liquid assets amount to 26 per cent of the fund’s net asset value providing us a well-stocked arsenal to buy future under-priced securities.”
“We would welcome some market dislocation as volatility is frequently the harbinger of opportunity.”
Heenan and Legg’s more cautious unconstrained approach (which focuses on stocks that are significantly undervalued despite sound underlying business franchises and with asymmetric risk profiles: significant upside potential with limited downside risk) has led to outperformance over the long term, but has meant they have struggled more recently.
According to FE Analytics, it has been a top quartile performer in the highly competitive IA Global sector since its launch in July 2007 with returns of 71.3 per cent, beating the MSCI AC World index by more than 10 percentage points in the process.
Performance of fund versus sector and index since launch
Source: FE Analytics
It has also been top decile in the sector for its annualised volatility, risk-adjusted returns (as measured by its Sharpe ratio) and maximum drawdown over that time.
Those returns have come from its performances during falling markets, such as its top quartile numbers in 2011 when the European sovereign debt crisis intensified and its gains during the financial crash year of 2008.
However, their high-weighting to cash and dislike of US equities has hindered returns over recent years. In fact, Kennox Strategic Value has underperformed against both the sector and index in each of the last three calendar years and is down again so far in 2015.
Source: FE Analytics
Nevertheless, Heenan is convinced their strategy will pay-off over the longer-term and that they won’t change their approach to chase returns.
“It’s not been easy for us, but I wouldn’t want to put my money into expensive areas of the market now,” Heenan added.
It is also not all doom and gloom though, as Heenan points out that his cash weighting has come down over recent months as he and Legg have found interesting opportunities in the commodities and energy space.
For example, they have been putting money to work in BP and Shell (which are among their top five holdings in their 29 stock-strong fund) following the recent oil price falls due to the low valuations on offer and strength of the two businesses.
He has also been tentatively buying gold miners on the back of their disastrous few years, largely as at their current prices they offer a significant amount of downside protection.
Kennox Strategic Value has a clean ongoing charges figure of 1.14 per cent.
