Active managers should be happy that volatility has returned to equity markets as this should lead to the conditions in which stockpickers can outperform, Old Mutual Global Investors’ Richard Buxton believes. 
Following a 2017 that was notable for volatility dropping to historic lows, markets have endured a turbulent few months in 2018 after concerns over the pace of interest rate rises and fears of a global trade war weighed on investor sentiment.
The below chart shows how the Vix index – which measures the implied volatility of the US stock market – was subdued for much of 2017 before spiking over the past few months.
Buxton, manager of the £2.2bn Old Mutual UK Alpha fund and chief executive of Old Mutual Global Investors, noted that this has been the “first proper equity correction” for some time but argued that investors should ultimately embrace it.
Performance of index over 12 months
Source: FE Analytics
“Having been cocooned in an unnatural environment of ever rising markets and low volatility, a period in which the US S&P 500 index, last year, registered not a single ‘down’ month, investors have tasted a morsel of the new normal,” he said.
“Something akin to the good old days of investing before markets were distorted by the continuous drip, drip, drip of easy money and no one was overly familiar with the, ‘it’s going up because it’s going up’ mentality.”
The manager added that many investors went into 2018 expecting markets to enter a melt-up – or a sharp rise as others rush into stocks to capture a rising trend – but this failed to materialise. He added that these investors are probably now hoping that the recent correction is just a one-off and calm conditions will promptly resume, but suggested this is a misguided viewpoint.
“A degree of fear, inevitably translating into price fluctuations, is healthy, giving active investors the opportunity to pick up bargains, while affording us the chance to trim top heavy positions whenever the occasion arises,” he said.
While expecting more volatility, Buxton is keen to point out that underlying fundamentals remain supportive for equities and there is little evidence that the economy is at risk of falling into recession any time soon.
However, he does see some important changes on the horizon that investors will need to deal with. These include the likelihood that inflation will pick up meaningfully and the US Federal Reserve unwinding its balance sheet.
The manager thinks that the yield on US 10-year Treasuries will rise past the “all-important” 3 per cent mark this year, although he does not believe this will rattle the equity market.
US 10-year Treasury yield
Source: Bloomberg
“Personally, I think the market can absorb the rise but the key word in all of this must surely be gradual. Bond yields should rise; gradually. Monetary stimulus should be reduced; gradually. Interest rates should rise; gradually,” he said.
“Against a background of gently rising interest rates, a change in stock market leadership should become apparent.”
Buxton has a bearish outlook for so-called bond proxies, or companies with above-average yields and solid, dependable earnings. While these stocks thrived under the ultra-loose monetary policy conditions of the recent past, they are not expected to fare as well when central banks are tightening.
“By contrast, UK banks, such as Barclays and Lloyds, should be the clear beneficiaries of a tightening interest rate cycle. Leaner, better capitalised, and the recipients of severely improved cashflow, these companies must surely be rewarding shareholders with higher dividend pay-outs sooner rather than later,” he continued.
Some 25.5 per cent of Old Mutual UK Alpha’s portfolio is in financials, with the likes of HSBC, Lloyds Banking Group and Barclays being top 10 holdings.
Aside from financials, Buxton said oil majors BP and Royal Dutch Shell – both of which are top 10 holdings in his fund – should be able to maintain their dividends even if the oil price drops to $50 per barrel. Mining groups Glencore and Rio Tinto (also top 10 positions) are in the “investment sweet spot” thanks to recovering commodity prices and improved cashflow.
This means the manager remains bullish for 2018 despite its challenging start. “The ability to make money this year may not be as easy as hitherto,” he said. “But the opportunities for the active manager appear, at long last, to be opening up. So, three cheers for the return of volatility and three cheers for a return to more ordinary conditions. I, for one, welcome the onset of the new normal.”
Performance of fund vs sector and index under Buxton
Source: FE Analytics
Buxton has managed the Old Mutual UK Alpha fund since December 2009, over which it has generated a 118.20 per cent total return and beaten both its average peer in the IA UK All Companies sector and its FTSE All Share benchmark.
Square Mile Investment Consulting & Research, which gives the fund an ‘AA’ rating, said Buxton is one of the most highly regarded fund managers when it comes to investing in UK large-caps. The research house also said his approach is “far sighted”, adding that “it can take some time for his ideas to be rewarded”.
“It should be noted that the approach can lead to greater volatility than other UK equity strategies and the fund's performance may accentuate any sharp market moves, both on the up side and the down side,” Square Mile’s analysts said.
“During more volatile periods, investors should take comfort from the manager’s extensive experience and indeed, his long-term track record which has successfully delivered returns in excess of the index across a number of market cycles.”
Old Mutual UK Alpha has an ongoing charges figure (OCF) of 0.85 per cent and is yielding 3.02 per cent.