Cautious investors can miss out on stellar equity rallies

RETAIL investors have become cautious in their asset allocations, and consequently may have missed out on gains in equities. The uncertain investment climate – driven by the Eurozone sovereign debt crisis and concerns about global growth – has pushed investors to seek the safety of fixed-income.

FLIGHT TO SAFETY
In uncertain times, investors flock to safer assets in an effort to protect their wealth. Recent data from the Investment Management Association shows that fixed-income had net retail sales of £518m in August 2012, and over the last 12 months has consistently been the best-selling type of fund.

Demand for fixed-income funds over the last year has pushed yields lower, raising concerns that the sector may be overvalued. Invesco Perpetual’s co-head of fixed interest Paul Read warns investors that bonds “are not particularly good investments [at the moment], and equities will be a better protector of your wealth over the medium term – particularly with respect to earning you a real rate of return.”

THE IRONY OF EQUITIES
Fixed-income’s popularity has come at the expense of equities. In August, equity funds had net outflows of £604m – the largest since November 2011, when the Eurozone sovereign debt crisis reared its head. Despite this, major equity indices have rallied in the last 12 months: the FTSE 100 is up nearly 20 per cent; the S&P 500 is up over 30 per cent; and the Dax is up by over 40 per cent. Of course, the investment climate was markedly different a year ago: it would have taken bravery bordering on insanity to overweight equities then.

Jason Hollands of Bestinvest says that the situation is ironic, pointing out that “given the stellar rally in equities, the UK All Companies Sector was the worst-selling sector in August, with net outflows of £401m,” even though it has been a good performer. Hollands believes that bond returns look dear and are “not at all convincing”.

When you account for fees, the returns of some funds can look more unconvincing. Christopher Traulsen of Morningstar says that it is paramount to consider fees – especially with fixed-income funds: “Costs are a key criterion when selecting a fixed-interest fund. The higher the fees, the harder it will be for a manager to outperform.”

Mark Dampier of Hargreaves Lansdown suggests a look at corporate bond funds: “Because of funding for lending [the government initiative to make loan rates cheaper], rates are coming under pressure, feeding through into fixed-income.” But with corporate bonds, you can still get above-inflation returns, while having the safety of well capitalised corporate balance sheets.

BEST OF BOTH WORLDS
Equity income funds are an option to consider. The sector is especially attractive for those who are about to retire, since it focuses on dividend-paying shares, giving the potential for capital appreciation as well as income through dividends.

These sectors have also been accused of being overvalued, largely for the same reasons as fixed-income funds. Dampier suggests that people have been accusing fixed-interest and equity income funds of being overpriced for three years now. “They may, in fact, be underpriced, because they are a predictable asset in an unpredictable world.”

THE WEIGHTING GAME
You do not need to make an absolute choice between investing in fixed-income and equity funds. Diversified portfolios should have a mix. The challenge is in deciding what weightings to allocate to bonds and equities. But it is important to understand that diversification does not remove all risks. Dampier explains that “if gilts collapsed, equities will still be affected.” He adds that if you seek safety, then be overweight cash: “It doesn’t yield anything, but will give you options when the outlook improves”. Ultimately, the weighting of your portfolio comes down to your view of whether equities have bottomed.

Portfolio weightings should be revisited periodically, but not too often. The key is to stick to a strategy. Don’t miss rocket rallies by constantly replacing your star performers with white dwarfs.