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Riding out the storm

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21 December 2018

After a tough 2018, David Prosser looks at how investors can position themselves for 2019 and the part investment companies could play in managing volatility.

Looking back at 2018, it’s fair to say it hasn’t been the most comfortable of years for investors. After a stellar 12 months for global markets in 2017, this was the year in which volatility made its return. The ups and downs in markets during December offered a microcosm of the year as a whole: it has often felt like a case of one step forward, two steps back.

So how should advisers and investors position their investment company portfolios for 2019? Well, there are essentially two competing schools of thought. The more optimistic pundits argue that in most markets and asset classes, bad news is now in the price; so whether you’re worried about Brexit, international trade wars or a global economy, all but the worst case outturn in 2019 could provide a boost. Less happily, there is no shortage of analysts anticipating more volatility in the year ahead – and potentially a transition from correction to bear market territory.

If you’re in the first of these two camps, there are some obvious places to go looking for investment company opportunities. The UK Equity Income sector, for example, has seen valuations slip over the past 12 months, but domestically-focused funds – including mid-cap and small-cap investment companies – stand to benefit from Brexit certainty when it finally arrives. Private equity funds have also been sold this year, with shares across the sector trading on unusually wide discounts to the underlying assets; here too, the sell-offs may prove to have been overdone.

For those with a more global outlook, emerging markets funds might offer opportunities. Emerging markets generally have suffered during 2018 courtesy of a stronger dollar, which increases the cost of many countries’ debt. But if the US economy slows next year, as many economists expect, that pressure could ease; and if a global recession is avoided, the fundamentals of emerging markets remain strong.

In the second camp, for investors and advisers who feel defensive, there are plenty of opportunities to use investment companies to take shelter. One possibility is the Flexible Investment sector, where managers have an unusual degree of latitude to allocate money to a broad variety of asset classes; in more difficult periods, they are able to reduce exposure to equities in favour of assets that tend to generate less volatility.

Alternatively, the investment companies universe includes a diverse range of funds through which it is possible to get exposure to alternative asset classes offering diversification benefits. These include funds investing in private equity, infrastructure, real estate and credit, all of which tend to have a low correlation with equities and therefore offer shelter from the storm.

One final thought. In difficult markets, the investment company model has much to offer. For one thing, volatility tends to favour active managers; the recent trend towards passive management may come to a halt as investors lose patience with vehicles that blindly follow the market down. Also, investors are prone to over-reacting in adverse conditions, selling out of markets en masse. This can be difficult for open-ended fund managers to deal with; they may even have to sell assets to fund redemptions, crystallising what were otherwise paper losses. Closed-ended investment companies do not have this problem.

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