Dog-free portfolios look to benefit

Rate cuts in America and global money flooding into London may lead to new market highs this year, says one adviser. And selective investors could be best placed to take advantage.

In another turbulent week for the FTSE 100, early gains were dampened by fears of an American recession.

Early last week the AFI Aggressive, Balanced and Cautious indices all rose as London’s leading share index crossed back over 6000.

The FTSE climbed after a difficult start to the year in global financial markets had driven it down to a five-month low of 5,901.7. Stocks were buoyed by increasing activity in large-scale mergers and acquisitions.

Having dropped 12.17% in the first three weeks of trading in 2008, the AFI Aggressive index recovered 1.81% at the beginning of last week, tracking the FTSE rally. The Cautious and Balanced indices also followed the market gains of 0.72% and 1.24% respectively.

The upward trend was abruptly reversed on Tuesday as data released in America showed a contraction in the services sector in January. The figures reignited fears that the slowdown in the American economy is pushing the country into a recession.

Despite the continued chaos in the markets the Investor Confidence Index compiled by Hargreaves Lansdown showed a 5% rise in January. The AFI panellists, however, say this is not a sign that investors are predicting a lessening of volatility in the market for the first two quarters.

Jonathan Wallis, head of retail fund research at Allenbridge Group, says investors are unlikely to change course from their preference for cautious managed funds just yet. The herd mentality that set in during the onset of the credit crunch led to investors frantically selling stocks, but they have since recovered their composure, he says.

“We found that clients have not been panicking but we haven’t seen any reduction in risk aversion,” says Wallis. “We’re not expecting any immediate recovery in the market as we probably won’t see signs of stabilising until the second half of the year.”

The speed at which the subprime crisis and subsequent market falls in America swept into European markets shocked market commentators.

In the current climate, therefore, Brian Dennehy, managing director at Dennehy Weller, says it becomes all the more important not to be swayed by short-term events in the markets.

“The horrible start to 2008 for world stockmarkets generated wall-to-wall hysterical media reporting by the week beginning January 21,” says Dennehy. “Yet by the end of that week the FTSE 100 index was down by just 31 points.”

Dennehy Weller’s road map, issued in December, predicted that rate cuts in America and global money flooding into London could provide the base for new market highs in 2008. This, says Dennehy, is still a possibility.

“For our optimistic view to play out in the relatively short term, the index should hold above 5700, and make quick progress towards 6500,” he says.

The continuing volatility and the wholesale selling of stocks is beginning to throw up some potential value for the discerning investor.

“I think that there is value on a selective basis,” Wallis says. “Good stocks have been sold off indiscriminately but I don’t expect them to realise their potential for a month or two.”

The greater need for selectivity was demonstrated by the net reduction of 13 funds from across the AFI benchmarks during the November rebalancing. The overall number of individual funds held across the three indices was reduced from 182 to 169 as the panellists increased their weightings in core stocks and reduced their exposure to British property. This reversed May’s rebalancing, where the number of funds increased by 13.

However, as Richard Philbin, co-manager of F&C’s multi-manager funds, says, selective investment is as much about avoiding the worst-performing funds as picking the best. This was particularly relevant last week with BestInvest releasing its Spot the Dog list of underperforming funds. Those that make the list underperformed over a three-year period and averaged at least 10% under the benchmark.

The Fidelity UK Growth fund, managed by Tom Ewing, was the only Fidelity fund to appear on the list. Peter Hicks, head of IFA channel at Fidelity, says greater selectivity was a core theme of Ewing’s investment strategy to improve the fund’s performance since he took over at the beginning of December.

“Tom has cut down the number of stocks in the portfolio,” Hicks says. “The volatility in the markets has opened up valuation differentials between similar stocks and he is looking to take advantage of that.”

“In terms of the P/E [price/earnings] ratio, this is going to be the year of the E,” he adds.

Set against the list, both the Balanced and Cautious AFI portfolios were able to avoid including any of the dog funds. The Aggressive managed portfolio, however, had managed to steer clear of them until the rebalancing in November, when the M&G Japan Smaller Companies fund was added.

The fund has underperformed the Topix Small index by 28% over three years. Since the rebalancing it has dropped more than 8%.