The events of the past three years have completely altered the investment backcloth against which fund managers are trying to earn above-average returns.

Fund managers can have an investment framework to operate within, but what do they do when a ‘black swan’ lands? How do they adapt their strategies and reshuffle portfolios when a once-in-a-century event happens – like a global pandemic or an outbreak of war in Europe?

To shed some light, Shares has talked to fund managers and looked at the portfolios of popular funds and investment trusts with UK investors.

Earlier this year, markets were anticipating the economy to crumble, but the emergence of advanced AI (artificial intelligence) systems has proved to be a game changer, says Saxo’s head of equity strategy, Peter Garnry. ‘Now, the bulls are back in town. Stock markets in 2023 have seen some of their best first half returns on record.’

WINDING THE CLOCK BACK

The pre-pandemic world seems like eons ago, so let us remind ourselves of what analysts and economists were saying about prospects for equity markets at the end of 2019. Scanning through 2020 outlook reports reveals an undercurrent of mild optimism despite a backcloth of increasingly worrying risks, and widespread agreement that a repeat of the double-digit returns seen in 2019 was off the table.

‘We think that returns from “risky” assets – equities, corporate bonds, real estate investment trusts and industrial commodities – will generally beat those from “safe” ones – government bonds and precious metals – again over the next two years, as the global economy finds its feet,’ wrote Capital Economics at the time, but ‘both will be weaker than in 2019.’

Citi’s economists thought global growth would settle at around 2.7% year-on-year in both 2020 and 2021 as global manufacturing activity rebounded.

Columbia Threadneedle analysts were favouring long duration assets. ‘Our base case is that there is unlikely to be an acceleration in growth and we are equally unlikely to see a deep recession. In that environment, the long-duration element of markets – be that in fixed income or equities – remains relatively attractive,’ the analysts said.

‘History suggests that years of sharp gains (as in 2019) are not usually followed by falls, but often instead by more modest growth – so 2020 should still be worth approaching in a positive spirit,’ predicted Deutsche Bank Wealth Management.

The pandemic would subsequently make a mockery of the above comments, and for fund managers to take a serious look at portfolio holdings. Ben Peters, manager of Evenlode Global Income Fund (BF1QMV6), says within weeks of full-blown Covid, three stocks had been sold from his portfolio; events business Informa (INF), fashion brand Hugo Boss (BOSS:ETR) and, perhaps surprisingly, Disney (DIS:NYSE).

‘We sold the fund’s holding in July 2020, and while it has a formidable content portfolio in family programming and had seen success with the launch of its Disney+ streaming service, we had concerns about the long-run costs of competing with other services, notably Netflix (NFLX).’

Disney shares rallied from around $120 in July 2020 to nearly $200 the following March. But the thinking behind the sale was right on a longer view, as Disney struggles to balance capital spending on film and TV production and marketing versus the fickle nature of subscribers. Disney shares are currently changing hands at $86.

TECH SUCCESS WITH A CATCH

Widespread lockdowns proved a boon for the tech space, particularly enablers of work from home and e-commerce, sending perceived winners soaring – Zoom Communications (ZM:NASDAQ) among the poster companies of the shift with its 700%-plus share price surge.

But work from home success came with its own problems for equity investors, eventually. ‘Satya Nadella of Microsoft is quoted as saying during the pandemic they saw “two years of digital transformation in two months”,’ says Blue Whale Growth Fund’s (BD6PG78) Stephen Yiu.

‘This was undoubtedly beneficial for companies in their digitisation journey, and therefore beneficial for investors. However, for many companies, this also closed the gap between where the share price looked to offer good value, to starting to look like fair value – therefore losing their ability to deliver outperformance for investors.’

Towards the end of 2021, the Blue Whale team were seeing signs of what they believed was an emerging inflection point for their fund. ‘We started cutting stocks from the portfolio that didn’t offer the upside they once had, and in some cases faced serious headwinds in the form of inflation and unsettled geopolitics,’ says Yiu.

Companies that ultimately lost their spots in the Blue Whale portfolio were Amazon (AMZN:NASDAQ), PayPal (PYPL:NASDAQ), Meta Platforms (META:NASDAQ) and Alphabet (GOOG:NASDAQ), leaving the fund with none of the FAANGs, once the darlings of every growth investor.

As the world turned and economies picked up, new threats emerged; rampant inflation becoming public enemy number one, forcing central banks into a swathe of interest rates hikes not seen in a generation. This asked different but equally testing questions of fund managers and the portfolios they held.

If interest rates create a more favourable environment for value companies rather than quality or growth companies, should not we adapt our strategy to buy the companies which stand to benefit, asked Simon Barnard rhetorically, manager of Smithson Investment Trust (SSON), part of Terry Smith’s Fundsmith investment empire.

His answer is an emphatic no. ‘Owning high quality companies with sustainable growth is a winning strategy over the long term, has been shown to work through several economic cycles, and is one which we know we can execute successfully,’ he said.

‘Whilst other managers may be able to run a value strategy, we believe it is inherently more difficult, as you cannot hold value companies for the long term if all you are doing is owning a poor-quality company at a low price, which you hope will re-rate in the future.

If this does happen (there is no guarantee), you then have to sell the company to find another such investment. This means that unlike our strategy, time is not your friend, because the longer you are holding the company and waiting for it to re-rate, the lower your annualised returns become, and if you are particularly unlucky, the worse the company becomes.

‘On the other hand, it matters less if it takes more time for the market to appreciate the value of the type of companies we hold in our strategy, because the highest quality companies tend to get better, or at the very least bigger, owing to their growth.’

It is a belief that means the Smithson portfolio has remained free of dramatic change. Companies such as Fevertree (FEVR:AIM), Halma (HLMA), VeriSign (VRSN:NASDAQ) and MSCI (MSCI:NYSE) stayed towards the top of the portfolio right through the pandemic, inflation and rate rise environment.

Barnard uses an analogy to illustrate his investment beliefs. ‘Imagine a dog walker crossing a field, their dog wildly zigzagging around them. We would relate the companies we own to the walker, clear in direction and making steady progress across the field, while the daily market price is like the dog, moving back and forth quite randomly.’

The fund manager believes that while current economic challenges may send the dog cowering for cover, given enough time, he believes the
price and value will eventually meet again, just as the dog and walker will ultimately leave the field together.

MAKING BOLD CALLS WHERE NECESSARY

While relatively low portfolio turnover is usually a good sign of commitment to a fund’s investments, managers must also not be afraid to make bold calls when the time comes. It is an area where Blue Whale sees itself standing apart from other funds.

‘We are willing to make significant changes in the portfolio in search of outperformance,’ says Stephen Yiu. Building its early high-performance reputation on tech names, it might surprise readers to learn that consistent stake-building in Canadian Natural Resources (CNQ:NYSE), the $48 billion oil sands mines operator, now makes it one of Blue Whale’s 10 biggest bets.

High quality reserves, strong management team and history of 23 consecutive years of dividend increases, gives Yiu the quality he is looking for in this previously unloved sector.

Making big calls is something Fundsmith Equity (B41YBW7) manager Terry Smith has never shied away from, and he continues to make cutthroat investment decisions in the name of shareholder returns. He recently revealed the sale of the fund’s stake in Amazon, a move that raised eyebrows.

Smith was late to the Amazon party, having only taken an opening stake in the e-commerce giant barely two years ago. At the time, he was reassured by Andy Jassy’s appointment as Jeff Bezos’ replacement as chief executive, having started and run the company’s hugely profitable Amazon Web Services cloud business.

Jassy’s stated principles – a focus on good returns on capital, concentrate on parts of the market where consumers are not already well served, and do something different to competitors – struck a chord with Smith in 2021. However, more recent Amazon comments about expanding its low margin grocery retail operation have pulled the rug out.

‘In our view, grocery retail has none of the (desired) characteristics and Amazon has already stubbed its toe in this sector with the Whole Foods acquisition,’ said Smith in his 2023 half-year letter to shareholders. Amazon looks like a miss for the fund manager, albeit a rare one, but when the reasons why one invested in the first-place change, then reassess and, if necessary, sell. This is precisely what an active manager should be doing.

This is surely where active managers should have advantages over index tackers, that they can invest in the best stocks in a market and avoid owning the humdrum. A similar thought process led Fundsmith to exit Adobe (ADBE:NASDAQ).

TO-DO LIST FOR ORDINARY INVESTORS

Even Warren Buffett has changed with the times, embracing companies in recent years that he never would have gone near before. Buffett previously shunned technology, airline and oil companies, either for being too hard to understand (technology) or not attractive enough.

Yet in 2023, Apple (AAPL:NADAQ) is the biggest holding in Buffett’s Berkshire Hathaway (BRK.B:NYSE) investment company by a country mile, while Chevron (CVX:NYSE) and Occidental (OXY:NYSE) rank sixth and seventh.

Ordinary retail investors can also adapt their own portfolios to shifting market dynamics by doing simple things. 

First, diversify across countries. Monetary policy is already starting to diverge across central banks, and this is likely to accelerate. Interest rates will move higher or lower in different countries at separate times (for example, see the US and UK), so it is wise not to only invest at home, but internationally.

Second, consider more active investing. Rather than relying solely on broad market index funds, you might want to brush up on how to pick quality companies and invest in them for yourself. With ultra-low interest rates no longer around to lift all stocks higher, you will need to find companies with strong return drivers if you want to see your portfolio expand.

Lastly, consider making room for alternatives. Higher interest rates also mean higher volatility, so look out for assets that do not necessarily rise and fall with the stock market, but that instead move to the beat of their own drum or have low beta. Alternative investments – things like real estate, commodities, infrastructure funds – can fit the bill here and could complement your allocations to stocks and bonds.

Have portfolios in popular funds changed much in the past four years?

In an attempt to answer this question, we selected 12 popular funds and investment trusts and used Morningstar data to analyse their full portfolios on three different dates.

We wanted to see where they invested just before the Covid pandemic struck, which we took as being the end of 2019. We then wanted to see the shape of portfolios at the end of 2021 as this was just before interest rates started to go up dramatically. And then we compared them to the most recent portfolio lists.

The goal was to see if the different market dynamics prompted a radical reshaping of portfolios. On the whole, they did not. It shows that managers have stuck to their investment strategy and not tried to chase whatever was in fashion  that month.

However, we did note they changed their minds on certain stocks. That is normal – portfolio positions can be sold if the investment case changes, valuations become excessive or better ideas found. Equally, new ones made, or positions added to, as fund managers spot opportunities.

For example, software group Autodesk (ADSK:NASDAQ) was Liontrust Sustainable Future Global Growth Fund’s (3003006) biggest position at the end of 2019. Now it languishes at position 26.

Rathbone Global Opportunities’ (B7FQLN1) two biggest positions were Amazon and Adobe in December 2019. Adobe no longer features in the portfolio and Amazon is the third smallest holding.

JPMorgan Global Equity Income had strong conviction in McDonald’s (MCD:NYSE) and Procter & Gamble (PG:NYSE) at the end of 2021. The former is now down the list in its portfolio and the latter has been sold completely.

Finally, to get an idea of how the average portfolio from the 10 funds in question has changed over the past four years, we used a scoring system to work out the shift in holdings between December 2019, December 2021 and the most recent data.

You can see the results in the accompanying table. Popular names in 2019 that have since fallen away include Alibaba (BABA:NYSE) and Sage (SGE), whereas the likes of L’Oreal (OR:EPA) and Novo Nordisk (NVO:NYSE) have become more popular this year.

DISCLAIMER: The author (Steven Frazer) and article editor (Daniel Coatsworth) are invested in Fundsmith Equity Fund and Smithson. Steven Frazer owns units in Blue Whale and Daniel Coatsworth owns units in Evenlode Global.

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