Passive funds are no place to hide from a bear market

A friend sends me a photo of a package of pak choi with a big Gucci label next to a nice Louis Vuitton box with some pretty cakes inside.

Later, he sends another one of some apples and bread spilling out of a Chanel bag. She tells me the footage comes from a contact in Shanghai, where luxury goods companies have apparently been helping their lockdown VVIP customers by sending them the kind of food that’s hard to find elsewhere. (Hermes is apparently good for meat.)

The bags that the food comes in have a secondary use: they can be used to show off the lockdown a bit. Social media is abuzz with news that some Shanghai residents have been signaling their access (and previous shopping habits) by using Prada and Chanel bags to take out their Covid tests for doorstep pickup.

I tell you this partly because it’s yet another example of the infinite adaptability of the corporate sector, but mainly because it’s a reminder of how much our world has changed. In two short years, Gucci in Shanghai has gone from letting people show off through expensive bags to letting them show off through vegetables. Something for you to add to your list of things you couldn’t have imagined in 2019.

For anyone in the financial markets, that list is getting longer. Inflation is high and continues to rise; even the Bank of England now accepts that more than 10 per cent is not only possible but probable. Interest rates are on the rise everywhere: with this week’s increase, they are now 1 percent in the UK.

The war in Ukraine shows little sign of ending, and of course China’s covid-zero obsession is screwing up the global supply chain, among other things.

At the same time, it would be crazy not to care about corporate profits: not all cost inflation can be passed on to consumers. Add all that to an overvalued global stock market and perhaps we shouldn’t be surprised that the S&P 500 is down 13 percent this year, the Nasdaq is down 22 percent and the MSCI World Index is down 14 percent. The Goldman Sachs index of unprofitable US technology stocks fell 10 percent on Thursday alone. Disgusting.

That said, not everything is going down the same way. Look at AJ Bell’s list of top performing funds in the first quarter of the year and eight out of 10 are in gold or energy. Look at the list of mutual funds and you’ll see something similar: BlackRock World Mining Trust (which I own) is up 30 percent in the quarter.

The worst-performing funds on the list are US funds, growth-oriented funds and smaller company funds: long-term retail investors’ favorite Scottish mortgage (which I still hold to the long term) has lost 40 % of its value in the last six months alone.

The message here seems clear: the market has changed. Rising inflation and interest rates coupled with tight supply in the commodity sector have begun to mean that the big winners of the last decade (tech and growth) have become obvious losers, while losers are becoming winners.

So here’s the weird thing. Investors appear to be looking at this combination of carnage and return to favor and focusing on the wrong part: Interactive Investor data shows that eight of the 10 most-bought funds on its platform in April were passive (mostly Vanguard).

A year ago that number was four. Interactive suggests this reflects “increased caution” on the part of investors. But here’s my concern: This might be some kind of reckless precaution.

We could argue about the pros and cons of passive investing practically forever. But one thing most people will agree on is that passive investing is really momentum investing. That’s nice on the way up. Not so nice on the way down.

Passive is not the place to hide from bear markets like this. Nor do I suspect that the technology sector is still expensive; however, the most frequently purchased investment trust on the platform is Scottish Mortgage.

At the same time, April saw the largest outflows on record from UK-focused equity funds (£836m), global fund network Calastone calculates. That’s despite the fact that, due to its mining and oil exposures, the FTSE 100 is one of the few major market indices that hasn’t fallen in the last six months.

Add up the past seven years, Calastone says, and “no new capital has flowed into UK-focused funds.” There is a similar sentiment in the responses to the latest UBS Investor Sentiment Survey. Investors said they were concerned, but also “are not adjusting their portfolios yet.” This feels a little crazy. If it’s obvious, which I think it is and I suspect Chinese luxury goods traders would agree, that the financial world of 2022 is very different from 2021, why the hell wouldn’t we change our portfolios?

You will say that in a market like this nothing is certain, that there is nowhere to go. That is only partially true. Sure, in a bear market nothing is totally certain, but history tells us that where there is value, there is some safety. And the value is emerging, though mostly in the places where you’re not investing. Japan is cheap (valuations are well below the 15-year medians); most emerging markets look good, with an average forward p/e of 12x); and the UK looks pretty good: the forward p/e here is 11 times, 13 percent below the 15-year median).

Duncan Lamont, head of Schroders’ strategic research unit, also points out that while the US is still expensive by most measures, it is significantly cheaper than it was (think pre-pandemic levels). ) and that there are huge sectoral variations: energy and materials. they are still cheap eg.

Look at all this and you will see that the best thing you can do is not run towards the winners of the pre-Covid world but towards those of the new one. There are huge secular changes underway. Allowing yourself to believe that things will return to “normal” anytime soon will not help.

That means a new focus on value, since it turns out that valuations do matter. And perhaps a new look at fund managers who understand this. Look at the value funds Oldfield Partners offers: Its global stock fund is down just 3.4 percent year to date. Look at the strategic value of Kennox (which I have). It is loaded with oil and gold, and has risen 10 percent in the last three months. And look at Barry Norris’s Argonaut Absolute Return fund, which is up 17 percent this year, again thanks to strong exposure to energy, materials and industrials. Finally, given the speed of change around us, you may be looking for companies that go out of their way to be creative, like Shanghai’s luxury goods purveyors.

Merryn Somerset Webb is the editor-in-chief of MoneyWeek. The opinions expressed are personal.

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