Bell Asset Management chief investment officer Ned Bell wouldn’t dream of exposing his clients to the kind of bets on perpetually low volatility that blew up so spectacularly this week, causing sharp falls in global shares.
Even the more conventional momentum bets embodied in many of the world’s biggest exchange traded funds are the very antithesis of his investing style, which is all about quality at the right price.
In his view, the explosion of sharemarket volatility and consequent blow-up of short volatility strategies shows what’s in store for other long equity momentum strategies as interest rates rise.
“I think this is just the first blip on the radar,” he told The Australian in an exclusive interview yesterday. “The January melt-up was kind of the last gasp and we now face a baton change away from the thematic darlings like Netflix, Amazon and Facebook. We have a huge boom in passive and thematic investing but the market is now staring down faster interest rate hikes and that’s huge.
“It’s symptomatic of the fact that we have had an eight-year bull market — driven by QE — so investors have become complacent and not as risk-aware as they should be. The good news is that the economic environment is the best it’s ever been, so if you have good-quality exposure to that improving economic environment you can do very well.”
After an unprecedented 404-day rise without a 5 per cent fall and an exponential rise to record highs last month, the US sharemarket has suffered its biggest falls in years, causing knock-on effects in Australia, after stronger-than-expected US economic data including faster average hourly earnings pushed US bond yields up to four-year highs, triggering an unprecedented spike in volatility.
“The US tax cuts fuel an already strong economic picture at exactly the wrong time,” Mr Bell said.
“That means inflation will hit the US sooner than expected and you will see faster US interest rate hikes. US equity fundamentals are strong right now, but US corporates have borrowed to buy back their shares but that makes less sense in a rising interest rate environment.”
On the positive side of the equation, corporate sales growth globally is the best it has been for years.
“The main issue for me is the imbalance caused by this passive boom, where the ownership risk is still very heavily weighted toward passive investment,” Mr Bell said.
“In a rising volatility environment caused by higher interest rates, that’s where you’re going to get more volatility.
“The proportion of US mega-cap companies owned by ETFs, passive funds and growth managers collectively has risen quite dramatically in recent years. So increasingly the shareholders of those types of companies are now momentum investors rather than fundamental investors.
“The fundamentals in isolation won’t necessarily hold up those mega-cap momentum bets because you’ve got a fairly flighty shareholder base. So while the fundamentals might actually be OK, they could be challenged by a rise in volatility — which is happening now — the VIX has just gone berserk.
“We haven’t seen many dead bodies float to the surface yet but we might in the next week.”
On Tuesday, Credit Suisse said it “experienced no trading losses” from Velocity Shares Daily Inverse VIX Short Term ETNs (XIV), which it will liquidate after an “acceleration event” was triggered when the intraday indicative value of XIV fell to less than 20 per cent of the prior day’s indicative value.
Overall sharemarket valuations look “OK”, with the forward PE ratio of the S&P 500 having fallen from 18.5 to 17.5 times during the correction in the past week, Mr Bell said.
“But it’s still a bit of a mystery how a lot of the leveraged funds, the hedge funds and quant funds have behaved in the last couple of days — the volatility could stay with us for a bit longer.”
It’s a scenario that Bell Asset Management prepared for last year.
“We were aggressively profit taking in the three months to January,” Mr Bell said.
“We are now seeing some terrific companies that have been sold off pretty heavily.”
In recent days the fund bought Proctor and Gamble and Compass shares after they hit multi-year lows.
“All these companies that we really like but have been too expensive are now getting down into our buy levels,” Mr Bell said.
“We are finding more of those opportunities in Europe, because the valuations relative to the US — even before the volatility of the last few days — have been a lot better.
“Germany has been hit pretty hard, but the economic picture there is terrific and there are some very well managed companies — like Siemens — that are very inexpensive on a US peer relative sense and have some great exposure to China.”
In Japan, Bell has scooped up Hoya, the second-biggest maker of optical lenses globally.
While there are lots of companies on his radar, Mr Bell remains cautious about valuations overall “because I think volatility is really starting to shake the tree and buying opportunities will come”.
“We consider ourselves to be contrarian investors working in a quality universe,” he added.
“What that means is that we identify the really high-quality companies and try to buy them opportunistically, but then also sell them when they are doing really well.
“But 45 per cent of our exposure is to global small mid-cap stocks which don’t have the ownership risk that comes with passive investing in ETFs that are heavily biased to the mega-cap stocks.”