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future imperfect

For fund selectors, it is an opportunity to reflect on the successes and disappointments of the past 12 months and to position their portfolios for the year ahead. For fund managers, it is a chance to share their views on where markets are likely to go. Indeed, some groups have already published their outlooks for 2013, on assets ranging from sovereign and convertible bonds to energy stocks and gold.

Summary

•Fund managers were rightly bullish on US large-caps throughout 2011, as the S&P 500 generated returns in all but one of the subsequent 12-month periods.

•Forecasts on all other equity regions were too optimistic, with US small-cap, European and emerging market stocks faring worse than expected.

•Managers were downbeat on government bonds, but sovereign debt was the only asset class to produce positive performances in every period analysed.

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But before deciding how much store to place in the latest batch of yuletide predictions, it is instructive to examine the accuracy of last year’s forecasts.

Expert Investor Europe is able to do this by analysing its Manager Sentiment Survey – a bespoke database of monthly fund manager opinions compiled in conjunction with Skandia, stretching back to the start of 2005. By plotting our sentiment readings from 2011 against index performance data from Morningstar, we can reveal where fund managers called the markets correctly, and where they got it wrong.

Western equities

Right on US large-caps, but too bullish on Europe

Fund managers rightly held a positive view on US large-cap equities throughout 2011, with the S&P 500 Index making gains in all but one of the subsequent 12-month periods we analysed. What is more, manager sentiment reached its most bullish level in October – precisely when the benchmark was primed to generate its biggest one-year rise, of more than 34%.

However, other predictions were far from accurate. Managers were over-positive on US small-cap and European equities during the first three quarters of 2011, for example, and unable to spot the start of a recovery in both asset classes during the fourth quarter – when the Russell 2000 and FTSE World Europe ex UK indices embarked on what became double-digit rallies over the following year.

Rupert Watson, head of asset allocation at Skandia Investment Group, both participates in the Skandia survey and uses its findings in his investment process. He says that the failure of fund managers to forecast the bounce in European equities cannot simply be attributed to heightened risk aversion following the large stock market falls in the third and fourth quarters of 2011.

He adds that the highly uncertain nature of the eurozone sovereign debt crisis also played a key role in their downbeat outlook. “It is difficult to have confidence in your 12-month view when there is so much event-risk,” he explains. “[In Q4 2011] my view, for example, was that eurozone equities might struggle until there was some kind of plan to resolve [the eurozone crisis]. But I did not have a strong view on whether that would happen after six months, nine months, 12 months, 15 months, or longer.”

Watson, who declared in a note last month that “the euro debt crisis is over”, adds that investors now face a similarly unpredictable, high-risk macroeconomic event in the form of the US fiscal cliff.

Japan

Upbeat forecasts were not matched by returns

Predictions in relation to Japanese equities were also poor. Fund managers were in aggregate bullish on the asset class in nine of the 11 months analysed, but the FTSE Japan Index fell in almost all of the subsequent one-year periods.

Interestingly, the strongest positive reading of 2011 occurred in March – the same month that a powerful tsunami struck Japan’s north-east coast. The upbeat stock market outlook may have been based on a belief that reconstruction works would boost Japanese companies. Yet the FTSE Japan benchmark tumbled by more than 12% during the following year.

Watson says the findings are arguably unsurprising, given that foreign investors have been “getting Japan wrong for over a decade”. He notes the consensus view that Japanese stocks are due for a turnaround – most likely triggered by looser monetary policy, which in turn could prompt global investors to reverse their long-held underweights in the country. However, he adds that fund managers often overestimate the ability of Japanese policymakers to do what is right for the economy.

“When I started working, my chief investment officer gave me two bits of advice – never bet against the US consumer and never bet on a Japanese recovery,” Watson recalls. “And there is some sense in that, in that the political and monetary policy response to the weak economy has disappointed repeatedly. I think that foreign investors have expected the Japanese authorities to do what they think should be done. But what should be done has been difficult politically, therefore it has not been done.”

Emerging markets

Managers called the EM recovery too early

Fund managers were similarly guilty of overoptimism on developing world stocks. Appetite for the region peaked in January, when sentiment readings for Brazil, Russia, India and China (BRIC), Asia Pacific ex Japan and emerging market equities hit levels not seen in any other asset classes during 2011.

However, the MSCI BRIC, FTSE World Asia Pacific ex Japan and MSCI Emerging Markets indices all posted double-digit falls over the following year, and disappointed in all subsequent 12-month periods until October when the three benchmarks began their long anticipated recovery.

Government bonds

Sovereign debt yields did not rise as expected

The flip-side of fund managers’ over-bullish call on equities was that they underestimated the prospects for sovereign bonds. Yields on developed world government debt were already at low levels in 2011, yet continued uncertainty over the global economy caused them to fall even further during the following 12 months. Indeed, sovereign debt was the only major asset class to deliver a positive return in every period we analysed, according to the Citi World Government Bond Index.

Despite the fact that many bonds still trade close to record low yields, Watson says it remains unclear when they will revert to more normal levels. “I think [yields] will rise on a 12-month basis but it might be not until 2014 – it is difficult to be confident about timing,” he says. “[Resolution of] the eurozone crisis and the fiscal cliff could take ten-year yields in the US up to 2.5%, perhaps 3% by the end of next year. But economic recovery would be needed to take them higher than that.”

Given that fund managers were wrong on almost every major asset class in 2011, should investors pay any attention to their outlooks for the year ahead? Watson concedes that there is “as much art as science” in making 12-month forecasts, but says it remains a worthwhile exercise.

“I do not find it enormously useful spending a huge length of time thinking about exactly where markets will be,” Watson adds. “But I think there is some value – both for fund managers themselves, and the advisers and investors who follow those fund managers – in having a good think as to whether markets are likely to go up, and if so, what the risks are to that view.”

tom@ybc.tv

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