Underperforming funds making a comeback - what are the best investments now?

Rising interest rates and high inflation weighed on stock markets for much of last year but investors may finally be benefiting from signs of a recovery.

As inflation slows and attention turns to the prospect of interest rate cuts, stock markets have experienced an upswing in the past two months, research suggests.

For example, the FTSE All Share Index is up 5.5% since the start of November, while the S&P 500 is up 12.2%.

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It comes as the cost of borrowing has remained frozen in the UK and US, raising questions of when interest rates will fall.

Analysis from interactive investor suggests this is benefiting funds that were sensitive to interest rate rises and high borrowing costs, meaning many previous underperformers are now mounting significant comebacks.

Some strategies have risen as much as 60% in just over two months, while more than 70 funds, exchange-traded funds (ETFs), and trusts are up more than 20%, the platform says.

"Real assets such as physical property and renewable energy infrastructure, cryptocurrency, technology, biotech, and smaller company funds and investment trusts, have all led the performance tables since 1 November 2023, when the market rally began,” says Sam Benstead, deputy collectives editor at interactive investor.

The investments making a comeback

The Bank of England (Boe) hiked interest rates from 3.5% to the current level of 5.25% during 2023.

The bulk of the increases came in the first eight months of the year as the BoE sought to tackle soaring inflation.

This was bad for funds and investment trusts backing companies that rely on debt for growth such as property and infrastructure, as the cost of borrowing was pushed higher.

However, many funds and investment trusts worst hit by interest rates are now experiencing a resurgence as inflation has dropped and interest rates appear to have peaked.

It comes as investment trusts are trading at record discounts, making them a viable option if investors are confident about other fundamentals in the portfolio.

For example, the share price return of the private equity-focused Schiehallion Fund investment trust from Baillie Gifford is down 24.8% on a one-year basis but has risen 59.5% over the past two months.

Logistics and warehouse backer Tritax EuroBox’s share price return was up 6.3% for 2023, but has risen 32.5% since the start of November.

Henderson Smaller Companies share price was up just 1.2% over 2023 but the return is 25% more recently.

Investors in the Pictet Biotech fund had a volatile year but it was up 15.27% annually and has risen 27% since the start of November.

"Lower interest rates bring good news for two types of stock market assets,” adds Benstead.

“First, those in competition with the bond market for income, as bond yields fall when rates drop, making bonds less attractive to income investors. Second, investments classified as 'long duration,' indicating profits are expected in the distant future, particularly high-growth technology stocks.

"This sheds light on the recent exceptional performance of a variety of funds and investment trusts over the past two months."