There are clear reasons why strategic bonds funds have not participated in the 'duration party' of recent years but, asks Gill Hutchison, shouldn't investors expect them to be, well, more strategic?
Judged by relative performance alone, investors could be forgiven for feeling a little disappointed with their strategic bond funds. Over one, three and five years, the sector average performance is behind that of both the Sterling Corporate Bond and UK Gilts sectors. And while it is closer to the average return of the Sterling High Yield sector, it still lags over five years (source: Investment Week/Morningstar, to 09/09/16).
Is this purely returns-based disappointment fair? On the basis of some of the fund marketing campaigns that have been deployed over the years, it can be argued it is. In the sector's younger and more optimistic days, investors were often led to believe that funds would move pro-actively through different market conditions, so they would be tactically or strategically positioned to outperform the other fixed income sectors over time. As is always the case, markets had other ideas.
The Investment Association (IA) Sterling Strategic Bond sector has grown steadily since its launch in 2008, when the (then) IMA reorganised the fixed income fund groupings. At that time, 66 funds were shifted into the sector, while today it features around 80. This is similar in number to the IA Sterling Corporate Bond sector, although - and perhaps not surprisingly - this more traditional sector still outweighs Sterling Strategic Bond in terms of assets under management.
The wide scope permitted by the sector guidelines has engendered a multi-faceted universe of funds. At The Adviser Centre, we break down our featured funds into five categories to aid analysis - Diversified, Dynamic, Value, Structural High Yield Exposure and Income Objective. We feature 11 funds in total - a relatively large number because of the wide range of fund types found therein.
Duration, duration, duration
Funds in the sector certainly have the flexibility and the tools, so what has held them back? In most cases, the answer is duration. This has been at the centre of most fixed income managers' angst in recent months - indeed, little else has really mattered.
Applying normal investment logic to this most abnormal of economic cycles has been immensely frustrating. Fearing the bottom in yields was never too far away, the majority of fund managers in this sector have been light on interest rate exposure, even as yields have fallen relentlessly.
The huge effect of duration is most plainly seen through the IA UK Gilts sector, where long-dated mandates have returned more than 20% over the course of a year, while the short-dated mandate in the sector is barely in positive territory (source: Investment Week/Morningstar, to 09/09/16).
Clearly, the positive impact of duration is gradually diluted as we move through the different IA sectors. The Sterling Corporate Bond sector naturally captures more of the move than the Sterling High Yield sector. Given its exposure to all areas of fixed income, the Sterling Strategic Bond sector typically sits somewhere in the middle.
While this goes some way to explaining why funds in the Sterling Strategic Bond sector have not participated fully in the duration party, shouldn't investors expect strategic bond funds to be, well, more strategic, and thereby capturing more of this opportunity?
In theory, yes - but the molasses of market liquidity and the costs of transacting have stymied many managers' more excitable intentions. Furthermore, managers have become increasingly reticent to run the gauntlet of central bank policy and irrepressible market technicals. Hence, they have been less inclined to express more extreme interest rate views.
What does your preferred strategic bond fund offer?
The diversity of the sector means investors cannot rely upon the IA sector average as a fair yardstick by which to measure performance success. In fact, the question of benchmarks for funds in this sector opens another can of worms.
To help investors, fund managers need to be clear about what they are seeking to achieve, how they intend to do this and what role their fund can play in a portfolio. Different funds within the sector can:
* Offer diversified fixed income exposure: These are funds that have structural allocations to all main segments of fixed income markets - government bonds, investment grade bonds and high yield bonds - and can be a useful ‘one-stop shop' for investors looking for a single fund to represent their fixed income exposure.
* Provide flexible fixed income exposure: Such funds are also likely be diversified but managers are willing and able to express stronger conviction in their positioning and shift the shape of their portfolios over time, often using derivatives actively to do so. These types of funds are close to the original concept of ‘strategic'. Particular caution is warranted in fund selection within this cohort, given the very wide range of approaches that are found in the sector, from more moderate to more aggressive. Investors need to be more tolerant of performance variability where greater flexibility is deployed.
* Deliver an attractive income stream: Some funds are designed with income delivery as the priority and should be judged primarily on this basis.
With this in mind, strategic bond funds clearly come in a wide variety of guises and so the selection of the most appropriate type for a client's particular needs is important - if not always straightforward. It is certainly relevant to question whether one is needed in a portfolio at all - after all, an investor's asset allocation may already be well diversified across different fixed income sectors.
Furthermore, for many investors, the fixed income element of a diversified portfolio plays a risk-offset role and, in that sense, many strategic bond funds - particularly the credit-heavy varieties - would be inappropriate choices.
Gill Hutchison is head of investment research at The Adviser Centre. To access the firm's free-to-air fund research and consultancy service, please click here
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