some funds are able to stand head and shoulders above others in the sector Because fund performance and volatility vary so considerably
The UK equity and bond income sector has some of the widest parameters of any Autif sector, with funds able to have between 20-80% invested in UK equities and 20-80% in fixed income.
As one might expect in a sector with such wide inclusion criteria, fund performance and volatility vary quite considerably depending on the importance placed on the fixed income element of the fund.
On average funds in this sector returned 14.54% over a three year period to the end of September, despite falls in the equity markets in the past 12 months. This average growth figure comprises a fall of 6.45% in the year up to the end of September 2001, and increases of 7.28% in the year to September 2000 and 13.35% between 1998 and 1999.
The performance of several funds in the 50 strong sector though stand head and shoulders above their peer group.
Jupiter High Income, managed by Tony Nutt is the best performing fund over three years, delivering positive returns of 43.43% on an offer to bid basis, net income reinvested. The fund has an annualised alpha of 7.88, compared to a mean of 0.6 but a well above average beta of 1.31.
Like most Jupiter fund managers, Nutt is not benchmark sensitive, preferring to rely on Barra risk analysis which he uses to identify marginal contributions to risk.
'At any one time, in any fund, there are perhaps half a dozen stocks driving outperformance and I need to identify the relative risk of the size of my holdings,' he said. 'In this sector, I am surprised more managers don't use this method of risk analysis. I don't think benchmarks are a particularly useful tool for risk analysis for this type of fund because of the bond element. What do you benchmark against?'
The volatility of the fund has increased in recent months as he has positioned the portfolio to be aggressively overweight in mid and small cap equities, holding 36% and 18% in each sector respectively. He is underweight large caps, which account for just 45% of the equity position of the portfolio. Following September 11 the market has been distorted by a flight towards liquidity, but better capital returns can be achieved from mid and small caps, Nutt said.
This aggressive stance on mid and small caps has been balanced by an unwillingness to take large bets on one stock. He currently has around 120 stocks in his portfolio, with his largest holding being 2.85% in Abbey National, although most equity holdings account for 1% or less of the portfolio.
The number of stocks in the portfolio is representative of his cautious outlook on the market.
He said: 'I look for companies that are deeply undervalued and are creating real value for shareholders through solid earnings per share growth. The large numbers of goodwill dividend write-offs we're seeing at the moment though don't make me feel particularly bullish.
There have been times in the past when we have had a more concentrated portfolio but we're currently holding quite a defensive position with a large number of stocks and around 6% in cash.'
The funds bond portfolio consists of short dated bonds, and has been characterised by low turnover. Together with convertibles it accounts for around 25% of the fund's holdings.
Nutt suggests Higher Income has benefited from identifying undervalued sectors early and holding onto them. His most notable plays have included building and construction, property, food retailers and what he describes as the 'right' financials. He also feels that now is too early to buy cyclicals.
Another top performer is Gerrard's Extra Income fund managed by Leonard Klahr, which has recorded growth of 33.19% over the three years to the end of September 2001 offer to bid, with net income reinvested. Like Nutt's fund he has a high alpha, but an even higher beta score of 1.5. He attributes the higher volatility to the fact that it is heavily invested in equities.
'Our equity exposure is effectively somewhere in the 90% and above range. We have the maximum 80% in equities plus around 15% in convertible bonds, which are really equities in disguise. As a result of this we have actually outperformed most funds in the All Companies sector,' he said.
He conceded that the fund's minimal presence in fixed interest vehicles may look like a token gesture but points out that this portion of the fund's exposure provides 20% of the income. He is a firm advocate of value investing and believes his conviction has been justified following the publication of recent figures indicating value has outperformed growth over the past three years.
'Some 18 months ago we were being hammered and were finding it quite tough, but continued to look for companies and sectors that were giving high-yields.
'I think people have come round to seeing the merit of investing in proper companies that are out of favour with the marketplace,' said Klahr.
Extra Income has no exposure to low yielding sectors such as pharmaceuticals and telecommunications and has placed a strong emphasis on large caps, with the top 10 holdings all FTSE 100 stocks, accounting for about 25% of the portfolio.
Despite small caps accounting for just 10% of the equity portfolio, Klahr said outperformance in this area had provided strong growth, with a number of stocks recording positive returns of 50% and above with companies such as Clinton Cards and Diploma top performers.
'One of the advantages of a having a relatively small fund, about £14/15m, is that we are able to make small plays of the kind that a larger fund wouldn't consider. For us a £50,000 investment is big enough to add value,' he said.
F&C's High Income fund is somewhat different to the other two funds in that 70% of its assets are invested in high quality corporate debt, with the remainder, mostly FTSE 100 stocks, acting as a quasi-tracker.
The fund has posted impressive results, 33.59% over three years, while over discrete one year periods in that time frame it has returned 22.33%, 17.5% and -7.06% respectively.
Fund manager Stephen Crewe said the fund only invests in A and AA rated debt and stays clear of debt issued by industrial and telecommunications companies. The bond portfolio has a low turnover, with many issuances being held to maturity, with importance being placed on the price paid.
Returns are augmented through the use of an unusual derivatives overlay strategy which involves the selling of call and put options based around future levels of the FTSE.
The strategy aims to add extra value by taking advantage of the discrepancy between actual share liquidity and the demand for call options. The desired return is an added value of approximately 3%, but returns thus far have yielded in excess of this.
Crewe said: 'The volatility of this fund is very low, (0.89 versus a sector average of 1.01), as we're not trying to make money from movement in credit spreads. This also means there are low transaction charges on this fund. Our aim is to minimise variations in the capital price of the fund.'
Regression analysis: Regression statistics can be used to compare the relationships between funds, markets or a specific benchmark index. They do not make the assumption that the variables (funds) are related as cause and effect, but permit them to be influenced by other variables (markets).
Alpha: The Alpha describes the theoretical reward obtained by one investment when the second investment has a zero return. To calculate the Alpha, the returns of each are taken and compared together to identify their relationship. This reveals relationships between investments in both bull and bear markets. When applied to portfolios, it can be considered to be the return over and above (or below) the market through portfolio strategy. Good managers have a positive Alpha.
Beta: The Beta is the amount the first fund moves when the other moves by one unit. Beta is a measure of relative volatility (absolute volatility is calculated by standard deviation).
If one fund always goes up and down by 1.5 times of the performance of the index, its Beta will be 1.5. This implies that if the return of the index is positive, then 1.5 times this positive return can be expected of the fund. If the index goes up (or down) 10%, the fund goes up (or down) 15%. Beta represents the volatility of the first investment versus the second. It is only an estimate and to be accurate there has to be a perfect correlation between the two investments.
Correlation: Correlation shows the strength of a linear relationship between two funds. A perfect correlation is when the investments behave in exactly the same manner. A perfect positive correlation is represented by 1, perfect negative correlation by -1 and no correlation with a 0. A perfect negative correlation suggests that for every 1% movement by the index we would expect to see -1% movement return on the fund and vice versa. This is an important factor when using modern portfolio theory.
Source: Standard & Poor's
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