although Traditionally thought of as producing unspectacular returns, the UK gilts sector is breaking that image after three good years
Three year figures have changed the perception that UK gilts underperform other asset classes.
The average fund in the sector achieved a return of 11.89% over the three year period to the end of September 2001, on an offer to bid basis. However, the gap between the top and bottom performing funds is not exactly narrow.
One reason for this differential is the ability of some funds to invest up to 10% of assets in corporate debt.
The worst performing fund is Whittingdale Gilt Growth which returned 8.77% in the three years to the end of September 2001, offer to bid. The best performing fund by some way is the Burrage Gilt Unit Trust which gave investors an impressive 20.58% over the same period. Most funds in the sector, however, tended to average returns of between 12%-15%.
Alpha scores also vary dramatically in the sector, ranging from -3.56 for the Merrill Lynch Long Dated Sterling portfolio and 4.98 annualised alpha for the Burrage Short Dated Gilt fund. Betas in the sector, which is considered low risk relative to most, vary from 0.14 for the Whittingdale Short Dated portfolio to 1.77 beta score achieved by the HillSamuel Bond index fund.
The Gartmore UK Gilt and Fixed Interest fund is the third best performing fund in its sector, returning 15.52% over the three years to the end of September 2001. It has achieved this with an annualised alpha of 1.6, nearly four times the sector mean of 0.46, and a below average beta of 0.87.
Its manager, Paul Grainger, currently has a holding of 9.8% in AAA, AA and A rated corporate debt. He highlights the fact that A is the lowest rated corporate debt the fund will hold. The fund is looking for the key characteristics of growth and stability when considering which debt to invest in, as well as avoiding any company or organisation which may be at risk from a downgrade.
'We're currently very keen on swap related products, such as debt issued from the World Bank and the European Investment Bank as there is a huge demand for it. We only invest in quality names which have sufficient liquidity and are at the right place on the yield curve,' said Grainger.
The fund currently has around 35% of the remaining 90% of the portfolio allocated for gilt investment, in short dated paper (0-5 years), 25% in short to medium (5-10 years), around 15% in medium term (10-15 years) and 25% in long-dated (15 years plus) debt. Grainger uses the FTSE Allshare as a proxy benchmark and a loose guide to risk and performance.
However, close comparisons do not always stand up to scrutiny because of the difficulty in catering for those funds which, like Gartmore, invest up to 10% of their assets in corporate credit.
Throughout the past 12 months the fund has been consistently overweight in the 5-10 year area of the yield curve and underweight the long end of the market. This was because Gartmore held the view that the Minimum Funding Requirement (MFR), which provided a great impetus to the long market, would be abolished or watered down, said Grainger.
'We were pleasantly surprised by the speed at which the Government has moved to abolish MFR following the Myners report. However, demand for long dated gilts has actually held up better than many people expected. Pension funds and life assurance companies, which have ongoing commitments, still require this kind of debt in order to meet their responsibilities. This is despite its relative underperformance as an asset class. We have now moved to a flat position on this area of the market,' he said.
The higher than expected pricing at the long end of the market has been prompted by a reduction in the supply of corporate debt following the events of September 11.
A lot of companies that expected to issue debt in September, have delayed issuance until a clearer picture of how events have affected the global economy is built up, Grainger said. The money that would have gone into this corporate debt has now found a home in long paper and unless new corporate debt starts to come through in both quantity and quality, this trend is likely to continue.
The Dresdner RCM Gilt Yield fund has not performed as well as the Gartmore gilt fund. But manager Mark Parry believes it is important to draw a distinction between a straight gilt fund, such as his and those that also invest in credit, which will have higher risk return ratios.
The fund returned 13.45% over three years to the end of September, offer to bid, and 6.49% over one year to the same date. The volatility was just below average with a beta score of 0.97, compared to a mean of 0.98 and marginally outperformed on its alpha ratio of 0.6 compared to the sector average of 0.47.
Parry said: 'Our fund does exactly what you would expect it to and we don't hold any positions in corporate debt. We prefer to run a clean and simple gilts fund without exposure to corporate bonds. Funds which have this kind of exposure may or may not have added value over the past 12 months depending on the type of company they invested in.'
Parry said he believed the bulk of his fund performance over the past 12 months was derived from an early decision to go overweight duration. He concentrated on the short end of the market which he said is more receptive to changes in interest rates, one of the main drivers of the gilt market.
He believes he has benefited from Dresdner's active management approach. This enabled him to increase the fund's risk profile earlier in the year, when he moved against the market expectation that interest rates would go up.
Schroder's Gilt and Fixed Interest fund has also performed well, with funds invested three years ago being worth 14.38% more at the end of September, on an offer to bid basis. It has posted only one year of negative returns in the discrete periods to the end of September, returning -0.78% in the year October 1998 to September 1999.
Its annualised alpha ratio is above the average at 0.67, while volatility was marginally higher than most at 1.03.
Fund manager Andrew Argyle has positioned the fund so that it is overweight corporate bonds, with just under 10% invested in investment grade corporate debt, which ranges from AAA to BBB.
Argyle argues the management team performed well by accurately predicting future market trends. He said: 'We try to look for bonds that are likely to be either down or upgraded to a different index in the near future, as tracker managers will be forced to either buy or sell these bonds accordingly. If we are able to predict where this will happen, we can position ourselves early accordingly and benefit from the widening of the spreads.'
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 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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