With equity markets struggling, all funds in the uk gilts sector have posted positive returns over the three years to the end of february
UK gilt funds have been a safe haven for investors over the past three years as equity funds have struggled to match the returns of their fixed interest counterparts.
The sector has also outperformed its UK other bond rival, but lags behind the UK corporate and global bond sectors in performance terms over three years.
The sector is one of the most homogeneous in terms of returns with all funds in the sector posting positive growth over the three years to the end of February. Three-year returns from the top and bottom performing funds in the sector display just a 7.96% variance.
The nature of the asset class naturally results in a top-down approach to stock selection, with value primarily added through interest rate and stock duration calls.
Gilt funds are limited in the assets they can gain exposure to by the IMA, which imposes a 90% minimum gilt requirement.
Consensus suggests gilt fund managers are currently positioned at the short to medium end of the yield curve, as wider concerns about whether or not the UK joins the euro is compressing yields at the long end of the market.
Jim Leaviss, manager of the £201m A-rated M&G Gilt & Fixed Interest Fund, said while uncertainty reigns about when the UK is likely to sign up to the single currency, long-dated gilts will continue to look unattractive relative to German bunds. If gilts are eventually to yield in euros, then German long-dated government debt offers more attractive yields with the same level of risk at a better price. Leaviss is currently favouring shorter-dated government debt, a tactic that has helped his fund outperform its peers over one and three years. Over the 12 months to the end of February, the fund posted growth of 3.07%, compared with a sector average of 1.91%.
Leaviss said: 'There were two main ways over the year that we added value. First, our yield curve view went very well. The very long end underperformed the middle end and, second, we were good on getting our duration decisions right last year.'
The discrete period between March 2000 through February 2001 also saw the fund deliver excess returns, up 7.75% compared with a sector average of 6.83%.
Leaviss said the technology crash and subsequent flight to quality saw huge inflows into the sector which led to a period of strong performance for the asset class. Leaviss also used his 10% allowance to invest in AAA-rated corporate debt, providing an extra kicker to the fund's performance.
Leaviss added: 'When other asset classes got into distress we saw people run for the safest thing, bonds. The year 2000 was a good one for bonds and we also owned corporates for most of the year and AAA-rated bonds had an extremely good run, which boosted performance.'
M&G Gilt & Fixed Interest has outperformed over the three years to the end of February, up 11.07% versus a sector average of 9.61%.
Mark Parry, manager of the Dresdner RCM Gilt Yield Fund, has less scope to boost returns, given that his fund has a pure gilt mandate.
That said, the fund has still consistently outperformed its peers, up 11.33% over three years to the end of February, equating to excess returns above and beyond the sector average of 1.72%.
Parry said: 'We look to add value by correctly predicting interest rate duration and through yield curve management. Macro analysis is the key thing, but within that there is room for stock selection.'
Given the fund lacks the scope to look outside of the gilt market, Parry said the mandate reflects this, targeting performance that results in a top third of the peer group ranking.
Parry took over the management of the fund in late 2000 and immediately positioned the fund long of benchmark duration, anticipating falling interest rates. He said: 'We were quite early in calling the lower interest rates. The fund's outperformance has been about getting the direction of the UK economy and interest rates correct.'
Parry suggested that another reason the fund outperformed over the past two years was the tendency of fund managers to expect interest rates and inflation to remain high, rather than looking forward.
Dresdner Gilt Yield delivered returns of 2.9% over the 12 months to the end of February and 8.93% from March 2000 through February 2001, compared with respective sector averages of 1.91% and 6.83%.
The fund is currently very defensively positioned, said Parry, as he believes rates will peak at a level below market expectations.
Aberdeen Gilt Income is also 100% invested in gilts, although it does have the capacity to invest up to 10% in corporates. The fund, which has returned 9.74% over the three years to the end of February, is managed by Norman McChesney. McChesney has been aggressively moving into shorter-dated securities since the fourth quarter 2001. The fund is now zero weight maturities of 15 years and over, with the longest exposure now to the 2013s and an average of exposure of just over five years, compared with a British Government All Stocks Index benchmark of 6.6 years.
Aberdeen Gilt Income outperformed in each of the past two years, returning 2.94% over the 12 months to the end of February and 8.47% between March 2000 and February 2001.
McChesney explained: 'We held reasonably long maturities in the last quarter of 2000, and in December 2000 we decided to shorten and zero weight the very long end of the market. Longs performed reasonably well until the end of 2000 and we got the timing of our move shorter correct, which led to the fund outperforming.'
The fund remains heavily exposed to short-dated maturities, as McChesney anticipates a below consensus rate hike this year.
He added: 'Our best guess is that interest rates will reach between 4% and 4.25% by the third quarter and maybe 4.5% by the year end but the market expectation seems to be 5%.'
The Schroder Gilt & Fixed Interest Fund, managed by Andrew Argyle, is currently favouring medium-dated bonds. Argyle's colleague, Robert Gall, manager of the Schroder Corporate Bond Fund and ex-manager of Gilt & Fixed Interest, said the fund's client base tends to skew the vehicle toward the long end of the market, which has led to outperformance over the long term. Over three years the fund has also outperformed, up 11.76% versus the 9.61% sector average.
Returns are also bolstered by 10% exposure to corporate debt, which the house remains bullish on. In the current climate of likely interest rate hikes, Gall said the fund has rebalanced toward the 10-year range.
Gall said: 'We have been cautious on long bonds versus 10-year maturities. Having seen 10-year gilt yields rise to recent highs of about 5.35%, we are positive on the outlook and believe there will be value in the gilt market.'
The combination of holding longer-dated securities and moving shorter in recent months has helped the fund outperform in each of the last two years, up 3.88% and 8.24%, respectively.
Exposure to corporates also buoyed performance significantly in 2000, he added.
Gall believes yields will improve as UK rates converge with those offered by US and European government debt.
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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