Traditionally, if you kept a diversified portfolio comprised of the main asset classes – equities, bonds and cash – your cash and fixed income exposure meant a proportion of your capital was kept fairly safe while the equity portion meant you could make money when markets bounced.
However, rising bond yields are stirring up fears of a bubble in the asset class, so they aren’t the go-to safe haven they once were – particularly after bonds underperformed in June. With this in mind, GAM’s Charles Hepworth outlines the asset classes investors should be running from – in favour of less correlated areas.
Sell:
Traditional fixed income
The first asset class Hepworth thinks investors need to steer clear of is traditional fixed income.
"Investors’ fears were heightened in June when Fed chairman Ben Bernanke hinted he would begin tapering quantitative easing by the year-end," he said.
"While the central bank was looking to shake markets out of their comfort zone, the move in bond yields around the world came as a surprise. Ten-year US Treasury yields rose to levels not seen since 2011 and the FTSE Gilts All Stocks index lost more than 6 per cent in total return terms from 2 May to 24 June this year."
Performance of index in June
Source: FE Analytics
Hepworth says this phenomenon was even more severe in emerging markets, where he points out sovereign yields rose more than 200 basis points in just two weeks.
"These developments reinforce our view that Government bonds in the US, UK and Europe do not offer compelling opportunities. Furthermore, the recent strong correlation with equities implies these bonds are unlikely to serve their traditional purpose as a diversifier," he added.
High yield bonds
In the past, investors who wanted higher returns but were still wary of taking on equity risk would have turned to high yield bonds.
While the asset class had a stellar run in the early part of the 2000s, Hepworth says it is time for investors to turn their backs on them as the threat of default risk ramps up.
"Spreads have widened in many markets with the exception of the US, where the economic recovery is reducing the implied default risk," he said.
"The strength of investor flows has kept the market buoyant but this also makes it vulnerable to a sharp pullback, especially if rising interest rates alter the risk-reward proposition."
Cash
It is no secret that leaving your cash in the bank is not going to do anything for your long-term wealth. With yields of roughly half a per cent, leaving money in the bank is actually losing investors money when the impact of inflation is factored in.
Hepworth says these are all reasons for investors to pull back from cash in favour of areas that can provide an inflation-beating return.
"Despite the Fed’s recent tapering comments, it is likely short-term interest rates will remain at or near zero for a long time," he said.
"Low nominal and negative real yields are a good way to help highly indebted governments deleverage. Additionally, just like the US in the 1960s, more stringent regulations on banks and pension funds will enforce large holdings of this low-yielding paper and should mean the market for cash and near-cash instruments will remain unattractive."
Buy:
Absolute return
Although many absolute return funds suffered in the most recent market correction, Hepworth says they are a better bet than many pure equity or fixed income plays.
"In recent weeks, an increasing correlation between equities, bonds and commodities has proved a strong argument for uncorrelated strategies which provide greater diversification than traditional government debt," he said.
"With that in mind, we are overweight several absolute return strategies, including global macro, fixed income, foreign exchange and equity long/short."
"Global macro strategies, for example, thrive in an environment of volatility and a resumption of higher cross asset-class dispersion should be ideal for realising strong returns."
The most well-known vehicle in this space is undoubtedly Standard Life GARS, which employs a number of strategies to deliver rolling positive returns over the medium-term.
Like other absolute return funds, it suffered in the correction, but has outpaced the sector over the medium-term.
Over the last five years, GARS has picked up 40.65 per cent while the IMA Targeted Absolute Return sector has made 16.32 per cent. The fund’s benchmark – LIBOR GBP 6m – made just 7.19 per cent.
Performance of fund vs sector and index over 5 yrs
Source: FE Analytics
GARS has also delivered positive returns over every calendar year since its launch in 2008, the only fund in the sector to have done so.
Private equity
Another area Hepworth likes is private equity, which can be difficult for private investors to access.
However, there are a number of investment trusts that invest in the space, such as the SVG Capital IT, Electra Private Equity and 3i Group.
"Private equity continues to offer compelling fundamentals and supportive flows, and we remain overweight," Hepworth said.
"Listed private equity investments did not suffer the same order of drawdowns compared with the more liquid equity markets during June’s downturn, and the asset class still offers around a 20 per cent average discount to NAV, which we continue to view as an attractive investment opportunity."
Frontier markets
An area that had a surprisingly low correlation to developed indices in the June market correction was frontier markets. The MSCI Frontier Markets index has managed to trump its developed counterparts since the start of the year, picking up 23 per cent.
Year-to-date performance of indices
Source: FE Analytics
"In June, many investors retreated into cash as the markets tumbled: this is not a strategy we have used as it makes market re-entry extremely challenging on the rebound," Hepworth said.
"We have been trimming our more generalist emerging market positions to reallocate towards frontier markets since March, where we were already overweight. Performance has been strong as a result of our pure frontier play, whose countries are arguably on a truer growth path."
