While he still rates FE Alpha Managers Ariel Bezalel and Ian Spreadbury, because the outlook for bond funds is looking increasingly uncertain – particularly in light of the FCA’s warnings over potential liquidity issues – he is concerned that multi-billion pound funds will be the worst affected if a large scale sell-off hits global bond markets.“The reason to remove it is purely a size issue because Jupiter Strategic Bond has performed very well for us,” Metcalfe said.
“However, I can’t see any real advantage that large bond funds have over smaller funds. There may be some small advantages around the edges, but we aren’t going to have any funds over £1bn in the current climate.”
A list of bond funds with more than £1bn in AUM would also include the likes of the £21bn M&G Optimal Income fund, as well as M&G Corporate Bond, Invesco Perpetual Corporate Bond and Scottish Widows Corporate Bond.
It total, there are 64 multi-billion pound fixed interest portfolios – 15.6 per cent of the entire market in the IMA universe.
The majority of experts agree that a multi-year bull run in bonds is coming to an end, with yields on government bonds and corporate credit expected to rise over the next couple of years as the global economy recovers.
The first signs of this happened during last year’s “taper tantrum”, when former Fed chairman Ben Bernanke warned that he was considering reducing QE. The announcement saw some bond prices plummet.
Performance of index in 2013
Source: FE Analytics
Though bonds have performed far better in 2014 than they did last year, many, including FE Alpha Manager David Coombs, have warned that the next five years will be very difficult for bondholders.
A number of industry experts have warned about large bond funds.
Manager of the £815m Kames Investment Grade Bond fund Stephen Snowden told FE Trustnet earlier this year that those who run multi-billion pound funds will materially underperform over the next few years.
Metcalfe admits that backing funds with an AUM of less than £1bn may not be enough to deliver strong returns, because the events which are likely to unfold in global bond markets over the coming years will be unprecedented.
However, as third party regulators have already warned about the impact that tighter monetary policy will have on bond market liquidity, he says it is only logical to assume that experienced managers who run a smaller pool of money will have the upper hand if there were to be a large scale correction.
“It is very difficult because we have never had this sort of environment and nobody really knows how big of an issue it is going to be. We just don’t want to be on the wrong side of it. It is one of those things that won’t come up on our fund screen as an identifiable risk,” he explained.
According to FE Analytics, Bezalel’s £2.5bn Jupiter Strategic Bond has been the best performing portfolio in the IMA Sterling Strategic Bond sector since its launch in June 2008 and has comfortably beaten its benchmarks in the process.
Performance of fund vs sector and index since June 2008
Source: FE Analytics
Bezalel (pictured) has become one of the most respected UK bond managers in recent years, with his often contrarian style attracting leading to mass inflows in recent years.
Metcalfe still rates him highly, but says backing a large fund is an unnecessary risk at the moment.“Money has been pouring into the fund because it has performed well and all things being equal we probably wouldn’t sell it; but this isn’t a normal environment,” he added.
Bezalel defends the size of his fund. He says that as he has a go-anywhere strategy is conducive with running a lot of AUM.
However, he says liquidity in the wider market is something he watches closely.
“While we have not experienced liquidity challenges in trading the fund, we are very cognisant that liquidity in certain sectors of the market has declined,” Bezalel said.
“This is largely due to regulatory changes in the banking sector which have reduced the ability of sell-side traders to take risk and hold inventory. We monitor liquidity in the fund on a continual basis.”
Metcalfe has also removed FE Alpha Manager Ian Spreadbury’s £1.4bn Fidelity Strategic Bond fund for the same reason.
Performance of fund vs sector since Apr 2005
Source: FE Analytics
Spreadbury, whose fund has been a top quartile since its launch in April 2005, says that the fund size actually helps him to outperform as he has access to decent primary market allocations and allows him to know where pockets of liquidity exist.
He also says the way in which he runs his portfolio means he is well-placed if liquidity were to dry-up quickly.
“I avoid building large positions in single bonds and concentrations in less liquid parts of market,” Spreadbury said.
“This means I have options when meeting redemptions – I can trim exposures across a broad range of bonds in small deal sizes or sell the most liquid bonds, whilst always retaining confidence in the overall credit quality of my portfolio.”
The largest individual weighting in Fidelity Strategic Bond is just 1.78 per cent. The figure is much larger for Jupiter Strategic Bond, at 3.63 per cent.
The Jupiter and Fidelity funds are by no-means the largest fixed income portfolios in the IMA universe.
FE Alpha Manager Richard Woolnough has defended the size of his £21bn M&G Opitmal Income fund on numerous occasions.
However, he has admitted that the growing AUM has meant day-to-day management is becoming more difficult.
Paul Causer, manager of the £5bn Invesco Perpetual Corporate Bond fund, told FE Trustnet in an interview last year that the argument against large-bond funds is illogical and simply doesn’t add up.
“If everyone wants to take money out of the asset class, then everyone would be hit. If you’re trying to sell £20m or £2m you are going to the same market makers. It’s the price you get for the bond which is the issue, not whether you’re going to be able to sell it,” Causer said.
Metcalfe sympathises with this view, but as he says no-one really knows what will happen to global bond markets over the next few years, he sees no point in investing in less-nimble funds when there are plenty of strong candidates with less than £1bn in AUM.
“On the balance of probability smaller funds are likely to deal with everything better than large funds. I’m not saying that positioning isn’t going to be important, but using a large bond fund isn’t a risk we feel we need to take,” he finished.
In an article later today, we will look at nimble funds that Metcalfe and other industry experts use within their portfolios.
