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Why your once top-rated bond fund will probably revert back to average

10 November 2014

Baillie Gifford’s Stephen Rodger tells FE Trustnet why investors are right to be concerned if their bond fund has become a multi-billion pound portfolio.

By Alex Paget,

Senior Reporter, FE Trustnet

Multi-billion pound bond funds are now only likely to deliver returns which are very similar to the broader market, according to Baillie Gifford’s Stephen Rodger, who says stock-picking managers need to run a smaller pool of assets if they want to outperform.

Much has been made of the growing size of certain funds within the IMA Sterling Corporate and Sterling Strategic Bond sectors recently, especially as investors tend to flood towards the funds and managers who have already shown an ability to outperform.

Those who warn that giant bond funds are dangerous say as liquidity within the fixed income market is falling and as bond yields are expected to rise over the coming years, managers running a large pool of assets will struggle to offload their holdings in a sell-off.

Despite that, a recent FE Trustnet study highlighted that size has had no real effect on funds’ performance.

Performance composite portfolios versus sector since Sep 2009

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Source: FE Analytics


However Rodger, manager of the five crown-rated £415m Baillie Gifford Corporate Bond fund, comes at the issue from a different angle.

While he makes no references to liquidity-driven corrections, he and his team have put together research on the bond market which suggests that managers need to have a smaller portfolio if they are to successfully generate alpha.

As a result of his research, the manager showed that in each of the last eight calendar years, close to 85 per cent of assets in the bond market have delivered a similar return to the index, while the rest have outperformed or underperformed by varying degrees.

Rodger argues that larger bonds only have the option of avoiding the losers to beat the index return, while nimbler funds can focus on finding the more rare winners.

“For us, you can see the attraction of picking the winners [outperforming bonds]. Of course, there is a slight problem with picking the winners – which is that it is a limited assets under management game,” the manager said.

“The nice thing about avoiding the losers is that you can run multiple, multiple billions doing that and its perfectly logical strategy and we have no problem with it. However, we do the other thing as we are trying to pick the winners, which is a limited assets under management strategy.”

“As your assets under management, or fund, grows then – provided on how much liquidity you want possess –you are going to be forced very quickly to have 200, 500 to 1,500 plus bonds in your portfolio and we now know that there are a lot of bonds that just do the index.”

He added: “The point is, the more bonds you buy, the more likely it is that you will deliver a return which is very similar to the index.”

He also claims investors can find out which bonds will either outperform or underperform in advance.

“The handy feature which categorises the winners and the losers is that they identify themselves to you ahead of time. The winners don’t put their hand up and say they will outperform, but in aggregate winners and losers identify themselves – and they do that by being relatively high yielding,” Rodger said.

“Before the year starts, if you look at the bonds which are relatively high yielding, when you get to the end of that year you will look that at that group and they will disproportionately have turned out either to be winners or to be losers.”

“That’s very handy, given that 85 per cent of the market doesn’t tend to do very much relative to the broader market. You could pick out a 200, 300, 500 or 700-bond portfolio, but you must recognise that year in year out, there are plenty of bonds which just do the index.”

Rodger says this could well be an issue for managers running multi-billion pound funds, however, as to have a decent level of portfolio liquidity they must hold hundreds of bonds and therefore must have a very high exposure to the “swathes” of assets which simply mirror the index’s return.

“Let’s imagine that, for once, you have perfect foresight and you pick the winner and you’ve found a bond that will outperform by 5 percentage points and you put 2 per cent of your fund in it, then its happy days because you’ve outperformed by 10 basis points at the end of the year.”

“Get a few more of those and you’re even happier.”

“The alternative approach is that you can seek to avoid the losers. You can sit there, and as your research has shown this bond underperforms by 5 percentage points, let’s not own it. But bear in mind, it’s about 0.01 per cent of the index as there are around 1,000 bonds in the index.”

“Again, you outperform, but this time by half a basis point, if you are lucky.”

The five largest funds in the IMA Sterling Corporate and Sterling Strategic Bond sectors include the likes of FE Alpha Manager Richard Woolnough’s £22.9bn M&G Optimal Income fund and the popular £5.5bn Invesco Perpetual Corporate Bond fund.

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Source: FE Analytics


Woolnough has told FE Trustnet on a number of occasions that his five crown-rated M&G Optimal Income fund isn’t too big.

However, though he says he builds his portfolio from a top-down view, his comments made earlier this year tend to agree with Rodger’s research.

“We have said this for a number of years now and we have had that question for a variety of our funds,” Woolnough (pictured) said.

ALT_TAG “The answer is: it makes it harder. Each time a fund gets larger, no matter what the fund, it makes it harder to add value through individual stock selection and it makes it harder to move things around.”

Rodger has managed the five crown-rated Baillie Gifford Corporate Bond fund, which is made up of 97 holdings, since September 2000 and Torcail Stewart joined him as co-manager in June 2009.

According to FE Analytics, the fund has been the third best performing portfolio in the IMA Sterling Strategic Bond sector since Rodger has been at the helm with returns of 127.13 per cent, beating the sector average by more than 25 percentage points.

Performance of fund versus sector since Sep 2000

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Source: FE Analytics


Baillie Gifford Corporate Bond – which is roughly split 70/30 between investment grade and high yield – also boasts top quartile returns over one, three, five, seven and 10-year periods.

It has a yield of 4.8 per cent and a clean ongoing charges figure (OCF) of 0.54 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.