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The major risk facing cautious investors in 2015

12 January 2015

Margetts’ Toby Ricketts warns that certain multi-asset managers are putting their investors’ capital at risk by buying into “defensive” assets for protection in the current environment.

By Alex Paget,

Senior Reporter, FE Trustnet

Investors are wrong to think gilts can act as a form of protection while on their current yields, according to Toby Ricketts, who warns that certain multi-asset managers are taking the dangerous step of piling into the government bond markets in the hope they will hedge against equities.

The large majority of multi-asset managers were severely underweight fixed income at the start of last year as it was expected to herald the end of a multi-decade rally in bonds. However, they were caught out by the surprise drop in yields and also by the fact that most equity markets struggled last year. 

Nevertheless, with 10-year gilts now yielding just 1.6 per cent – having started last year at close to 3 per cent – Ricketts, who heads up a number of funds of funds at Margetts, warns that bonds will now be highly correlated to equities because they are so expensive.

He questions why managers are currently buying them as, with yields so low, they will offer next to no capital return over the longer term and it is also very unlikely that they can act as a hedge.

“You’ve got to wonder, are they buying them to make money or as a form of insurance?” Ricketts (pictured) said.

“If it’s for insurance, the danger will come. The reason why a lot of managers see them as a form of insurance is because bonds have typically been negatively correlated to equity markets. However, in the taper tantrum in 2013 both equities and gilts dropped at the same time.”

The taper tantrum occurred in May 2013 when former US Federal Reserve chairman Ben Bernanke warned the market that he was contemplating reducing quantitative easing.

According to FE Analytics, this caused the value of bonds, equities and gold to all fall at the same time – as the graph below shows – leaving the large majority of multi-asset managers with nowhere to hide.

Performance of indices during the taper tantrum
        
Source: FE Analytics 

Ricketts, who currently has next to no exposure to bonds within his portfolios, warns that a similar situation is likely to happen in financial markets when the likes of the Fed and the Bank of England start to tighten monetary policy even further.

“The point is, when interest rates start to rise there’s a chance that the value of both equities and bonds fall together. When that happens, you will wish you weren’t holding gilts and instead you will want to be in cash,” he said.

However, while bonds disappointed investors during the sell-off in May/June 2013, they once again acted as a safe haven last year.

Our data shows the Barclays Sterling Gilts Index delivered a stellar return of 14.64 per cent last year while the FTSE All Share was up just 1.18 per cent. On top of that, those returns usually came during periods of heightened volatility in the equity market.


Performance of indices in 2014



Source: FE Analytics 

Ricketts warns that gilts only acted as a form of protection last year due to their higher yields, but now they are at historical lows he says many of peers are being naïve by buying into the government bond market in the current environment.

“I think that is what many of them believe will continue to happen, but there have certainly been periods where it hasn’t and those managers could end up being disappointed.”

Ricketts added: “The problem with fixed income is that you run out of road. Yields have fallen and fallen, but they can’t fall much further.”

There are a number of managers who agree with Ricketts’ bearish outlook.

One of the most outspoken of those is JPM’s Bill Eigen, who holds around 60 per cent in cash in his £8.2bn Income Opportunity fund – which is a go-anywhere fixed income portfolio – as he is concerned that the government bond market is massively mispriced.

He told FE Trustnet late last year that prices no longer reflect economic realities, given that the US economy has grown at around 4.3 per cent over the last two quarters, inflation is hanging around 2 per cent, unemployment is down to 5.7 per cent and quantitative easing has now stopped. 

Eigen therefore warned that when the Fed does start to raise rates, there will be devastation in the bond market – far more so than there was when the central bank tightened monetary policy in 1994.

“If the Fed does what it says it is going to do with interest rates, the bond market is going to violently react to that because it’s just not priced for it – that’s my problem,” Eigen (pictured) said.

According to FE Analytics, the BofA ML US Treasury index lost 8.71 per cent in 1994. The S&P 500 didn’t fare much better, ending the year with losses of 4.28 per cent.

Performance of indices in 1994



Source: FE Analytics

Eigen continued: “I think 1994 was easy because you had 10-year US treasury yields at 7-8 per cent.”


“We had a massive cushion. Now you are talking about yields at just over 2 per cent. If you get yields normalising to just 4 per cent, there is going to be devastation in the fixed income markets, absolute devastation. You will have bond funds down double digits, easy.”

Ricketts has managed funds of funds in the IA universe since June 1992. He currently runs five portfolios on his own and co-manages two others with Wayne Buttery.

One of his best relative performers has been the £90m Margetts Venture Strategy fund, which has typically been very overweight emerging markets and Asia Pacific funds. According to FE Analytics, it has been the third best performing portfolio in the IA Flexible Investment sector over 10 years with returns of 151.96 per cent.

It has also outperformed the sector over one, three and five-year periods. The fund has an ongoing charges figure (OCF) of 1.77 per cent.

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