At the same time, however, most investors will have a high weighting to equity funds due to the possibility of higher returns over the long term.
Therefore, to add a layer of protection to portfolios, absolute return funds have become increasingly popular over recent years, with no less than 71 per cent of the IA Targeted Absolute Return sector’s members having been launched since the market bottomed out after the last financial crisis.
However, Canaccord Genuity investment director Justin Oliver says investors shouldn’t feel the need to buy absolute return funds – which often have high ongoing charges and levy performance fees.
He doesn’t use any absolute return funds within his CGWM portfolios. He favours a more ‘old school’ strategy to portfolio diversification by using cash and gilts as he says government bonds are the best, and cheapest, equity hedge around.
“We hold gilts not because of what they are going to return, but what they can help with when, shall we say, markets get stressed,” Oliver (pictured) said.
“We ran some figures and it showed that in 18 of the last 22 occasions when the FTSE All Share has experienced a quarterly decline, gilts have delivered you a positive return. I think that will continue to be the case.”
Data from FE Analytics supports Oliver’s research.
Our data shows the FTSE All Share has delivered negative returns in 14 quarters over the past 10 years and, though not an exact hedge, the average fund in the IA UK Gilts sector has delivered a positive return more in 10 of those quarters the equity index has fallen.
You can get an impression of this from the bar chart below, though we apologise that it is slightly busy.
Quarterly performance of sector and index over 10yrs
Source: FE Analytics
Oliver holds roughly 14 per cent in gilts across his portfolios as a result, even though most experts have warned against buying them at their current yields.
At the time of writing, 10-year gilts yield just 1.58 per cent following last year’s rally in government bonds, which saw the average fund in the IA UK Gilts sector return a hefty 14 per cent as macroeconomic risks mounted.
Performance of sector versus index in 2014
Source: FE Analytics
However, Oliver points out that he isn’t buying the bonds for capital growth but purely for protection.
“Why would UK equities decline? It will probably be because growth has disappointed. I seem to remember that even in the early 2000s people were talking about gilt yields not being attractive and questioning how long the bull market would continue,” Oliver said.
“Yet, 14 to 15 years later we are saying the same think and gilt yields are even lower. That relationship [between bonds and equities] isn’t set in stone, but I can’t see why that would change over the very short term.”
There is no doubt that gilts have been a very good equity hedge over the years, but many experts – such as Margetts’ Toby Ricketts – have warned that the correlation between gilts and risk assets will only grow tighter from here given yields are now so low.
Critics of the traditional barbell portfolio asset allocation approach point to the performance of government bonds during periods when talk of tighter monetary policy is rife in the marketplace.
A good example was during May 2013’s taper tantrum – when the US Federal Reserve warned the market it would reduce its quantitative easing programme, which caused the value of both bonds and equities to fall.
Performance of indices during the taper tantrum
Source: FE Analytics
An even more extreme example was in 1994, when the Fed unexpectedly hiked interest rates and caused bond yields to soar while sparking a sell-off in the equity market.
Performance of indices in 1994
Source: FE Analytics
The likes of JPM’s Bill Eigen have warned that government bonds simply cannot act as a hedge anymore because they are so overpriced.
As he is a firm believer that the Fed will keep its word and start to gradually raise rates, he says 1994 will look like nothing compared to the devastation which will occur in the bond market this time around because yields are so low.
Also, managers such as Old Mutual’s John Ventre have urged the Fed to begin to raise rates now as even though the 50 per cent fall in oil price has created deflationary headwinds, it has only hidden future problems.
He points out that as unemployment levels in the US have fallen to very low levels, wage levels will start to rise which will cause an inflationary impulse.
“This fall in inflation and fall in unemployment doesn’t make sense. We believe the Fed is potentially a long way behind the curve. They should have been raising rates already and while this lower oil price has notionally bought them time to push rate rises out to the end of the year, that is a mistake,” Ventre (pictured) said.
Oliver counters that though the argument that both bonds and equities could fall together has validity, it is very unlikely.
“I can see the argument there, but it is not one I wholeheartedly agree with,” Oliver said.
“Clearly, it is a risk that the Fed does unexpectedly raise rates akin to 1994. However, let’s forget oil and energy prices for a minute. Even before they fell, there were very few signs of inflation in the system. We continued to see five-year forward breakeven rates decline.”
“Also, you have to remember, what is inflation? Inflation is where you get demand exceeding supply but the fact is that we haven’t got excess demand at the moment, that’s what commodity prices are probably signalling.”
He points out, for example, that demand expectations outside of the US are very weak.
“We’ve seen the IMF scale back their expectations for global growth, Europe hasn’t got demand, neither has Japan, China is still growing but at a slower rate than it was before and we’ve seen stress in certain emerging markets.”
“I don’t see inflation as a problem and therefore I don’t see that the Fed will raise rates or be in a hurry to do so.”
Another reason why investors may want to reconsider relying on absolute return funds is that very few of them have been tested yet, as Square Mile’s Richard Romer-Lee pointed out to FE Trustnet last month.
“We’ve seen lots of strategies launched since [the financial crisis] which haven’t really been tested and when the doomsday comes it will be interesting to see how many of those do well and how many of them can give you an acceptable asymmetry of risk,” Romer-Lee said.
He added: “On average, it’s like any sector: some of them are really good, some are not and quite a lot of them are unproven.”
Also, our data shows that in the periods when bonds and equities have fallen together in the past, absolute return funds haven’t covered themselves in glory.
For example, during 2013’s taper tantrum only 20 per cent of funds in the IA Targeted Absolute Return funds made a positive return. The list of 53 funds which lost money during that sell-off included popular portfolios like Standard Life GARS, Jupiter Absolute Return and CF Eclectica Absolute Macro.
However, Oliver admits that neither gilts nor absolute return funds can give out-and-out protection against equity market falls and that is why he uses cash in his portfolios.
“Sometimes a 0 per cent return is good, in a way. Go back to 2008, the best performing assets were things like gilts and treasuries, but cash looked very attractive in relative terms,” he added.
