It is often said that diversified funds offer better capital preservation characteristics than more concentrated offerings as all their eggs aren’t in one basket, while at the same time, managers who pride themselves on their stock-picking abilities should deliver higher returns during a rising market – which has largely been the case in fixed income over recent years – as they bet big on their best ideas.
However, this piece of research shows only one of those views has stood the test of time.
As part of the study, we built an equally weighted portfolio of the IA Sterling Corporate Bond sector’s 10 most diversified portfolios – measured by the proportion of their assets in their top 10 holdings – and another equally weighted portfolio of the sector’s 10 most concentrated funds.
Performance of composite portfolios versus sector over 5yrs
Source: FE Analytics
According to FE Analytics, the portfolio of diversified funds – which includes M&G Corporate Bond, Royal London Corporate Bond and Vanguard UK Investment Grade Bond Index – has returned 47.07 per cent over five years, beating the sector average by 7 percentage points.
On the other hand, the portfolio of concentrated funds – which includes FP Brown Shipley Sterling Bond, Jupiter Corporate Bond and Standard Life Investments AAA Income – has gained 39.40 per cent over that time.
The portfolio of diversified bond funds has also beaten its concentrated rival in each of the last five calendar years, which include the rising markets of 2010, 2011, 2012 and 2014 as well as the more difficult conditions in 2013 when bond prices corrected significantly after the US Federal Reserve (Fed) announced plans to ‘taper’ its quantitative easing programme.
On top of that, diversified bond funds have had a marginally lower maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible times – than the concentrated portfolio.
On a fund-by-fund basis, the trend is all too clear to see.
Out of the 10 funds in the portfolio of concentrated funds, eight of them have found themselves in the third or fourth quartile over five years. The two funds which are exceptions are portfolios run by Baillie Gifford, a group which prides itself on its long-term and bottom-up approach to investing.
Robert Baltzer has proved his stock-picking skills as his £310m Baillie Gifford Investment Grade Long Bond fund, which has just 84 positions and its top 10 holdings account for 26 per cent of the total AUM, has been the best performing portfolio in the sector over five years with returns of 72.6 per cent.
One of the major drivers of those returns was its performance last year. Due to its long duration characteristics, it revelled in 2014’s falling yield environment and gained more than 20 per cent as a result.
However, on the other hand, seven of the 10-strong portfolio of diversified funds have been second or first quartile over five years while other three – Scottish Widows Corporate Bond, Henderson All Stocks Credit and L&G Sterling Income – have all been third quartile.
The three best performing concentrated funds over that time are run by Royal London; namely its Sterling Credit, Corporate Bond and Ethical Bond funds, which are all top quartile with returns of more than 53 per cent.
The table below highlights the differences between the average fund in the two composite portfolios regarding the amount their top 10s account for, how many individual holdings they have and their size.
Source: FE Analytics
There is a huge size difference between the two different types of portfolios, as the average diversified corporate bond fund has an AUM of £2bn, while the average concentrated fund is significantly smaller at £183m.
It is difficult to work out whether the current list of diversified funds were actually more concentrated this time five years ago, therefore it could well be the case that the funds’ number of holdings have grown as more and more investors have piled in to get exposure to past outperformance.
Certainly, advocates of smaller funds have said that large bond fund managers are forced to own more securities due to illiquidity in the fixed income market and are therefore diluting their chances of outperforming in the future.
Some also warn larger bond funds, which will in turn be more diversified, won’t be able to cope in the event of a significant sell off in fixed income as they will be unable to offload their assets in a hurry.
However, our study shows that diversified bond funds not only outperformed in last year’s strongly rising market, but fared just as poorly as smaller concentrated portfolios in tougher market conditions.
The best example is during the May/June 2013 ‘taper tantrum’ when the bond market fell out of bed as a result of the Fed’s comments that it would look to tighten monetary policy.
As the graph below shows, the most and least concentrated funds performed exactly the same during the correction.
Performance of composite portfolios versus sector during the “taper tantrum”
Source: FE Analytics
Gaving Haynes, managing director at Whitchurch, admits that he is slightly surprised by how much the portfolio of least concentrated funds has outperformed over recent years, but says he would always prefer to back a bond manager who isn’t taking too many high conviction calls.
“We would choose a diversified bond manager, to be honest,” Haynes (pictured) said.
“If you are running a very concentrated portfolio, you are taking credit specific risk and as most we use bond funds in out low to medium risk buckets, you really want a fund that can iron out the volatility.”
“Managers like Richard Woolnough [whose M&G Corporate Bond and Strategic Corporate Bond fund sit in the least concentrated portfolio] has a very diversified portfolio and has outperformed in the past due to his big macro calls on the bond market.”
While our research suggests investors may want to turn to diversified funds in the IA Sterling Corporate Bond sector, FE data shows it has paid to be more concentrated in the high yield space.
Performance of composite portfolios versus sector over 5yrs
Source: FE Analytics
When we ran the same study with the IA Sterling High Yield sector, the portfolio of the least most concentrated funds – which include Invesco Perpetual High Yield, Newton Global High Yield Bond and Threadneedle High Yield Bond – has outperformed both the portfolio of concentrated funds and the sector average.
However, the portfolio of concentrated funds has given investors a rougher ride over that time as its maximum drawdown has been greater over five years. Then again, it is likely that most investors who turn to specific high yield bond fund within their portfolios are willing to put up with a relatively high level of volatility.
