Cautious funds are designed to steer investors away from riskier parts of the market, such as equities. One common way of doing this is to have a higher allocation to bonds, which have traditionally had an inverse relationship with the stock market.
According to FE Analytics, the average fund in the IA Mixed Investment 0%-35% Shares sector, which was the old IMA Cautious Managed sector, has just under 55 per cent of assets in fixed income. They also have, on average, 9.5 per cent in cash and 3.1 per cent in alternative investment strategies.
Source: FE Analytics
However, some professional fund pickers argue that holding a large part of cautious portfolio in bonds is an increasingly dangerous strategy given the high valuations being seen across the fixed income market and the likelihood that a correction is on the horizon.
Marcus Brookes, who heads the multi-manager team at Schroders, has been bearish on bonds for some time, preferring to use cash and alternatives to dampen equity risk.
Schroder MM Diversity, which is the team’s lowest risk fund, currently has 31.8 per cent of its asset in cash and 29.2 per cent in alternatives. The fund, which made just 1.12 per cent in 2014 when the sector was up 4.85 per cent, only has only 10 per cent in fixed interest.
Brookes said: “The fixed income market is a real struggle for everyone. This was the main reason we produced fourth quartile returns over the course of 2014 and that may make you think we should reassess our view.”
Performance of fund vs sector during 2014
Source: FE Analytics
“We reassess our view all the time but, honestly, a gilt that’s yielding 1.6 when core inflation is at 1.5 per cent makes no sense for a long-term investor. For us to be as wrong this year as we were last year, gilts have basically got to go to zero.”
The manager notes that the spread and yields in most parts of the bond market are close to record lows. This is reducing the margin of safety, even in higher risk areas such high yield and emerging market debt.
“At some point this is going to give you a negative return and it’s going to be a shock because high-quality assets really shouldn’t lose money - but they will do if you pay the wrong price for them. I’ve been saying ‘cash is king’ for about a year. It hasn’t quite worked yet but I’m fairly sure it will do.”
The bond exposure that Schroder MM Diversity does have tends to be through the more bearish fixed income managers out there. Its largest position is to Bill Eigen’s JP Morgan Income Opportunity Plus fund - we’ve written about Eigen’s views on a number of occasions, including how he expects “devastation” in the bond market and why most bond funds are set to lose money.
David Coombs, head of multi-asset at Rathbones Unit Trust Management, currently has just over 30 per cent of his Rathbone Multi Asset Total Return Portfolio in ‘liquidity assets’. Of this, 13.58 per cent of the allocation is in conventional government bonds, 11.10 per cent in index-linked government bonds and 20.38 per cent is high quality credit.
Like Brookes, he has a decent slug in cash with more than of that 30 per cent liquidity allocation being held in the money market. The fund also has 17.60 per cent of assets in diversifiers such as macro hedge funds, long/short equity strategies and bricks and mortar property.
“With the extra volatility you want to have cash right now and not be rushing into the market. I’m sat with 20 per cent cash in my lowest risk fund because I’m really struggling to invest in the asset classes that are uncorrelated to equities [as] they just don’t look attractive,” Coombs said.
The impact of quantitative easing and the persistent reach for yields has made bonds and some parts of the equity market look expensive, leading many investors to look at alternatives and niche assets.
Assets such as these tend to be relatively illiquid and include areas such as industrial metals, soft commodities, frontier market equities, life settlements, distressed debt, student accommodation, ground rents and litigation funding. However, Coombs thinks investors should be wary of these areas, despite their often attractive yields.
“If you look at the funds invested in those areas, they would probably tell you they’re quite low volatility. But volatility is only one measure of risk and as we found out in 2008 the property market was not very volatile then it fell about 25 per cent,” the multi-manager said.
“Liquidity risk is massively mispriced, that’s not ground-breaking to say. Commercial property, bonds, any asset class with a decent yield doesn’t look particularly great value right now because of the yield reach. I do worry about investors constantly chasing yield from here, whether it’s equities, bonds, property or infrastructure.”
Jonathan Webster-Smith, head of the managed service portfolio team at Brooks Macdonald Asset Management, says running a cautious portfolio has become “exceptionally hard”, as the assets they would naturally hold have already done very well and have higher downside risk.
“The difficulty is deciding where to put money. Being low-risk you can’t just say ‘I’ll put it in the equity market’. I think it is getting harder and harder to find non-correlated assets without taking significant downside risk,” he said.
“I think you’ve potentially seen disproportionate returns from the low and low-to-medium risk funds. That’s why I think it’s dangerous. Last year our returns were average because we didn’t hold long-dated gilts and without them it was quite tough.”
Webster-Smith highlights short-duration US high-yield bonds as a trade that he made us of in his cautious portfolio between 2010 and 2013 but has become increasingly unattractive as bond market valuations soared.
“For a low-risk investor they were absolutely perfect because they gave you 7 per cent and the capital value shouldn’t go or down,” he explained.
“Up until the start of 2013 you have steady income and capital but then the problem was the yield then dropped from 7 per cent to 3 or 4 per cent at worst. So what was a really attractive asset we have to sell and go into a total return vehicle.”
Webster-Smith currently prefers to get exposure to the bond market through funds with more flexible mandates, such as M&G Optimal Income, Neuberger Berman Global Bond Absolute Return and Templeton Global Total Return Bond funds.
In an upcoming article, FE Trustnet will look for cautious funds that have low weighting to bonds, for those that want to minimise exposure to this part of the market.
