An imminent sell-off in bonds and looming weakness in property make hedge funds the only diversifying game in town for investors’ portfolios, according to Marcus Brookes, head of multi-manager at Schroders.
Brookes (pictured) has been a consistent pessimist of the broader fixed income market of late, believing six years of ‘easy’ monetary policy – a combination low interest rates and most importantly the quantitative easing (QE) programmes of the world’s leading central banks – has overinflated bonds and left them ripe for a crash. This will likely be triggered by the beginning of interest rate rises by the Federal Reserve this year, he adds.
“The first action of QE is to raise the price of government bonds – that means their yield goes down. For a small QE programme that wouldn’t be a problem because the guys that want to own government bonds, because they have a liability to, will go and buy some more but the Federal Reserve did $4.5trn worth of it,” he said.
“Our belief is that this money has flowed everywhere and most financial risk assets are more expensive than they should be because of QE. But the most overvalued are bonds because that is where the Federal Reserve has continued to keep buying, which led us to the conclusion that we should be underweight bonds,” he added.
“Alternatives is the bit [of the market] we think should give us pretty decent returns in what could be a fairly shady market. We are six years into a bull market – that’s quite a long way.”
According to FE Analytics, fixed income has bounced back from the nadir of the financial crisis over the past six years, with both corporate bonds and gilts having made strong and mostly uninterrupted progress. However since February both asset classes have shown some weakness.
Performance of indices over 6yrs
Source: FE Analytics
Across Schroders’ range of funds of funds Brookes has made use of two hedge funds to act as diversification away from global equity markets. He has steered clear of property, which is a common diversifier, believing it is also set for weakness as interest rates start to rise.
“We do like alternatives but not just because it is called an alternative – there are lots of things out there masquerading. If you cast your mind back to 2008 life settlements were the ultimate alternative, and indeed it was an alternative way of losing money. I would not class property strongly as a good alternative [so] we quite like hedge funds.”
Brookes cites Majedie Tortoise as a good example of a daily dealing hedge fund that meets his aims. The fund is currently closed to new money but its performance in the down year of 2011 demonstrates its diversifying abilities.
“It is not a bond fund and it is not an equity fund. It is something different and it made money in a falling market because its manager was short most markets,” the manager said.
Co-managed by Matthew Smith and Tom Norris, the fund has beaten both UK equities and corporate bonds since the eve of the financial crisis eight years ago with a return of 137.52 per cent. This compares with a gain of 54.36 per cent in the FTSE All Share and gain of 61.9 per cent in the IBOXX UK Sterling Corporate All Maturities index.
Performance of fund and indices over 8yrs
Source: FE Analytics
Brookes has the fund in his £1.4bn Schroder MM Diversity, the £293m Schroder MM Diversity Balanced, the £213m Schroder MM Diversity Income and the £170m Schroder MM Diversity Tactical funds – all as a top 10 position.
The long/short equity fund has been notably strong in 2008 and 2011 when most indices lost money, making a respective 6.94 per cent and 10.85 per cent when both bonds, equities and the average mixed asset fund lost money.
Another example of when bonds didn’t act as a diversifier from key equity markets is in May 2013 when then Fed chairman Ben Bernanke started talking about scaling back monetary easing, effectively announcing that QE would start to end soon in what became known as the ‘taper tantrum’.
Brookes also has a position in the Morgan Stanley Diversified Alpha Plus fund in the belief it will work in similar way in as it did during the taper tantrum – make modest gains as bonds and equites sell off sharply.
The €8.2bn fund, run by Cyril Moulle-Berteaux, is up 16.33 per cent since its launch in 2008, significantly behind bonds and equities after having particularly suffered over the past year.
Performance of fund and indices since 2008
Source: FE Analytics
Brookes also holds the fund across the Diversity range, appearing in all their top 10s but with the largest proportion in Schroder MM Diversity where it makes about 7.5 per cent of the total portfolio.
It has an OCF of 1.03 per cent and is open to new investors.
Schroders multi-manager funds have struggled over recent time frames. Brookes puts this poor performance, caused by a high cash weighting and underweight to bonds across the range.
“Over the course of 2014 we had very little in bonds, which was not great considering what they did. The UK corporate bond sector and gilts went up a lot but we felt that equities should do well because the recovery was coming through and one of the outcomes of QE is that financial stability was put in place, which meant people were starting to invest and that multiplier effect would mean profits would go up.”
“Actually, equities hardly did anything last year. The good news for us is that this is starting to switch around this year and given that where we were wrong last year we might be more right this year.”
“As we felt like bonds were too expensive at the beginning of 2014, now that they have done another 14-15 per cent we really believe that they are very, very expensive. Instead of picking up a paltry return from bonds I’d rather sit on the side lines and wait for the January sale. It is going to happen.”
Brookes is still overweight Japanese and European equities, believing they are two very strong potential areas for upside.