FE Alpha Manager Richard Woolnough’s giant M&G Optimal Income fund has seen significant outflows over recent months, according to FE Analytics, though expert opinion is split on whether investors are being prudent or alarmist in exiting. 
The now £22.7bn fund has shrunk by £1.8bn since the end of March – a period which has been categorised by increasingly negative sentiment towards fixed income and substantial spikes in government bond yields.
That £1.8bn figure does include capital losses, though, and FE data shows that approximately £800m has been redeemed from the fund in the three months up to the end of May while £630m came out during May itself.
Nevertheless this is still a significant amount of outflow from the UK’s largest bond fund, which is headed up by FE’s best rated Alpha Manager – especially as the rest of the sector saw combined outflows of just £131m in May.
It is unsurprising that retail investors have turned more cautious on bonds generally and a recent FE Trustnet poll showed that just 10 per cent of readers thought fixed income looked more attractive after the recent sell-off.
The correction was caused by a variety issues such as improving economic data, a kickback against negative rates and a lack of underlying liquidity which saw major government bond indices fall by more than 5 per cent – and many warn that it was just a warning shot for a more “brutal” correction when interest rates do eventually start to rise.
Performance of indices in 2015
Source: FE Analytics
It is also unsurprising that M&G Optimal Income has become so popular given Woonlough’s calibre and the fund’s superior long-term performance.
According to FE Analytics, it has been the best performing IA Sterling Strategic Bond fund since Woolnough (pictured) launched the portfolio in December 2006 with returns of 88.36 per cent, has beaten its peers in six out of the last eight calendar years and has been top decile for its risk-adjusted returns, annualised volatility and maximum drawdown since inception.
Performance of fund versus sector since launch
Source: FE Analytics
Therefore, while sentiment has turned increasingly negative towards fixed income, are investors right to have sold this top-performing portfolio?
Hawksmoor’s Ben Conway points out that a fund of this size will always cause concerns given the perceived liquidity constraints that come with it, but he questions whether the outflows have come about because of its AUM.
“I’m playing devil’s advocate here, but if you ever wanted to make a valid argument that fund size isn’t much of an issue, you would use M&G Optimal Income as a great example,” Conway said.
“Clearly, the fund has taken on a lot of assets but performance has been really strong. I don’t think people have decided, ‘oh my goodness, this fund is too big’ – because you could have said that at £10bn, £15bn or £20bn.”
FE data shows the fund has nearly tripled in size over the past five years but has still been a top quartile performer in the sector and is among the best performers in terms of its alpha generation and information ratio over that time.
Conway therefore says there is no clear reason for the outflows but points out that given its size and the proportion of the sector’s assets which are held in the fund (about 70 per cent), if investors were going to start allocating away from bonds then M&G Optimal Income was always going to be disproportionally hit.
Nevertheless, the manager admits that he and his team sold the fund a number of years ago as a result of size concerns but stayed with the highly-rated M&G fixed income team for their replacement – namely the more nimble £1.3bn Global Macro Bond fund, which is managed by Jim Leaviss.
“It is a very different fund and has a total return objective. However, the point is if you can find a fund with a good manager, who has a large amount of resources and running a smaller pot of money, they generally will have more tools available,” Conway said.
There have been growing concerns about liquidity in fixed income markets, particularly in the corporate credit space, as due to the new regulatory environment investment banks can no longer act as the market makers they once were.
Last year, the RBS’ liquidity monitor showed liquidity in the credit markets, which it categorises as a “combination of market depth, trading volumes and transaction costs”, has declined by close to 70 per cent since the financial crisis.
The worrying aspect, according to RBS’ data, is that it is still falling.
These concerns about liquidity have been exacerbated by the negative outlook for fixed income as the consensual view is that bond yields will continue to rise from here as the world’s central banks begin to tighten monetary policy, economic growth improves and inflation returns.
Many of those experts also think that larger bond funds will be worst hit in a structural bear market in the asset class, as they will take longer to liquidate positions in falling markets and therefore take on larger capital losses.
There are also figures to suggest that this has already been the case. Using data from FE Analytics, we built two equally weighted portfolios of the 15 largest and smallest funds in the IA Sterling Corporate Bond sector at the start of the year.
As the graph below shows, the portfolio of the largest funds – which has an AUM totalling £44bn and includes Woolnough’s other multi-billion pound M&G Corporate Bond and Strategic Corporate Bond funds – has underperformed the portfolio of smallest funds (which has a combined AUM of £459m) since gilt yields peaked this year in early February.
Performance of composite portfolios versus index during bond sell-off
Source: FE Analytics
Conway agrees that bond fund size is an issue, but says Woolnough isn’t necessarily going to be hit any worse than the average fixed income portfolio given his expertise and the resources available to him.
“We have been worried about liquidity in corporate bond markets. However, people do have an axe to grind as managers running smaller funds will always say larger funds are most at risk.”
“The bottom line is, if you have large corporate bond fund that offers generic exposure and owns many of the same bonds as its peers and the time comes to sell those bonds – it is going to be a problem as everyone is going to be trying to sell them and, as we know, investment banks don’t have the inventory they once did. That’s the worry.”
“We have always said that we need a really, really good reason to buy a large fund and liquidity is an issue. However, if you have a manager who is already taking care of these risks then we would view any redemptions as a cause of volatility and not a permanent loss of capital.”
While the M&G Optimal Income fund, which counts investment grade credit as its largest physical and net exposures, has underperformed the sector so far this year as the team’s view on Europe didn’t initially work out, it fared better than most during the actual sell-off and has had a lower maximum drawdown than its average peer so far in 2015.
Performance of fund versus sector in 2015
Source: FE Analytics
M&G has also been very vocal in terms of defending the fund’s size. While Woolnough has admitted that it has become harder and harder to add value on a stock-by-stock basis as the size has increased, he says they are counteracting the increased AUM by expanding the team’s expertise.
The FE Alpha Manager also pointed out that the fund has also never been about bottom-up stock picking, but rather has been built around his and his team’s macroeconomic view – an argument which is supported by most fund selectors.
Ben Willis, head of research at Whitechurch, is far more sceptical though and warns that the recent outflows could start a “snowballing effect”.
“It is a flexible fund and therefore has had the capacity to grow its assets. M&G have also increased their bond fund range to offer investors alternatives to their standard funds,” Willis said.
“However, the issue is that everyone has to deal with the so-called bond conundrum such as what is going to happen when interest rates rise? Investors are looking for alternatives and if M&G Optimal Income does start to go through a period of underperformance, they could see it as a signal to think ‘I’m going to get out’.”
“The problem is, while the fund is diversified, it still has significant exposure to the bond market and when managers have redemptions they have to sell their most liquid assets which can often be their best performers.”
“I’m not saying it is going to happen, but that could be a problem for M&G if there is a run on this fund. He would have to sell-down a lot of his assets and while Woolnough could manage it, but create real issues.”
Willis has never held the fund and says investors should now consider looking for alternatives.
“We’ve sold out of our holdings in M&G and that’s not because we think Woolnough isn’t an exceptional manager – we think he is, actually. It is because we are concerned about the size of their funds.”
“At the end of the day, who has gone into that fund? Retail investors. Who are always the last to leave a fund? Again, it’s retail investors. If they do start voting with their feet then the outflows could be wholesale.”
In an article over the weekend, FE Trustnet will take a closer look at funds which could act as alternatives to M&G Optimal Income.
