Investors should not give up on bonds, as abandoning them would be admitting you no longer believe in diversification, says Liontrust portfolio manager John Husselbee. 
Many investors and analysts have cooled on bonds, one of the hottest asset classes over the past 12 months.
Indeed, as the below graph shows, global bonds have returned 16.79 per cent over the last year, with investors spooked by a lack of certainty causing a flood of interest in the asset class.
Performance of Barclays Global Aggregate index over 1yr
Source: FE Analytics
This has been magnified by an increase in governments buying bonds as part of their monetary policy and quantitative easing programs, such as in Europe, the UK and Japan.
“Within bonds it is the rate normalisation that is a large fear within the portfolios,” said Husselbee, who runs the model portfolios with co-manager Paul Kim.
“That doesn’t mean we totally abandon bonds. To totally abandon bonds is to say that you no longer believe in diversification.”
He added: “Diversification is one [issue] where you will accept that you have a blend of asset classes and in that blend over periods of time some will go up and some will go down.
“In the long run they will all generally speaking go in the right direction and create you a portfolio which will help you exceed your return and do it for a lower risk.
“So we don’t abandon bonds despite the fact that bond yields have gone up and that they may continue to go up. You may cause a capital loss from that but we still enjoy the benefits from diversification.”
However, while he still holds bonds, using his scoring system outlined earlier in a previous article, he is now scoring government bonds and corporate bonds lower, meaning he has some excess capital.
But with a generally cautious view on the economy and the portfolios in capital preservation mode, he must invest somewhere, and is looking more into the alternative space, particularly absolute return and hedge funds, to find diversification.
“We were scoring four we are now scoring three [for the global environment] – we changed that in June, the manager said.
“In the balance that means you have to do something with the money that you traditionally have in bonds and so therefore you are looking to balance that between getting a different type of return and also getting a different type of risk reduction or defensive play in your portfolios.
“Absolute return and hedge funds we see them as providing low correlation to traditional asset classes then divide them into return enhancers and risk reducers.
“There are a lot more of those funds now post-2008 than there was before,” he said, adding that they are “liquid alternatives that have responded to retail investors who ask for daily dealing and lower costs and better transparency”.
In recent years, absolute return and hedge funds have come under fire for low and in some cases negative returns, and Husselbee says they have “disappointed” over the last two or three years.
“One of the reasons for that is because the majority of them have a cash-plus or in some cases an inflation-plus target. Well cash-plus is short duration and these assets have suffered over the last couple of years as yields have been falling is short duration assets.
“That’s had a major play on hedge funds and absolute return funds because if your benchmark is short duration then I think you’ve seen how some of these funds have struggled.”
The first fund he is invested in is the H2O MultiReturns run by Natixis, which has returned 30.78 per cent over the last three years, though it struggled in 2016.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
“H2O is a Paris-based investment boutique. It’s actually owned by Natixis – the large global asset management company. They have a global/macro approach in a liquid, alternative fund,” he said.
“Basically it blends a portfolio which includes equities, bonds and currencies and puts that together to create a global hedge fund.”
The £225m fund, run by Jeremy Touboul and Vincent Chailley, has a contrarian nature, adding more risk at times of market sell-offs and has made almost half of its returns from the currency market.
Next up is the £762m Jupiter Absolute Return fund run by James Clunie, which uses a short-book to enhance returns.
Shorting (or short selling) is when an investor or manager sells a security they do not own to buy it back at a (hopefully) lower price.
Clunie has been vocal in how he makes full use of the long/short nature of the fund, arguing that this offers him an edge.
The manager took over the fund Philip Gibbs in September 2013 and since then has returned 18.85 per cent to investors.
Performance of fund vs sector and benchmark over manager tenure
Source: FE Analytics
Husselbee said: “James Clunie is on the doorstep – he’s not that far away – he’s transparent in what he does and he bases a lot of his process on academia and I quite like that.
“You are backing alpha here and I quite like that he’s not afraid to use some of that theory into practise.
“He started running these funds when he was at Scottish Widows and he has not been up at Jupiter for a number of years so they would be our two hedge fund type scenarios.”
He adds, however that he is probably adding a bit more volatility than absolute return funds so balances these with the £2.3bn Pyrford Global Total Return fund.
“Once again a global/macro approach but interestingly an approach that doesn’t short anything,” Husselbee said.
“The only thing they do is currency hedge but they take a long-only approach to absolute return and they have achieved an extraordinary track record over the long-term.”
The fund has more than 71 per cent exposure to the UK market, with 56 per cent in UK fixed income and 15.20 per cent in UK equities.
“In all of these cases, the thing that Paul and I are most concentrated on is demonstrating the consistency of the investment process because if the process is sound and clear and works over time you want to make sure that the managers are applying it because you don’t want them to miss out on any opportunities that they have designed their process for.
“There is a balance between skill and luck,” he said.