Fixed income returns have been strong in recently years benefiting from a low rate environment and uncertainty surrounding equities markets, but Old Mutual Wealth portfolio manager Stuart Clark has sought out alternatives to the overvalued asset class.
Over the past three years, the Barclays Global Aggregate index has increased 28.85 per cent as yields have fallen to near-record lows as the yields and prices have an inverse relationship.
However, some asset allocators have shunned the sector over what they consider highly-priced assets with little value for longer-term investors.
Performance of index over 3yrs
Source: FE Analytics
“We are overweight alternatives against fixed interest because, as with I think a lot of our peer group, we are struggling to identify value in the fixed income space,” Clark said.
The manager has a forward return expectation for the asset class of around 1.5 per cent per annum for the next 10 years with a volatility of 6 or 7 per cent. “Compared to cash that is an inefficient asset class,” he said in an article earlier today.
“With government bond yields where they are, the outlook is that we have much lower forward return expectations for fixed income at this point in the cycle than we would historically have had.
“What can we do with that money? Some of it can go into cash, or where we have strong ideas within the alternatives space, we can hold alternatives and for the purposes of this portfolio we are classifying this area as including commercial property, global equity absolute return and commodities.”
He explained: “We are working the analysts at the moment to try and come up with more diversified alternatives so we can put more cash to work.
“If we can identify a good alternative fund that is providing us with 5-7 per cent per year then that is fantastic relative to cash and any day of the week I would rather hold that as long as I am comfortable with the risk.”
One area he has invested in is commercial property, where the manager owns Henderson UK Property, managed by Marcus Langlands Pearse and Ainslie McLennan.
But Clark has been reducing his exposure following the issues that surfaced last year when many funds in the sector were forced to gate to stem the number of outflows in the wake of Brexit.
Clark said: “Where looking back two years we had more commercial property in the portfolio because it diversified across multiple asset classes, obviously last summer we had the liquidity issues in the sector and we took the decision to take our property weight and spread it across other diversifiers.
“We have 2.5 per cent in Henderson Property at the moment but I would say if you looked back 12 months we probably had a higher exposure to commercial property than the peer group.”
Performance of fund over 2yrs
Source: FE Analytics
He added: “We were very happy how Henderson managed the positions through the suspended period but coming out the other side we decided to reduce our exposure to this new weight.
“We don’t have a cap on commercial property but we thought that was the right level given the outlook post Brexit.
“If we get to the point where we see Henderson and the other commercial property funds getting successfully destructured and dealing with the liquidity risk that is in the portfolios then we might be able to increase the exposure to that part of the market again going forward.”
Where he has been increasing his exposure is to absolute return strategies, notably the Old Mutual Global Equity Absolute Return and Absolute Return Government Bond.
“Absolute return government bond diversifies against fixed interest risk but is more closely correlated to high yield and equity,” the manager said.
“Instead of holding one alternative position, we are spreading the risk whilst also increasing your exposure across those different holdings.”
Performance of funds since MPS launch
Source: FE Analytics
Since the model portfolios were launched in February 2014, the two strategies, aimed at keeping volatility to a minimum while providing an absolute return, have risen 4.93 and 1.11 per cent respectively.
The third and final area he invests in is commodities, with the five crown-rated BlackRock Gold & General fund – overseen by FE Alpha Manager Tom Holl and co-manager Evy Hambro – which he says provides a macroeconomic hedge. 
“You end up sounding like it is the solution for everything but you get some inflation protection,” Clark said.
The fund invests in global shares of companies which derive a significant proportion of their income from gold mining or commodities such as precious metals. Despite this, the fund still provides diversification against equities and other asset classes, Clark said.
“Yes, it is slightly more correlated to global equities but when you compare it to global natural resources or global REITs – which are very highly correlated to global equity – Gold & General is around 0.3 correlation to global equity (the others are in the 0.75 region),” he said.
“You still end up with some diversification benefit to equity, but you also end up with this inflation hedge and macro shock hedge and we saw that around the Trump election.
“As people got more concerned about the Trump reflation trade maybe falling away and equity markets started rolling off, gold started picking up quite nicely.”
Indeed, despite falling immediately after Donald Trump won the US election, as doubts were cast about his effectiveness in getting his policies through congress the index rose markedly towards the start of the year.
“Obviously, this doesn’t feed back immediately into the gold shares but if you saw a sustained rally in the gold price then I would expect gold equities to pick up accordingly and offset some of the losses that would be happening elsewhere in the portfolio,” the manager added.
“It gives us the Trump growth disappointment hedge and actually if Trump is extremely successful in inflating the US economy up to 4 per cent per annum GDP growth and you therefore see inflation pick up more significantly it can offset inflationary risks as well.”