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Quilter Cheviot: The two seriously unloved areas we’re still backing for diversification

20 July 2017

Quilter Cheviot’s Simon Doherty outlines why he still holds gilts and absolute return strategies despite concerns for each sector.

By Jonathan Jones,

Reporter, FE Trustnet

Absolute return funds and government bonds are two areas Quilter Cheviot managed portfolio services manager Simon Doherty has continued to back to provide his portfolios with diversification. 

Government bonds have had an extremely strong run in recent years as ever lower interest rates have left investors hunting for yield.

This has pushed the yields of many asset classes lower, with the price therefore rising to new levels, as the below graph shows.

Performance of index over 10yrs

 

Source: FE Analytics

In the UK, gilts have risen 91.57 per cent over the last decade but many investors fear the great bond bull market could be coming to an end as central banks begin to discuss raising interest rates and unwinding accommodative quantitative easing measures.

Indeed, this scenario outlined above remains Doherty’s base case, with the manager noting that he does not expect a huge level of return from bonds from here on in.

“Gilt yields rose modestly last quarter, though still remain close to historical lows and do not appear to offer much value, especially when elevated levels of inflation are taken into account,” he said.

However, he added that he does not think the investment environment calls for a drastic unwinding of gilt yields, despite what some analysts have predicted.

“Having said that, we remain of the opinion that yields will be slow to rise as we expect the Bank of England to keep interest rates low for the foreseeable future, and from a portfolio construction perspective continue to see the asset class as a defensive allocation within client portfolios in the event of a reversal in market confidence,” he explained.

As such, his allocation to conventional UK government bonds is higher than it has been for some time, with recently sold inflation-linked bond positions reallocated to gilts.

The largest fixed income holding in the balanced portfolio is the £1.3bn Allianz Gilt Yield run by Mike Riddell, which makes up 10.5 per cent of the fund.

The fund, which is 98.6 per cent weighted to government bonds and holds 1.1 per cent in cash, has 32.4 per cent invested in bonds with a duration of more than 20 years.

“Mike Riddell who runs that fund is very pragmatic in terms of the way he runs what is a conventional gilt fund essentially,” Doherty said.

“He’s never going to do anything that is drastically away from the primary focus of that vehicle but he is quite willing to move the duration of that fund around quite sizeably within the parameters he has set himself.


“He is neutral duration having been overweight previously so he has reigned that in and captured the rally that we saw from gilts earlier in the year.

“He also takes shorter-term positions in index-linked gilts within the fund as he sees some inefficiencies in the way in which the syndication takes place within the index-linked gilt market – so he is willing to allocate on a short-term time horizon.”

Doherty added: “But it is essentially conventional gilt exposure, actively managed, which we think is a more appropriate way to approach the asset class at the current time.”

Over the longer term the fund has performed well, returning 84.44 per cent over the past decade.

While this is slightly behind the benchmark it is good enough to place the fund in the top quartile of the IA UK Gilts sector, as the below shows.

Performance of fund vs sector and benchmark over 10yrs

 

Source: FE Analytics

On a shorter time frame it has also held firm, as the fund has been a top quartile performer in the sector over the last year, losing 1.69 per cent compared to the sector’s loss of 2.62 per cent.

Doherty noted that the high allocation reflects his view that gilts continue to play a risk management role within the portfolios even though he is not drastically positive on the outlook for the asset class.

The other area that the manager has maintained an exposure to, despite broadly negative sentiment from investors, is the absolute return sector, though again it represents an underweight position overall.

The balanced portfolio’s benchmark has around 10 per cent exposure to the sector while Doherty holds 8.4 per cent.

The manager said while this is not a “drastic” underweight, he has chosen to invest this additional capital in his overweight position to international equities.

“A lot of managers have struggled in the recent environment and we see that as a source of capital to allocate to higher conviction ideas elsewhere whilst still maintaining a position,” he noted.


However, Doherty said hedge and absolute return funds are areas that the team have been considering more closely in recent months.

The portfolio still holds a number of key holdings, one of which is the Invesco Perpetual Global Targeted Returns fund.

The £10.3bn portfolio is run by Dave Jubb, David Millar and Richard Batty, who came over from Standard Life Investments having worked on its flagship Global Absolute Return Strategies (GARS) fund.

“One of the strands of the old GARS team that set up at Invesco Perpetual, it is a thematic multi-asset fund that has performed pretty well year-to-date and is delivering positive returns,” Doherty said.

Indeed, so far this year the fund is up 2.74 per cent, and has made a positive return in each of the last four calendar years since its launch.

Performance of fund vs benchmark over 4 calendar yrs

 

Source: FE Analytics

The fund aims to achieve a positive total return in all market conditions over a rolling three-year period with a gross return of 5 per above UK three-month Libor.

The portfolio centres around themes from which it draws potential trade ideas. Generally it will be made up of 20­-30 trades with an expected return of 0.25 per cent to 0.50 per cent per year over a two-to-three year time horizon.

The team also look at upside and downside risk when making these trades, focusing on not only the ‘worst case’ return but also the correlation of trades to protect the fund from unforeseen market events.

As trades are selected for different reasons not every trade in the portfolio will perform at the same time but if two thirds of the trades perform then the fund should achieve its targeted returns.

The fund has a yield of 1.51 per cent and an OCF of 0.87 per cent.

Doherty also holds a number of other positions in the portfolio for diversification purposes, including Old Mutual Global Equity Absolute Return run by Ian Heslop, GAM Star Absolute Return Bond and LFIS UCITS Premia.

“There are differentiating offerings there within our alternatives space in terms of volatility and annualised returns but what we hope is that as a basket it has quite a diversifying impact within the portfolio,” Doherty said.

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