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Miton’s David Jane: Don’t look to bonds for portfolio diversification

14 November 2018

The multi-asset manager warns that fixed income assets might not be doing the job that investors expect them to do.

By Gary Jackson,

Editor, FE Trustnet

Investors will need to search further afield for assets that can protect portfolios against falls in the equity market as bonds appear to be no longer performing this role, according to one multi-asset manager.

Equity markets were hit by a significant sell-off in October, which some investors believe could be the start of a more pronounced period of volatility. While fixed income would traditionally rally during times of stock market stress, this did not seem to be the case in October.

David Jane, who runs the £554.5m LF Miton Cautious Multi Asset, £76.8m LF Miton Defensive Multi Asset and £2m LF Miton Balanced Multi Asset fund, noted that bond yields rose during the sell-off, noting that “bonds’ promise of inverse correlation isn’t bearing fruit”.

Price performance of indices during 2018

 

Source: FE Analytics

Furthermore, the manager argued that bond yields look set to continue rising in the near term thanks to the Federal Reserve’s commitment to hiking interest rates in the US and the European Central Bank’s planned withdrawal of quantitative easing (QE).

“With bond yields heading higher in most markets, leading to capital losses across the fixed income spectrum, it’s easy to question the role of the asset class,” he said. “The historic purpose of bonds was as a low risk income generating diversifier, which performed well when equities were weak. This appears to be no longer the case.

“Most scenarios that are negative for equities are also negative for bonds, unless, despite the evidence, you continue to believe in the negative correlation of government bond yields to equities. If you do believe in this flawed relationship, you will need an awful lot of currently loss making long-dated bonds to balance a small position in equity, a recipe for negative real returns.”


Jane said that an “unusual scenario” appears to be playing out in the markets. Equities have spent much of 2018 worrying about an economic slowdown but this has not been reflected in corporate bond credit spreads, implying the bond market is more sanguine about the economic outlook than equities; typically, you would expect credit spreads to act as a lead indicator.

But this does not mean bonds look attractive. The economy now has high levels of corporate debt: there has been a long period of expansion since the global financial crisis, leading to a general sense of optimism and companies using ultra-low interest rates to take advantage of highly-affordable debt.

While the average company likely to find their debt servicing costs manageable even with expected interest rate rises, Jane noted that there are still plenty of “zombie companies” that are already struggling to service their debt; as rates rise or if the economy takes a turn for the worse, then investors would be less willing to lend to business such as this.

This draws the Miton multi-asset teams, which comprises Jane, Anthony Rayner and Henna Hemnani, to conclude that there is little upside and plenty of downside for most bonds. But where do they see opportunities to diversify portfolios?

Fund managers’ inflation expectations

 

Source: Bank of America Merrill Lynch Global Fund Manager Survey – Oct 2018

“Investors must look more widely for diversification and risk-off type assets in the current environment. While we can hold a position in short-dated corporate bonds, expecting a small return from the income and our capital back from maturity, this is unlikely to generate much return,” Jane said.

“Ultimately, we must recognise it’s a strategy dependent on a continuing benign economy. As a result, we’re always on the lookout for reasonably priced assets that can deliver a return that’s broadly uncorrelated to the economic cycle.”

One diversifier that the team is using in its portfolios to protect against inflation is lowly-indebted infrastructure equities, especially when they are active in less economically-sensitive areas. The funds have exposure to airports, railroads, pipelines and telecommunication networks.

While each infrastructure area has a higher degree of equity beta than corporate bonds and has its own amount of sector specific risk, they tend to display lower volatility than equities and often grow revenues close to nominal GDP, giving a degree of protection against rising interest rates.


In addition, the team has been building a position in real estate investment trusts (REITs), although this weighting is still at a low level in its portfolios. The managers like REITs as rising inflation is a big driver of the rents they charge tenants.

Exposure to gold has also been increased as a risk-off inflation hedge. In some of the Miton multi-asset funds, this exposure has taken the form of a direct gold ETF (exchange-traded fund) while others own gold mining equities.

“Diversification is very difficult to achieve at present, particularly in the simplistic approach of combining long-dated bonds with equity,” Jane concluded. “A more nuanced approach is required, considering the risks we’re trying to diversify away, and recognising that equity beta is much more unavoidable than it has been for some time.”

Performance of fund vs sector under Jane

 

Source: FE Analytics

Jane has managed the LF Miton Cautious Multi Asset fund since June 2014, over which time it has generated a 26.65 per cent total return. This puts it first-quartile in the IA Mixed Investment 20-60% Shares sector, where it is ranked 21st out of 124 funds.

Over this time, the fund has been one of the more volatile members of the peer group but this appears to have paid off as it is also in the top quartile for risk-adjusted returns as indicated by the Sharpe ratio.

LF Miton Cautious Multi Asset has an ongoing charges figure (OCF) of 0.84 per cent and is yielding 2.89 per cent.

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