6th May 2022
This week I’m carrying on from where Dan left off in last week’s Crescendo. Last week’s note had the following lines in the final paragraph, “If bonds do not perform their role as defensive assets and are unable to deliver a positive real return, then there are huge implications for how the whole investment industry is structured. Most conventional bond funds were given low risk scores even when yields (and prospective returns) were at all time low levels and were thus material building blocks of most cautious portfolios”.
We have long had the view that bonds (generalising I know given there are myriad different bonds) are not as low risk as the investment industry believed. There are many definitions of risk in the industry with the most common being either the extent of a portfolio’s deviation from a benchmark or the measure of volatility of an asset. Our definition of risk is the probability of a permanent loss of capital after the impact of inflation. The decline in bond yields to ultra low levels in recent years significantly increased the risk of a permanent loss of capital after the impact of inflation if you bought and held those bonds to maturity. As a result, over the past c.3 years we have had very low fixed income exposure across our Funds, and where we have owned bonds, it was with a preference towards low duration private and alternative credit with superior yields. Yes, yields continued to fall and yes, being too early is the same as being wrong, but our low allocation to bonds has proven correct in recent months in terms of our relative ranking within our funds respective peer groups. As Dan said last week, “the start of 2022 has seen one of the biggest drawdowns in history for bond markets, including the third largest drawdown in a century for the US 10-year Treasury bond. Wasn’t that supposed to be risk free?”
Most, if not all, participants in the investment industry today have been investing or advising during a period of falling bond yields and falling inflation and we have all been taught and conditioned to believe that bonds are low risk and therefore suitable for all low risk or cautious portfolios. The Oscar-winning 2015 film “The Big Short” begins with a display of the following quote attributed to Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” That belief that bonds = low risk is why so many cautious investors who have such high allocations to bonds in their portfolios are the ones most surprised and upset by their recent performance (for reference, the iShares Core UK Gilts ETF is down 13.4% since December! *). Because bonds for the last 40 years, up until 2021, have acted appropriately for low risk investors, our industry assumed they would forever and is why everyone’s investment parameters, benchmarks, asset allocation tools, guidelines etc have bonds as the foundation in all low risk portfolios.
The Investment Association, the trade body for UK investment managers, is responsible for setting the definitions of the various sectors in which the thousands of funds registered for sale in the UK reside. Each sector will have a broad asset allocation intention, such as UK All Companies (every constituent fund will invest in UK equities), but also restrictions to prevent managers drifting beyond their mandate (every fund must have at least 80% invested in UK equities). The intention is to help investors compare similar mandates easily. The problem comes in the multi-asset, Mixed Investment Sectors where one of the restrictions for the ‘lowest risk’ sector, the 0-35% Shares Sector, is to have at least 45% invested in investment grade bonds. This means funds within that sector must have almost half their exposure in the highest quality corporate bonds or government bonds, which had the lowest yields this time last year. It is no surprise therefore that this sector has underperformed the ‘highest risk’ multi-asset IA Flexible Sector over the past year falling 4.1% compared to Flexible’s -1.1% **.
This methodology is enforced across the huge and highly influential fund rating industry on whom the financial adviser community relies for deciding which funds to buy for their clients across the risk spectrum. Our Hawksmoor Vanbrugh Fund, which is the 6th least volatile in its IA Mixed Investment 20-60% Shares Sector (previously called the Cautious Managed Sector) over the course of its 13+ years, is rated by one such agency as a 5 out of 10, in line with other ‘balanced’ funds because of its low bond allocation and preference for alternative assets via investment trusts which they find hard to define. This defies logic in our view given our very different definitions of risk.
I fully acknowledge it is a near impossible job to pigeon-hole the many different flavours of funds into sectors and risk rating brackets, but surely this recent period of underperformance for cautious portfolios is a wake up call for the industry to move away from this ‘bonds=low risk’ mentality. If interest rates and inflation continue to climb and central banks remain on their aggressive hiking cycle then there could be more losses to come for those clients who have specifically asked for losses to be minimised. A lot more thought and words are needed to discuss this properly, or it might take a George Ross Gooby esque moment of enlightenment to make the industry sit up and take action, but at the very least a more forward-looking process for assessments of risk is required instead of relying on the past patterns of performance.
*source FE fundinfo GBP Total Return 08/12/2021 to 04/05/2022
**source FE fundinfo GBP Total Return 04/05/2021 to 04/05/2022
Daniel Lockyer – Senior Fund Manager
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