Flexibility with strategic mandates

Although some funds in the IMA Sterling Strategic Bond sector are managed in the ‘unconstrained’ manner this would imply, in reality, Gill Hutchison, head of investment research at City Financial, says the majority of funds are managed to a specific asset allocation framework.

For this reason, she says it is important to understand an individual fund’s objectives, parameters and biases in order to ascertain its benefits and potential pitfalls for an individual investor.

Strategic funds have the freedom to invest across different bond types – government bonds, investment grade corporates and high yield, for example – and to vary the interest rate ‘sensitivity’ of the fund through a technique called ‘duration’.

Duration is a reflection of how long it will take to recover the initial investment value from coupons paid under the terms of the bond. The longer it will take the recover the investment the more likely it is interest rates will eat away at the value.

This contrasts with some other fixed income funds that only invest in one type of bond.

One common feature of these funds is that they are not constrained by a benchmark. As such Stuart Rumble, investment director for fixed income at Fidelity Worldwide Investment, says strategic bond funds can access developing areas of the market like emerging market debt.

Furthermore, Mr Rumble says fixed income benchmarks are ‘debt-weighted’, meaning countries and companies with the greatest amount of debt make up the largest proportion of the index. He says advisers will find that strategic bond funds are not subject to those constraints.

He adds: “Benchmarks can also force funds to trade when benchmark allocations change and buy into less liquid securities... Strategic bond funds’ broader access across bond markets can provide greater portfolio liquidity than benchmark-constrained funds.

“Flexibility is no guarantee for good results – it is difficult to always be invested in the right place at the right time. To mitigate this risk, most strategic bond funds guarantee a certain degree of diversification in their stated investment objectives.

“It is therefore important to carefully assess the historical asset allocation of a fund to ensure it has been consistently diversified and to check the performance track record reflects the fund’s risk and return objectives.”

Mark Wright, fund manager of the CF Seneca Diversified Growth fund, agrees that these funds bring with them diversification benefits and the potential to deliver more consistent returns, but also that ultimate performance may vary and investors may be exposed to risks they did not envisage.

He says this will more likely be the case for investors in more complex funds, that is Strategic Bond funds that have particularly wide investment powers and use derivatives, counterparty-backed instruments which provide a ‘synthetic’ return from the performance of a benchmark.

Mr Wright explains: “The use of derivatives effectively introduces leverage to a fund, exposing investors to a new form of risk.”

Carl Lamb, managing director at Almary Green, says strategic bond funds can be viewed as a natural core holding for a fixed interest investor.

Effectively Mr Lamb says strategic bond funds allow the investor to outsource their fixed interest exposure to the fund manager to make strategic asset allocation decisions on their behalf and thereby can reduce the need to hold a range of fixed interest funds.

He says: “The ability to move between fixed interest asset classes can help an investor avoid the chance of holding an inappropriate fund at the wrong time in the investment cycle and from the adviser’s point of view reduce the need to spend time researching

“The diversification can be seen to reduce volatility and theoretically allows the possibility to make positive returns at all stages of the investment cycle.

“The wide spread of possible investments that can be held can provide more opportunity to maximise returns. The facility to utilise derivatives can be used to reduce risk or even to increase returns.”

But Mr Lamb warns advisers to be aware of the reliance on one fund management group to make the asset allocation decisions rather than spreading between alternative funds and managers.

Mr Lamb says: “If used as a core holding the innate flexibility [of the management approach] can mean that the fund risk can alter as the fund manager changes the asset allocation and hence the investor cannot be sure exactly what the fund manager will be holding at any one time.”