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Can DFMs avoid high-yield havoc? Raab exit points to end of correlation game

Welcome to Asset Allocator, FT Specialist's newsletter for wealth managers, fund selectors and DFMs. We know you're bombarded with information, so each day we'll be sifting through the mass to bring you what you need to know, backed up by exclusive data and research.


In it for the duration

​Rising defaults, looser covenants, other late-cycle risks…worries about what could go wrong with high-yield debt have been around for a while now. No sign yet of a slump – as we've noted, HY has actually outperformed IG credit this year even as benchmark yields rise – but it's more than enough to give wealth managers pause for thought.

Part of the solution for many DFMs has been short-duration high-yield bond funds. After all, lower interest rate sensitivity while retaining a healthy yield makes for a pretty attractive proposition.

There are reasons to be more wary here, too. Edward Park, deputy CIO at Brooks Macdonald, says some advocates may have overlooked a problem with the structure of these funds. 

Certain portfolios define the duration of their holdings by "yield to call" dates – the amount of time before a bond is able to be voluntarily matured by the issuer. But if things do take a turn for worse, it wouldn't be too long before some of this debt starts trade below its issue price, making calls less likely. That creates a problem:

Short duration bond funds are typically able to buy bonds that either have a time to maturity, or a time to call, of two to three years. Should issuers choose not to mature these 'yield to call' bonds, the actual duration of the funds could increase markedly. 

The issue probably won't keep wealth managers awake at night - Brooks itself still has a small amount of exposure to short-dated HY debt within its model portfolios, though this has been pared back in recent months. 

But it's a reminder of how even "safer" parts of a portfolio could fall foul of a true downturn. Most DFMs continue to back the asset class, not least because performance has been particularly strong of late. That can be a hindrance as much as a help when it comes to future prospects.

DFMs' EM favourites

The fact that emerging markets make up the lowest equity allocation in the average Balanced model portfolio won't come as a huge surprise to wealth managers.

Even for higher-risk portfolios, diving into EM comes with several tricky questions. Will the asset class recover from this year's drubbing? Does it stand a chance of doing so while trade war questions still linger? Do problems in Turkey and Argentina risk contagion?

On top of that, EM has been something of an Achilles' heel for wealth firms: DFM fund picks in the space have struggled to beat the wider universe in recent years. Those that are still given sizeable backing by wealth managers can be found below:

Fidelity Emerging Markets still commands a decent following, despite having trailed peers over the last three years. Fund buyers clearly value Nick Price for his defensive approach, which saw performance fall off during 2016's value rally.

The same could apply for another popular three-year laggard, Glen Finegan's Janus Henderson Emerging Market Opportunities.

Inevitably, DFMs also continue to back well-known outperformers, such as Hermes' offering.

Not all buyers are hiding in established names. The appearance of an ETF suggests that some have made a tactical bet on the asset class for now. 

Other approaches also crop up, including income offerings from JPMAM and boutique Somerset.

It's the appearance of Charlemagne Magna New Frontiers that may hold a clue to future tactics, however: avoiding the Brics and seeking out (theoretically) uncorrelated exposures is looking a more and more attractive option for some wealth managers.

Raab sees exit

The resignation of Brexit secretary Dominic Raab is the latest sign that one of the more reliable post-referendum market trends is breaking down - at precisely the wrong time for asset allocators.

Theresa May might have got her Brexit deal past Cabinet yesterday evening, but today's developments show we're still a long way from the end of the process.

Sterling's reaction reflected that - it fell from $1.295 to $1.285 on the news this morning. In truth, that's another relatively meaningless move in the grand scheme of things. For all the headlines about the currency this week, it remains more or less rangebound. And absent a more serious political shock, or Parliament having its say on the deal, this state of affairs could well continue for a while yet.

What's more notable is how the FTSE 100 has moved this week. As FT Alphaville highlighted earlier this morning, there are signs that the inverse correlation between the pound and the FTSE has broken down again.

News of a withdrawal deal being agreed with the EU earlier this week sent both the currency and the index up. And in the past hour, sterling's 1 per cent fall has had no discernable impact on the benchmark.

Allocators will still get a helping hand from a more serious fall in sterling, courtesy of their overseas holdings. But it's worth giving more serious thought to assumptions about how UK stocks will react when Brexit negotiations do eventually come to a head.

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