Breaking down bond exposures

​If there's one thing asset allocators agree on, it's that bond investing is becoming more difficult. That almost goes without saying at this point. But where they can't reach a consensus is on how to resolve the problem.

Differing attempts to answer this question mean all kinds of different combinations can now be found in wealth managers' portfolios; traditional government and corporate bond mandates sit alongside more flexible funds, emerging market debt and inflation-linked mandates.

We've already examined DFMs' exposure to flexible and short duration bond funds within their balanced models, finding that the yield pick-up on offer from strategic bond funds means they're more popular than peers in those portfolios.

But other risk models have different requirements than balancing growth and income. The chart below uses our fund selection database to run the rule over MPS ranges as a whole. To keep things (slightly) simpler, we've included absolute return bond funds in the strategic bond fund category this time around.

Strat bond funds again come out on top: 80 per cent of wealth managers use such offerings in at least one of their model portfolios. But as the chart implies, few DFMs are content to leave their bond allocations entirely up to these go-anywhere managers.

The are significant variations in how this extra bond exposure is taken. Short duration and the more traditional investment grade corporate bond funds have a home in most ranges. After that comes a steep drop: other types of bond fund are just as likely to be excluded as included. 

Gilt funds remain much more popular than their global government debt equivalents, reflecting the need to produce sterling-based returns at a time when hedging's become more complicated.

Inflation-linked debt still finds a place in many portfolios, despite such bonds typically having a longer duration and price rises remaining relatively subdued globally.

But dedicated high-yield debt exposure just isn't as popular as you might think. DFMs recognise that strategic bond funds tend to hold a fair amount in the asset class.

They might also be worried about late-cycle risks: more than half of the HY exposure shown above is in the form of short-duration high-yield portfolios. That's the chart's underlying lesson: combining different types of bond exposure has become vital to wealth managers' chances of success in the asset class.

Momentum-breaker for ethical funds

Does ethical screening hinder returns? The last few years would suggest not, and the rise of ESG-themed model portfolios means many DFMs are now more convinced of the benefits of sustainable investing. 

On top of that, the world of ESG is now about much more than just negative screening. Yet the past year has seen certain ethical investment strategies opt to exclude some of the biggest growth stocks of the past decade. Increasingly, this is a complicating factor for those wealth managers who run their own specialist portfolios or buy ethical funds.

The Faangs have continued to drive markets this year - on the way up and on the way down. But tech companies, embroiled in multiple controversies, increasingly risk falling foul of ethical (or related) screening processes.

EdenTree is one asset manager steering clear of most of the big names. Here's Neville White, the firm's head of SRI policy and research:

All Faang companies, with the exception of Netflix, have been subject to sustained and serious controversy. Only one – Alphabet – has been approved for inclusion in our Amity funds, with Apple and Facebook excluded.

He adds that Amazon probably wouldn't make the cut either, while Netflix is not held for a different reason – it's too expensive.

Other firms with popular sustainable ranges, such as Liontrust, have also dropped Facebook over the past year.

The difficulty comes from the fact that plenty of other sustainable investment offerings continue to include tech stocks in their portfolios. And when they are included, their size means they take a prominent position: Amazon currently represents a top-10 holding for funds run by F&C, Hermes and RLAM.

Sustainable investing has always had an "eye of the beholder" element to it. Factoring tech stocks into this scenario means performance discrepancies are likely to grow larger as time goes on.

Short-term/long-term

The fourth quarter has reminded everyone that few asset prices fluctuate as much as the oil price. The gradual recovery seen over the course of 2018 has flipped into a sudden bear market.

It's more bad news for the commodities complex. Add questions over the trade war, the perennial issue of whether or not a serious Chinese slowdown is on the cards, and 101 other possible ways of reading the resources runes, and it's no surprise that most DFMs have washed their hands of the sector entirely.

As we discussed a couple of weeks ago, this uncertainty has benefitted passive products. Trackers, and in particular ETFs, are increasingly being used as a way of taking short-term exposure in an unloved area that looks oversold and/or might be displaying some positive momentum. 

For commodities, think also financials or emerging market debt. Four in every five fund selections in these areas is via a passive offering.

The contrast with themes or sectors that wealth managers expect to endure is clear. Dedicated exposure to the technology or healthcare sectors typically doesn't take the form of a passive vehicle: 75 per cent of these holdings are via active funds.

From the perspective of maintaining professional relationships, it helps that there are fewer noses put out of joint when quickly buying and selling an ETF. But even putting that aside, buying an active fund remains a big commitment, and that's why much of the industry's "patient" capital is still active in nature.