Asset AllocatorNov 16 2018

Through a hedge backwards and DFMs' top European equity selections

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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.

 

Through a hedge backwards

This evening's Federal Reserve decision is set to pass without event, but there's plenty of action expected further down the line: another rate hike in December, followed by three more next year. From DFMs' perspective, that further compounds a portfolio construction problem that's been getting more serious all year.

Ten-year Treasury yields now sit above 3.2 per cent - pretty attractive on the face of it for yield-starved investors such as UK wealth managers.

The problem is that these bonds are usually hedged back to sterling if they're to sit in domestic portfolios. And with the UK base rate at 0.75 per cent compared with a Federal funds rate of around 2.25 per cent in the US, the cost of hedging is now effectively well over 1 per cent per year. As a result, wealth managers have been forced to step back from their hedges or switch into other debt.

As of 2018, "the economic motivation for owning hedged treasuries in lieu of gilts - based purely on the interest rate dynamics - is no longer there", says Alex Harvey of Momentum GIM.

Accordingly, Momentum swapped its US bond index fund for a UK equivalent back in the first quarter of the year, and our database shows just one DFM was holding US Treasury exposure via a hedged share class as of last month.

The dynamic is unlikely to change in the near term, given the Brexit effect over here and the perception over there that new(ish) Fed chair Jerome Powell is more hawkish than his predecessor Janet Yellen.

For UK investors, it means sterling-based exposure to what's ostensibly the world's safest asset class now comes at a price not seen since the financial crisis. And the other conventional options - eurozone government debt or gilts - bring particular risks of their own. One more tough decision to be made at a time of general uncertainty over asset allocation.

Continental champions and challengers

Yesterday we noted that European equities was one area in which boutique fund houses' offerings haven't outshone their larger peers of late - when it comes to DFMs' selections, at least.

Similarly, our research last week showed that Europe was one area in which wealth managers had reduced allocations over the third quarter. So we decided to dive back in to our database to look at exactly which offerings are retaining fund selectors' confidence.

The chart below shows the most popular selections from the European equity space - encompassing growth, income and small-cap funds - as a proportion of all such funds held in model portfolios.

The top two picks aren't surprising: BlackRock European Dynamic and Jupiter European need little introduction, and performance has remained healthy this year even as investor confidence in the continent's recovery has been shaken

The relative lack of high-quality European income funds means the trio included here always had a good chance of standing out, particularly for those model portfolios which focus on producing a healthy yield. 

One other possible conclusion to draw is that trackers aren't as dominant in Europe as elsewhere: index funds from Vanguard, iShares and the like tend to account for more significant proportions of other equity sectors.

Most notable of all is the inclusion of Miton European Opportunities. The fund has not been around that long - it doesn't have a three-year record - but its presence indicates wealth managers are open to backing newer funds, even without high-profile managers attached, if the process is right. We'll be examining that impulse in more detail next week.

Reclassification or bit of a reach?

Regulatory speeches can be rather deadening affairs - watchdogs tend to save their policy pronouncements for hefty consultation documents rather than oratory. But FCA chief executive Andrew Bailey's speech at the Investment Association culture conference earlier this week did contain a nugget of interesting information.

Bailey identified passives and ethical investing as notable areas of growth for the investment industry, and suggested the rise of the latter was "in the opposite direction" to the former. He added:

Of course, these two developments can co-exist. Indeed, I would go so far as to say that they will, and that in doing so there will be some reclarification of the meaning of active investment.

He appears to be hinting that sustainable investing will ultimately give active firms the chance to redeem themselves with consumers.

The unspoken part of this argument says that much of the playing field will effectively be conceded to passives: ultimately, active managers will be confined to specific themes or sub-sectors where they can add value.

Panellists at yesterday's FT Wealth Management Summit, discussing these very topics, agreed that private markets and less liquid areas of public markets will remain fruitful hunting grounds for active managers come what may.

But we're still a long way from any kind of full-scale retreat, as the chart above emphasises. Most DFMs are keeping the faith across much wider swathes of the asset allocation spectrum - and if choppier markets do continue into next year and beyond, they will hope the active industry's much touted ability to protect on the downside will emphasise it's not going anywhere just yet.