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Asset Allocator

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The equity income funds calling out to DFMs; Buy lists versus interest rate risk

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When wealth managers look at the damage done to their portfolios in recent weeks, they’ll expect the usual diversifiers to have helped bail them out: alternatives, bonds, cash. But many equity income strategies will also be playing a larger role than first thought.

Simply put, that’s because of the popularity of enhanced income/call overwriting strategies among fund buyers. According to our MPS tracker (which assesses DFM fund selections across more than 300 model portfolios) funds such as Schroders’ Income Maximiser range are increasingly the go-to picks when it comes to equity income plays.

That looks prudent, because the call writing aspect of these funds is starting to come into its own.

“Until we see equity volatility pick up, it will be difficult to turn the overwriting strategy into a net contributor to performance,” RWC wrote at the start of October. Lo and behold, here we are.

Greater volatility, of course, allows covered call strategies to more easily boost income by writing options on their underlying holdings. Giving away upside has less opportunity cost when rising shares are harder to come by. “It’s getting easier”, sums up Fidelity Enhanced Income manager Dan Roberts.

It’s been a rapid change for these funds. Some, such as the Liontrust portfolios run by Olly Russ, had effectively suspended their covered call programme for many months as volatility levels dwindled. Sure enough, the manager said last month that he had restarted the process in October.

So it’s not surprising that enhanced income strategies have been heading up the performance charts in recent weeks. The nature of underlying holdings will have helped, too.

It’s not an entirely straight path from this point. Moving to the late-cycle stage doesn’t just mean more volatility. It also results in more M&A deals - and enhanced income funds tend to miss out on the share price benefits when their holdings are taken over. But for DFMs looking for yield, the income uplift is more than enough to compensate.

In it for the duration

Corporate bond funds are, by design, pretty unassuming strategies, and that's just why DFMs like them. Grinding out modest returns looks a pretty good starting point for a portfolio from hereon in.

We've discussed how the staid world of investment-grade credit is starting to get a little racier - and not necessarily to discretionaries' benefit. Wealth managers will be keeping this kind of concern in the back of their minds. And at the front, when it comes to bond funds in general, will be interest rate sensitivity. 

The question is whether those concerns truly apply to corporate bond portfolios. These funds still form the core of DFMs' fixed income exposure in many cases, and most will tend to run fairly chunky duration exposures. But there are some which take a more cautious approach to rates.

With this in mind, we’ve taken a snapshot of the most popular corporate bond funds, as chosen by DFMs in our MPS database, and added details on the stated interest rate sensitivity of each. The most widely held names sit at the top of the chart below.

There’s an element of clustering to be observed here. Many have a duration of between six and eight years, with the average for the group standing at 6.5. And each of the most popular four names has at least 7.4 years of interest rate sensitivity.

If DFMs are comfortable with this – as their top picks suggest – it may be because duration levels are managed more aggressively elsewhere within fixed income allocations.

This can come via the use of short duration products, but also through a preference for flexible bond funds with limited duration. That said, most strat bond funds are on the longish side: the average duration of popular picks in that sector stood at 5 per cent in our recent analysis.

There are isolated examples in the selection above of funds with low rate risk, like Liontrust Monthly Income or Invesco Sterling Bond. But these, frankly, are something of an exception. The benefits of IG credit are still enough to relegate duration concerns to the background for now.

Lone rangers

Rob Burnett’s departure from Neptune, announced last week, is one of the more unusual moves of recent times. Not the act of leaving itself - that still comes with the territory for active managers and fund selectors, as we’ll discuss in the coming days - as much as the destination: he plans to start his own fund management business.

A couple of years ago, leaving an established firm to set up shop on your own was all the rage. The more recent examples, though, have acknowledged the need for some kind of external support. Look at Paul Marriage and John Warren, setting up their company earlier this year under the wing of a “multi-boutique” parent

The major independent successes of recent years have been either the industry’s biggest asset gatherers or, in the case of Richard Pease (and Marriage and Warren), had the ability to bring their fund with them.

Burnett will have a plan in mind, and may well go down the Woodford route of piggybacking on another firm’s resources to start with. But that won’t eliminate the regulatory and legal costs that are now inherent to running a fund management company. And from UK selectors’ perspective, a European equity fund is a much more limited offering on which to base a business - particularly if you’re a value manager. It's a tough starting point, and will be watched closely by others still harbouring hopes of striking out alone.

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