Are there alternatives to a strategic bond fund?

He says alternatives to using a strategic bond fund include making sure you have an allocation split between the  three main areas of fixed income. 

This, claims Mr McMahon, should give a more stable asset allocation.

However, he warns there is enough freedom within the gilts, corporate and high-yield sectors for managers to take up significant macroeconomic positioning, so this means investors need to take care that they are aware of the overall exposures of their portfolio to different outcomes.

He says: “It would be possible to pick three separate bond funds all of which were strongly positioned for a [president] Trump reflation trade, for example, which would lead to poor returns if this trade reverts.

“If following this route, investors should do enough research to understand which macroeconomic events and trends they want to be exposed to or hedge out by buying contrasting strategies.”

Fixed income allocation

Ashis Dash, associate director of fixed income strategies at Morningstar, says by allocating to a strategic bond fund, investors hand over some of their responsibility to allocate across fixed income sectors to the fund managers.

The alternative would be to invest in individual bonds or specific fixed income sectors. Both of these approaches have their advantages and disadvantages.Ariel Bezalel

He agrees an alternative to a strategic bond fund would be to create a portfolio using a range of specialist funds, with the investor allocating risk across a range of fixed income sub-sectors such as investment grade, high yield, government, emerging market and inflation-linked bonds. 

Mr Dash adds, depending on the sophistication of the investor, they can also use derivative overlays to manage the overall portfolio’s credit beta and duration.

This more granular approach, he claims, ensures the portfolio is diversified and, broadly, has exposure to most of the fixed income sub-sectors.

However, selecting specialist funds within a range of fixed income markets may require considerable resources. Additionally, the investor will also need to move allocations across these funds based on the market environment, which will require a good grasp of macroeconomics and market technicals.

Taking control

Ariel Bezalel, manager of the Jupiter Strategic Bond fund sees the alternative being the ability to invest more specifically.

He notes: “The alternative would be to invest in individual bonds or specific fixed income sectors. Both of these approaches have their advantages and disadvantages.”

By owning individual bonds, Mr Bezalel says the investor has ultimate control over what to buy and sell, when, and for how much. 

“They can buy into a fixed rate of return and calculate their future cash flows based on the bond’s coupon and principal,” he explains.

However this security and control comes at a cost that the investor needs to be aware of.

“As most investors will want a diversified portfolio of bonds, this will mean having sufficient funds to buy across different issuers, currencies, maturities and credit risk. Investors are also responsible for researching and monitoring the financial health of the issuers and take on all the associated credit, liquidity and market risk.”

Therefore investing in specific fixed income sectors offers more diversification than holding individual bonds, but still allows investors a degree of control as they can target their exposure to regions, currencies, maturities and sub-asset classes like high yield and emerging market debt. 

Beware volatility

But be aware that this approach also requires a certain level of expertise and, given the increased volatility of bond markets in the last few years, an active approach, says Mr Bezalel.

This means investors should view any allocation to a fund in this sector within the confines of their current portfolio and whether their chosen fund complements their current asset allocation.Jordan Sriharan

“As with owning and trading individual bonds, higher execution costs may detract from returns, for example when rotating between fixed income sectors. In addition, the sheer size of the global fixed income market means that holding individual bonds and sectors also means keeping track of a large, complex and constantly evolving market,” he says.

“Against the unprecedented levels of market uncertainty in recent years, an active strategic bond fund that can navigate this large and developing investment universe may provide a balance of diversification, risk and returns. A fund with a cautious view that accommodates market-specific risks, together with a nimble and reactive approach to market developments and opportunities, may be a wise stance as uncertainty continues.”

Jordan Sriharan, head of collectives research and senior portfolio manager at Thomas Miller, has a warning for investors who are looking at alternatives to strategic bonds.

He says: "It is clear that the array of strategies in the Strategic Bond sector is wide. At a very simple level some are focused on generating income, while others attempt to generate a total return utilising the full range of securities within fixed income, including derivatives.

"This means investors should view any allocation to a fund in this sector within the confines of their current portfolio and whether their chosen fund complements their current asset allocation."

He cautions: "This brings us to a final word of warning - beware of funds that attempt to benchmark themselves to the wider IA Strategic Bond universe. The vastly different risk-adjusted return profiles of constituents in this space results in shorter-term, quartile performance that can often be a simple reflection of the credit cycle." 

samantha.downes@ft.com