At a time of cost pressures on portfolios and elevated valuations across a number of asset classes, the question of how best to gain core market exposure is proving a tricky nut to crack.
The world’s largest asset manager, BlackRock, sent a message earlier this year by changing its line-up of strategies in the equity space. It converted a raft of active funds into quantitative-based vehicles, cut fees, and said the products would be marketed as core holdings to fund selectors.
While BlackRock, and undoubtedly many others, see these inexpensive quantitative strategies or passives as the future for core equity exposure, the trajectory is less clear for fixed income products – which are typically cheaper but are arguably plagued by more serious valuation concerns.
Emma Morgan, portfolio manager at Morningstar, says: “There is probably a place for something more factor-based, but we’re not seeing it yet. In most cases, the implementation of the portfolios would be much more challenging than [choosing either] pure passive or active.”
Quilter Cheviot head of fixed income Richard Carter adds that such smart beta products remain in their infancy. “I am yet to be convinced it’s something I would have as a core strategy,” he says.
“But I wouldn’t be surprised if a few more people tried to push those.”
There are barriers to firms adopting a more factor-based approach. As bonds are traded over-the-counter rather than on an open exchange, quantitative or algorithm-based strategies are more difficult to design. Conventional fixed income passives are also open to criticism.
The popularity of fixed income ETFs is growing, with Morningstar figures showing European bond ETFs racked up €14.6bn (£13.1bn) of net inflows in the first half of 2017. But reservations remain.
On a simplistic level, products that track fixed income indices provide greater exposure to the most indebted companies. This may not be of huge concern in the government or investment-grade space, but further up the risk spectrum passive management is perhaps less ideal.
In light of these problems, asset managers have sought different ways to attract fund buyer interest as demand for simpler, cheaper core holdings increases.
Some have pointed to the example of ‘buy-and-maintain’ strategies, which proved popular among institutional investors and have started gaining traction among discretionary fund managers. The aim of such funds is to actively select bonds but let them run until maturity, re-investing coupons and minimising transaction costs. These strategies can provide exposure to a range of credits and duration with, in theory, minimal volatility and lower fees.
Axa Investment Managers has begun marketing its buy-and-maintain fund to adviser and discretionary clients. Rob Bailey, the firm’s head of UK wholesale distribution, says the fund is being marketed as a core fixed income holding.
The strategy – which has an ongoing charge of 0.17 per cent – was previously labelled ‘smart beta’ for institutional clients, owing to its off-benchmark credit selection but overall passive management. Mr Bailey says its relatively low fee comes from an ability to bring annual turnover down to 6 per cent compared with 20 per cent for a basic fixed income ETF.
However, as with many strategies that have come over from the institutional world, concerns over liquidity management are at the fore. Given bonds are held to maturity, fund flows could disrupt other investors. Mr Bailey says the firm manages this by having more than 200 holdings, while inflows and outflows are managed alongside the reinvestment of coupons.
But Ms Morgan says institutions provide a more “stable pool of capital” than individual investors, implying that buy-and-maintain strategies may not work as well were they to fan out to wholesale investors in general.
Quilter’s Mr Carter says he has studied the strategies, but adds fund buyers must take their own benchmark considerations into account before overhauling core fixed income holdings.
“Our benchmark for UK fixed income is 100 per cent gilts. So if we’re allocating to corporate bonds, that’s an off-benchmark bet; it would never be core for us. But I can see why that might become a core holding for those who have corporate bond benchmarks,” Mr Carter says.
The need for bonds to be defensive and dependable may dictate what type of exposure lies at the core of fixed income. For some, government debt has as much downside risk as equities in the current environment. “We might see a kind of barbell [approach] going forward where you have core, ‘slightly core’ and then more active where the managers differentiate themselves,” Ms Morgan predicts.
As this example suggests, there may prove no single solution to the problem. Cutting costs while retaining a low-risk approach may ultimately only be achievable in a piecemeal way.
