With a deteriorating bond backdrop – whether you buy the ‘end of 30-year bull market’ argument or not – investors need new routes into this asset class. One option is Ignis Absolute Return Government Bond fund, which seeks to beat cash on a rolling 12-month basis irrespective of market conditions, while taking limited risk.
Since launch in April 2011, the fund has grown to more than £1.7bn and has already proved its mettle amid tough markets, producing positive numbers during the summer’s taper tantrum for example. In the 32 full months since coming to market, it has registered a loss in just seven and this has only exceeded 1% (1.03% in September 2012) on one occasion. The fund currently shows a 6.79% annualised return. At the helm of the fund is the group’s 12-strong rates team, led by Russ Oxley and also including Ignis chief economist Stuart Thomson. Chris Fellingham joined the group as chief executive in 2010 and was keen to introduce the rates methodology – available in the institutional space since 2005 – to a wider audience.
Helen Farrow, a product specialist on the team, says: “Chris has a strong long/short background, setting up George Soros’ London office for example, and has brought that to bear at Ignis. Our view is that an absolute return approach gives fund managers the maximum flexibility to perform regardless of what happens in markets, which is clearly important given the current backdrop.” Separating alpha and beta is vital to the Ignis approach, particularly given the chequered – albeit short – history for absolute return funds in the UK. “Many so-called absolute return bond funds that launched in the mid-2000s were actually full of beta and while they did well in 2006 and 2007, several lost serious money in 2008 when the market fell,” adds Farrow. “In contrast, our approach is about finding genuine alpha – that is not to say beta is all bad and we do take some directional views, but market returns in isolation are unlikely to produce consistent absolute performance.”
Managing downside risk is also critical to the process and limiting volatility, combined with the solid annualised return, has led to a strong information ratio. Finally, the team looks to invest using high-quality, liquid instruments, which makes government bonds a good fit for absolute return investing according to Farrow. “We are operating in very liquid developed government bond markets, which means trading is cheap and efficient and we can run a nimble, active portfolio,” she adds.
Forward thinking
As a government bond fund, the process begins with in-depth macro work, led by Thomson, to identify key themes. This underpins everything that follows, with the team seeking the best ways to express these views, largely through directional calls on interest rates, relative value positions between different forward interest rates or foreign exchange exposure. Focusing on forward rates is central to the philosophy and Farrow says these provide a better way of delivering outperformance from government bonds than more traditional approaches.
“The traditional process focuses on duration, measuring how much the price of a bond will change for a given change in its interest rate,” she adds. “Duration implicitly assumes the discount yield curve can only move in parallel, but this conceals a huge amount of information. In contrast, forward rates are interest rates for specific periods in the future. By looking at government bonds of different maturities it is possible to work out the expected rate for one year in, say, three or five years’ time.” This means forward rates reveal more and better information compared to headline rates, allowing the team to express its views more accurately and target specific opportunities. Rather than simply buying 10-year debt for example, Farrow says the best opportunities are currently in the middle of the curve so the fund owns what she calls five-year/five-year exposure.
“Forward rates also bring diversification benefits, as they tend to move relatively independently of each other,” she adds. “Correlation is lower than between many asset classes, which is one reason we were able to withstand the panic selling over summer when [Federal Reserve chairman Ben] Bernanke first announced the possibility of QE tapering. Many funds holding some emerging market debt for example felt they were sufficiently diversified but struggled when everything fell together.”
In simple terms, if the team expects the forward rate to fall, they will hold government bonds or related instruments that provide a long position in that rate; if they expect rates to rise, they go short. This forward rate focus marks the fund out from peers and the engine for this work is the team’s proprietary ClearCurve software, initially designing by Oxley alongside Lehman Brothers back in 2005. ClearCurve calculates forward curves and the team overlays its macro views onto this, with the software highlighting which rates are cheap and expensive and signalling where long or short exposure could add value.
Apart from short, medium and long-dated forward rates, the team has various other ways to express its views, with FX, inflation, asset swaps and volatility trades making seven sources of alpha in total. These all have different drivers, again improving diversification across the portfolio. With FX for example, this is limited to 25% of portfolio risk and Farrow says positions are typically where currency provides a better way of expressing a macro view than bonds. “In Japan for example, we have had the right macro view and predicted much of the Abenomics monetary policy. Although central bank purchases of bonds are positive, we also felt policies could lead to higher inflation, which would be negative for bonds, so an FX position was a better way to play the theme, selling the yen versus US dollars.” Overall, the fund will include around five macro views at any one time, expressed via 15 to 20 positions. On top of that, the team tactically trades around these positions. Farrow says while they might be constructive on the outlook for a particular region in the medium term for example, the managers will hedge out downside risk if a short-term event causes negative sentiment.
Looking at positioning since launch, early exposure was based on a rates being ‘lower for longer’ macro view, expressed via long positions in forwards rates across the US, UK and Germany.
Shifting positions
Farrow also highlights volatility trading as a positive strategy through 2012, with the team predicting a drop off as policy measures in Europe reduced the potential of extreme macro events. “Elsewhere, we have also been short of inflation in markets like the UK, seeing little pressure for rising prices and inflation expectations as too high,” she adds. “Consensus suggested QE would prove inflationary but we never bought into that.”
Moving forward, Farrow says the announcement of QE3 – or QE infinity – in September 2012 was a clear turning point for markets, pushing real interest rates to negative levels in the US. “This basically encouraged people to spend and this has helped get growth back on a sustainable footing. For us, the improving macro picture in the UK and US means rates will eventually start to rise so we shifted our position to reflect that,” she adds. “Our short in five-year/five-year forward rates meant we were well positioned for the selloff over the summer, when markets were caught off guard by Bernanke’s tapering announcement. Following strong performance, we reversed the position ahead of the Fed’s September decision to delay tapering.”
Elsewhere, the team has taken profits on the short inflation position in the UK and US, moving long of short-dated inflation after break-even levels went too low. The short yen has been positive for returns although after a strong period of performance, the managers have taken this off for now. “Following the team’s recent meetings in Japan, we believe there is limited appetite from the central bank for significant new measures in the short term, although further reforms are expected in the medium term,” adds Farrow.
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