Thursday 21 May 2015 by Alen Golubovic Opinion

How to beat the fund managers at their own game

We question whether an increased weighting in cash is an appropriate course of action for individual investors

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With the increase in volatility in bond equity and markets, some fund managers are reducing their exposure to bonds and equities and increasing their portfolio allocation to cash. However, individual investors don’t necessarily have the same goals or restrictions as fund managers, and are probably less focussed on periodic returns beating a benchmark.

It’s always worth seeing how fund managers allocate their investment portfolio and respond to market conditions. Broadly speaking, we are seeing some fund managers re-weight their portfolios from fixed income and equities and increase their holdings in cash. Last week it was reported that UBS Global Asset Management (UBS) has opted for cash and reduced its exposure to bonds and equities in its funds because of concerns that markets are not adequately prepared for a probable increase in volatility. UBS has also almost halved its allocations to bonds and introduced a substantial cash allocation that makes up 40% of its key multi-asset fund. These are the most significant changes made to its funds since the last Greek crisis in 2011.
 

Now, while fund managers’ primary responsibility is to deliver the best returns to their investors given a particular investment mandate, demonstrating good year-on-year historical performance is a key selling point for their business. For a fund manager, a bad year of performance could signal an increase in redemptions and loss of funds under management which flows through to their own bottom line. For example, lower management fees. And when it comes to conservative funds, it’s even more important not to show a poor performance in any given year. So when the first signs of potential risk emerge in bond markets, they will look to preserve positive returns by increasing a portfolio allocation into cash. In addition, large fund managers have the flexibility to move in and out of positions with relative efficiency to take advantage of shorter term opportunities, because of their scale.

These investment decisions by large fund managers are part of the broader reason why bond yields have increased over the past month. Bond yields move in the opposite direction to bond prices and so yields increase when bonds are sold off. The chart below shows how Australian and US government bond yields have spiked upwards since the beginning of April. The 10 year Australian government bond yield is up 62 basis points while the equivalent US yield has risen by 39 basis points.
 
 Australian and US 10 year government bond yields
Source: Bloomberg, FIIG Securities. Most recent bond yields are as at 21 May.
 

The question is whether you follow what some of the fund managers are doing by selling bonds and increasing your exposure to cash. This may not necessarily be the right course of action for an individual investor. Individual investors may not be as focussed on periodic returns in the way a fund manager is, or they may be less focussed on day-to-day volatility in their investments and more interested in the total return they expect to earn over a holding period.

In today’s low rate environment, the investment thesis around holding money in cash has changed. No longer can it be expected to generate a reasonable return over inflation, and so over time, funds parked in cash earning 2% are likely to be eroded in real terms. We are seeing the Australian cash rate at an all-time low and investors need to consider how much of their investment portfolio they want allocated to cash in such a low rate environment.

Earlier this week, we provided a list of low risk, investment grade Australian corporate bonds which investors can buy to earn 2%-3% over the cash rate (please see the link in related articles below). For what is a relatively low degree of risk, an investor can earn more than double the cash rate and stay ahead of inflation.

Bond prices will fluctuate day to day with movements in underlying bond yields and credit spreads. These swings have been larger in recent months as large parcels of bonds have been sold off. While bond prices will fluctuate over time, remember there is a contractual obligation from the issuer to pay out the full principal at maturity. In other words, by investing in a bond, you have the certainty of knowing what your capital payoff will be if the bond is held to maturity, and the risk that you take is the credit risk of the bond issuer meeting its contractual payment obligations.

So, if you are not concerned about day to day volatility in bond prices, now is a very good time to consider whether you can afford to sit on cash earning little to nothing in real terms, or whether some of that parked cash is better off earning an additional 2% to 3% in another very low risk option: Australian investment grade corporate bonds. 

Please speak with your FIIG representative if you are interested in investing in Australian dollar investment grade corporate bonds.

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