Fund managers hit the spot

The sub-prime fallout in the US has highlighted the seriousness with which financial markets are over-leveraged and overstretched.

And while the search for income has enticed many retail investors into highly-levered products, the risks inherent in those investments are now becoming apparent.

This bout of market dislocation is not over, but the extent to which it is a temporary adjustment or a more fundamental change is as yet unclear. It is a tricky time for financial planners and investors.

So much of the global growth in the past five years has come from the US, and so much of the US economy’s growth has come from the housing market.

Housing revaluation

Now with the housing market going through a period of revaluation and contraction it is expected that will spill over to consumer spending.

One thing for sure is volatility will continue while this plays out.

But in addition to uncertainty, something else emerges, this environment presents a good buying opportunity for investors in defensive assets who are equipped to differentiate the good from the bad and the ugly.

Having a market that differentiates between winners and losers rather than just a trending market means there is more opportunity to add value.

Caution returns

Certainly it is still a time to be selective and cautious about adding some of the possibly impaired assets to portfolios, but good active managers will be able to see the wood for the trees.

Manager selection, and good qualitative research on managers, is once again a key decision for planners and investors.

But choosing the right manager is only part of the relationship, and being able to communicate openly on an ongoing basis with the manager is also relevant. This extends beyond general client relationship to a frank and open discussion about portfolio holdings.

Transparency is king

Investors have learned some valuable lessons during the past few months of market volatility, and transparency is probably the key.

Anyone invested in a hedge fund has learned the hard way about liquidity and leverage, but it should now become a basic line of questioning for any investor or planner.

Just as portfolio holdings are disclosed by equities managers and most defensive asset managers, investors should be asking fixed income managers what they are investing in, what risks they are taking and what leverage they have in their portfolios.

It is crucial that investors know about and understand the underlying assets in which the fund is investing.

While generalisations tend to overemphasise, many investment academics believe the dynamic, new methods of adding alpha are coming from the fixed income space.

The main reason for this is because fixed income analysts are used to using financial instruments, and the available tools to them in this millennium have usurped anything used in the past.

Sexy, not stodgy

So what this means, is the fixed income asset class, with its oft-thought of conservatism is actually bringing sexy back.

Overwhelmingly one of the key roles of fixed income is defensive, but it is now possible to do that with an alpha-adding function as well.

In the past three years developments in the credit derivatives market have transformed the credit market from a relatively illiquid long-only market, to a much more liquid long-short market. This provides an array of different opportunities in terms of optimising carry and the ability to tactically adjust positions more quickly and efficiently.

In an environment where longer maturity bonds have a more bearish outlook, an active manager that can quickly and efficiently go long-short in credit markets should be able to add value.

At last there is some good news for fixed interest investors and after a period of poor absolute returns, it is likely both absolute returns and returns relative to equities will be stronger.

As in any asset class there are some specific areas of opportunity for investors within the fixed income space.

While diversification in a portfolio is still king, so as to be insulated against the risk of single-event catastrophes causing stress, the opportunities to add value within fixed income are in areas not yet reacting to longer-term growth, areas that are under researched such as local emerging markets and the currencies of those markets.

In addition, a skewing of client portfolios towards more cash-related benchmarks is a significantly positive starting point to invest; to generate 7 to 8 per cent returns in Australia from moderately risky assets is compelling.

Financial planners should be taking a long-term view in setting client portfolios, and getting the asset allocation decision correct is widely recognised as generating up to 90 per cent of return for investors. A key part of that asset allocation decision is the role of fixed income.

Fixed income as an asset class is the most traditional of all defensive assets, and inherently it’s transparent, liquid and has reliable returns.

This can be demonstrated by movements of the general bond index to the unfavourable investment conditions facing the sector in the past few years.

From June 2004 to June 2006 the US Federal Reserve Bank raised rates 17 times, but throughout that whole period the Lehman Global Aggregate Bond Index never ventured into negative territory on an annualised basis, with the worst one-year rolling return recorded in June 2006 at 1.23 per cent.

This is because the tail risk, or the risk of a really bad result (or a negative return), is not as high for fixed interest investments as it is for other asset classes.

Reliability

This reliability is one of the asset classes’ most enduring qualities, and together with its transparency and liquidity provides a good basis for which to invest.

More importantly, the range of funds that are now available from reputable fixed income managers has significantly increased the potential for an adviser to add value to a client’s portfolio.

Being able to target areas such as local emerging markets, good quality high yield, and actively managed funds that offer significant alpha over cash, should help investors achieve better absolute returns from their defensive assets over coming years.

Given the recent market turmoil, it seems likely that inflation and interest rates will be drifting up in the next three to five years, and investors that have reaped the benefits of risky assets would do well to get some protection in the form of active fixed interest.

Peter Dorrian is senior vice-president at Pimco .