Libby Newman, Senior Investment Analyst responsible for this sector commented, “Traditional income funds include the more conventional Australian, global and diversified fixed interest products that are generally managed with reference to a widely accepted fixed interest market benchmark such as the UBS Composite Bond Index.”

“On the other hand, alternative income funds are typically absolute return in nature, managed with the aim of generating returns that exceed cash or a cash proxy, such as the UBS Bank Bill Index, by an arbitrary margin.”

In the traditional income space, four funds attained Lonsec’s highest rating, Highly Recommended. These were the PIMCO EQT Global Bond Fund, the PIMCO EQT Wholesale Australian Bond Fund, the PIMCO EQT Wholesale Diversified Fixed Interest Fund and the Schroder Fixed Income Fund.

Two alternative income funds were rated Highly Recommended – CFS Global Credit Income Fund and Macquarie Income Opportunities Fund.

Index Funds and ETFs vs. benchmark agnostics

One of the trends noted in the report is the continued popularity of index funds as a low cost alternative to active management.

“In Lonsec’s opinion, given the dislocations and upheaval in global financial markets since the GFC, that active managers are better placed to add value than they have for a number of years,” said Newman.

One of the discussion points in the industry has been that while fixed income indices make good benchmarks, they don’t necessarily make good investment strategies. The reasons for this include:

• Some fixed income indices exclude large parts of the universe including floating rate notes, inflation linked securities and sub-investment grade issues which can have performance and diversification benefits to a portfolio
• Construction of fixed income indices tends to reflect the market capitalisation of fixed rate investment grade sectors – i.e. issuers with the greatest debt  have the highest index weights
• In the US, fixed income benchmarks currently have an increased weighting to government exposure at a time when interest rates are at 60 year lows and the risk of rising interest rates (and falling bond prices) is arguably the highest it’s been in decades.

“Lonsec has observed the emergence of Funds which are constructed without regard – or with less regard – to benchmarks in a portfolio construction sense and instead seek to deliver positive returns in all market environments,” said Newman.

“Faced with the prospect of rising bond yields, these managers can significantly increase the weighting to cash or floating rate securities which are likely to perform better than fixed rate bonds in a rising yield environment.”

These products include:

• Vianova Strategic Fixed Income, which invests in 100% investment grade securities, with an Australian focus and relatively low exposure to credit
• Kapstream Absolute Return Income, which retains a minimum 85% in investment grade quality credits and seeks to add value via a number of trades in global interest rate markets, largely via derivatives
• Perennial Tactical Income, which aims to be a one stop shop for cash, floating rate and fixed interest exposure, potentially relieving advisers from what is essentially a duration decision, allocating between cash and Australian bonds.

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Libby Newman, Senior Investment Analyst, “While there are broad general characteristics common to each group, no two funds are alike, even within the same category,” said Newman.

“This makes an ‘apples for apples’ comparison virtually impossible, even within sub-sectors.”

Unlike Traditional Income sector products which are typically managed with reference to a widely accepted fixed interest market benchmark, such as the UBS Composite Bond Index, Alternative Income sector products tend to be managed with the aim of generating returns that exceed ‘cash’ (or a cash proxy such as the UBS Bank Bill Index) by an arbitrary return – in other words, absolute return in nature. Collectively, they may potentially invest in a much wider set of assets.

Products in the Alternative Income (High) sector are expected to exhibit and maintain exposures to securities that are either specialised and/or have a higher degree of credit risk. “Alternative Income (High) products are generally expected to exhibit a higher level of volatility and therefore are not for all investors,” observed Newman.

Bank deposits – the new black?

“The introduction of the Commonwealth Government guarantee in October 2008 skewed the risk reward landscape offering investors access to almost risk free returns from banks covered by the guarantee” said Newman.

The Government also offered banks and State Government issuers the use of a Government Guarantee to access wholesale funding in the capital markets (which is what many of the Alternative Funds invest in). The guarantee on wholesale debt issuance ceased in March 2010, though many of the securities issued under the program can now be found in various Alternative Income and Australian Fixed Interest funds.

“Essentially, this – coupled with relatively high term deposit rates – has resulted in investors depositing with the banks directly rather than in a diversified fund structure,” said Newman.

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