Libby Newman

Lonsec releases Multi-Asset Sector Review

A rapid expansion in the number of multi-asset funds and products is generating a new wave of competition, as fund managers rush to position themselves in the burgeoning multi-asset sector.

According to leading research house Lonsec, the number and variety of multi-asset products have grown immensely over the past two years, with 2015 seeing an influx of new entrants, as well as fund managers seeking to build on existing offerings.

Lonsec’s Multi-Asset Sector Review, released today, includes 34 new additions to Lonsec’s multi-asset fund coverage in 2015, which follows an increase of 31 funds in the year prior. This growth is providing investors and financial decision makers with a growing range of investment products, driven by the recent popularity of the multi-asset approach as well as innovations that allow multi-asset funds to leverage their scale and broaden access for investors.

“We are seeing a lot of development in the multi-asset space at the moment” said Libby Newman, General Manager of Fixed Income and Multi-Asset at Lonsec. “Some of this growth is attributable to more widespread use of ‘white label’ products, which allow advisers to gain access to products and services typically tailored to wholesale and small institutional clients. We are also seeing a resurgence in Investment Bonds, which are popular among investors seeking alternative ways to tax-effectively save.”

According to Ms Newman, the rise in the number of multi-asset products is the natural result of continued growth in funds under management and ever-present competitive pressures.

“With the flow of funds, changing regulatory environment and central bank intervention distorting asset prices, we have seen a proliferation of new investment products,” said Ms Newman. “In the multi-asset space, solid interest in real return strategies has seen global players enter the Australian market in quick succession. Many have established track records in real return investing in the US and UK, and are keen to test their wares against Australian CPI+ benchmarks.”

Overcoming the low-growth problem

Superannuation funds (61–80% growth assets) were the top-performing sub-sector in 2015, with Lonsec’s peer group returning 6.9% on average, supported by allocations to the outperforming property sector. Low-cost funds were the laggards, returning 3.9% on average and impacted by higher allocations to the Australian equity sector, although over a seven-year period they have produced superior returns net of fees (see table below).

As multi-asset investing heads into an upswing, the dual challenges of low growth and high levels of uncertainty continue to plague markets. Global institutions have continually revised their growth outlook downwards over the past three years, with the IMF in April downgrading its growth estimate for 2016 from 3.4% to 3.2%.

“Investors are still looking for incontrovertible signs that the global economy is improving,” said Ms Newman. “We have not been seeing the sort of growth we expected two or three years ago. The main challenge for multi-asset funds is how they respond to this environment.”

Multi-asset strategies are seen by many investors as an effective way of generating solid risk-adjusted returns, with performance driven predominantly by asset class diversification. However, in periods of systemically low growth, even multi-asset managers may be limited in what they can achieve.

“The shift towards diversification and low correlation has not been the return driver many fund managers had hoped for,” said Ms Newman. “With increased volatility and uncertainty, many managers have tried to diversify away from traditional asset classes and towards alternatives such as hedge funds, which were generally flat in 2015. So while multi-asset investing is certainly effective, it is not immune from the low-growth challenge. Managers are now looking further afield at ways to deliver their objectives. This may include lowering their return targets, expanding the opportunity set, widening asset allocation ranges, or moving up the risk curve.”

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Libby Newman

For unconstrained bond funds, 2015 was a year of reckoning, with many failing to meet their benchmarks. Lonsec’s Fixed Interest Sector Review, which tracks the performance of individual fixed interest funds, shows that the unconstrained sector produced disappointing results in 2015, reflecting a broader struggle for returns as volatility and bearish sentiment seized markets in the second half of the year.

Unconstrained funds have become increasingly popular, with an explosion in growth over the past two years. Given the attention unconstrained funds have drawn from investors, Lonsec established a new unconstrained sector in its fixed interest coverage, providing unique insights into a diverse and often complex area.

“Unconstrained investing involves moving away from fixed interest benchmarks, giving fund managers more flexibility to use different strategies to seek returns and manage risk,” said Lonsec General Manager for Income and Multi Asset, Libby Newman. “This is especially relevant given uncertainty around interest rate movements. With mixed signals globally, investors can feel confident knowing that the manager has the flexibility to respond to market trends.”

“However, as Lonsec’s research shows, unconstrained funds faced a tough year in 2015. While an unconstrained approach does provide flexibility, there is no guarantee that you will generate good returns regardless of which way the market moves.”

Unconstrained funds missed their benchmarks in 2015

While unconstrained funds generally performed well in 2014, risk adjusted returns in 2015 were significantly lower. The overall return after fees for the unconstrained sector in 2015 was 2.05%, significantly below the AusBond Bank Bill Index return of 2.33% (see table below).

Low returns reflected poor performance across the market. According to Lonsec’s research, most fixed interest sectors were down on 2014, with 2015 annual returns well below three-year averages, with the exception of the broad-based ETF category. Multi Asset Income struggled in 2015, but was still one of the best fund types, returning an average of 3.9%, with five out of seven rated funds outperforming the index. Global Fixed Interest, one of the top performing categories in 2014, was one of the worst performing in 2015, returning only 1.3%.

Lifting the lid on unconstrained bond funds

“Our research shows that many unconstrained bond funds are highly correlated with equity and high yield, reflecting the additional credit risk inherent in some unconstrained strategies,” said Newman. “This means that when equities are underperforming, unconstrained funds may tend to underperform as well, and that’s what we’ve seen in 2015.”

While unconstrained fund returns were mostly positively correlated with aggregate bond indices, they also show significant correlation with high yield and equity benchmarks. “Ideally, unconstrained bond funds will meet their return and risk targets while avoiding high correlations with high yield and equity,” said Newman. “The purpose of unconstrained investing is not simply to provide a direct substitute for these higher risk alternatives. Investors are looking for more flexibility, not necessarily more risk.”

“What we found is that a lot of these funds were quite highly correlated with these higher risk sectors in 2015. Given that a lot of these funds are new on the block, it’s hard to get a good idea of performance. But 2015 was certainly an interesting test case.”

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Bond market returns over time have less to do with capital gains or losses, they are largely driven by income.

Despite predictions that the end of the bond market is nigh, Lonsec’s income sector has expanded considerably over the past few years.

This growth has been driven by increased demand for financial products that pay regular distributions, the launch of the bond ETF market and an evolution of absolute return focused strategies that tend to have more flexibility to adjust duration and therefore sensitivity to rising bond yields and capital losses.

Lonsec Senior Investment Analyst, Libby Newman, said, “One of the most frequently asked financial adviser questions of the past few years has been ‘should I be getting out of fixed interest?’”

“As yields plummeted, driven by the extraordinary monetary policies adopted by global central banks, the number of articles calling the end of the bond market rose”.

Unlike equities, bonds provide some certainty in terms of their returns – a regular coupon and return of principal at maturity, assuming there is no default.  However, it is still possible for income funds to provide negative returns due to market value fluctuations.

For example, an investor may experience a loss if they are forced to sell when:

• Interest rates (and expectations of future interest rates) go up sharply – and the prices on bonds commensurately fall
• Credit spreads deteriorate (widen).

“However, it is important to remember that bond market returns over time have less to do with capital gains or losses, they are largely driven by income – regular interest payments and reinvestment income earned when cash flows are put back to work in the market,” said Newman.

“Indeed many periods of negative or soft returns are followed by strong years because the coupon interest and bond maturities can now be invested at higher rates.”

“The yield on an Australian Commonwealth Government 10 year bond has risen about 1.0% compared to this time last year, and the capital loss (if yields rise the price of the bond falls) pretty much cancels out the income earned over the year.”

However, there is much more to the debt securities market than Australian and US government 10 year bonds. Over the same period, credit spreads (the premium for investing in a company rather than with a government), have narrowed, so corporate bonds have been able to deliver a positive return, even with the headwind of rising yields.  Then there are floating rate bonds, which are also less impacted by rising yields than their fixed rate counterparts.

“So you can see that Funds that can tap in to the full spectrum can still deliver positive returns and an income stream,” said Newman.

So, should you get out of bonds?

“Well, you’d expect me to say no. Australians own fewer bonds than investors in other parts of the world and want steady income in retirement, so I am pleased to see Commonwealth Government Bonds increasingly visible and available for retail investors to trade. But you definitely need to understand what your bond fund can do before you invest in this type of financial product. ”

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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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