In an environment marked by persistent inflation pressures, geopolitical uncertainty and fiscal imbalances, managers in the Unconstrained Bonds and Specialised Income sectors are increasingly allocating to securitised debt and high-yield credit. These sectors are offering comparatively more attractive risk‑return profiles than traditional fixed income benchmarks, which remain concentrated in low‑yielding segments.

Traditional bond indices capture only a narrow slice of the global fixed income universe and exclude areas such as high‑yield credit, non‑agency mortgage‑backed securities and leveraged loans. As a result, benchmark‑constrained strategies have become increasingly exposed to heavily indebted issuers offering limited upside.

By contrast, unconstrained and specialised income strategies are typically managed against a cash benchmark and have the flexibility to adjust duration, rotate between sectors, and deploy capital across a wider opportunity set. This flexibility has become an advantage amid heightened volatility.

Securitised debt has emerged as a key focus, particularly agency and non‑agency mortgage‑backed securities, asset‑backed securities and commercial mortgage‑backed securities. Agency MBS provide implicit government backing with a yield premium to investment‑grade credit, while non‑agency MBS and ABS offer higher yields backed by diversified consumer loan pools. These characteristics have made them attractive where consumer fundamentals and underwriting standards remain sound.

Private asset‑backed securities have also gained attention. Lending to asset‑backed warehouse facilities offers a yield premium relative to public markets, reflecting higher complexity and lower liquidity. These arrangements require careful structuring and deep credit due diligence, particularly around enforcement rights and lender hierarchy, to ensure appropriate compensation for risk.

High‑yield credit has also re‑entered portfolios as managers respond selectively to improved issuer fundamentals and a reduced presence of weaker credits following the expansion of private debt markets. Allocations have generally been tactical and risk‑aware, with managers avoiding deteriorating sectors and using hedging tools to manage downside risk.

As fixed income markets continue to evolve, flexibility and active management are becoming more central to portfolio outcomes. Unconstrained Bonds and Specialised Income strategies are increasingly positioned to navigate valuation constraints while seeking income, diversification and resilience in uncertain conditions.

By Michael Elsworth, Manager, Fixed Income

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Michael Elsworth

Lonsec Research Releases Alternatives Sector Review

According to Lonsec Research’s recently released Alternatives Sector Review, alternative funds have significantly underperformed both equity and bond benchmarks over the last five years, with fees and a poor macro environment weighing on returns. But despite this underperformance, alternatives are still seen by investors as a valuable addition to their portfolios, particularly in terms of providing diversification benefit, with client interest ticking upwards over the past two years.

“There are a number of possible explanations for the underperformance of hedge funds as a sector,” said Michael Elsworth, General Manager Alternatives and Specialised Research. “One is that the sector and individual funds are becoming too big. Another is that hedge funds are finding it increasingly difficult to deliver alpha in the current macro environment, which has been exacerbated by ultra-low interest rates and quantitative easing, and which has produced lower dispersion between securities and higher correlation between the major asset classes.”

Recent underperformance was reflected in Lonsec Research’s Alternative fund ratings, which were negatively skewed, with a higher number of ‘Investment Grade’ ratings than ‘Highly Recommended’ ratings. In the 12 months to 31 August 2016, total returns across the broader Alternatives asset class ranged from -33.0% to 8.5%, while the median fund return was modest 2.8%.

“It’s certainly not the recent performance of alternatives that’s driving demand,” said Elsworth. “Essentially, investors are assessing the risk and return trade-offs offered by equities and bonds, and they don’t particularly like the look of either at current levels. Yields have been driven to record lows, while share markets have been priced ever higher, and investors are keen to find something that is not correlated with these major asset classes.”
Fund flows are steady but some funds are getting the lion’s share

Lonsec Research has seen client interest in alternative strategies pick up over the last two years, although this renewed interest has not yet translated into a material level of overall fund inflows. Based on current levels of interest, the sector may experience an increase in fund inflow, although it may not be spread equally across the sector.

“We have seen an overall increase in fund flow within Lonsec’s Australian advisor channels,” said Elsworth. “However, it is worth noting that only a handful of funds have seen significant inflows. As has been the case since the GFC, the big winners in terms of fund flows and market share still appear to be well established hedge fund managers with strong reputations and established brand names. Of the funds covered by Lonsec Research, recent inflows have predominantly headed in the direction of managed futures strategies, which have demonstrated strong long-term track records.”

According to Lonsec Research, the shift in appetite for alternative funds predominantly reflects concerns around the macro environment, and in particular the fear that correlations between traditional asset class returns may converge. This have led financial advisors and investors to consider other strategies with the ability to drive returns, particularly those which have historically displayed – or have the potential to display – low correlation of returns to bonds and equities.

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Continued growth of SMA platforms in coming years: Lonsec

Lonsec has undertaken new research into Australia’s  separately managed account (SMA) platforms in recognition of the increasingly important role SMAs play in offering investors heightened transparency and greater control over their investments.

In response to strong interest from its clients, Lonsec conducted what it believes to be the first comprehensive research into SMA platforms in Australia.

SMAs are normally non-discretionary in nature, in that the operator of the platform executes changes to model portfolios, but does not make the investment decision. By contrast, Individual Managed Accounts (IMAs) are normally run on a discretionary basis. Providers must be licenced as Managed Discretionary Account (MDA) operators.

Lonsec assigned ‘Approved’ ratings to each of the five SMA platforms it reviewed. The five SMA operators collectively account for over $2 billion in assets under management and over half of the total SMA market (defined as funds tracking model portfolios).

According to Michael Elsworth, Lonsec’s General Manager – Specialised Research, the SMA market falls into two broad categories: the large banks surveyed tend to view their SMA platforms as adjuncts to their wrap administration platforms, generally offering a narrower range of model portfolios. Meanwhile, specialist financial services groups, with strong orientation towards technology, are competing with the established players, in part by offering a more extensive range of model portfolios.

Both larger banks and specialist financial services companies committed to growing their SMA businesses over the next two years.

“In essence, usage of SMAs will likely grow thanks to both greater demand from advisory groups and other investors and to new and competitive solutions that are delivered by banks and other companies that are strategically committed to SMAs,” Mr Elsworth said.

Lonsec took a two-pronged approach to the research, reviewing investment managers and their model portfolios while also looking at the administrative services provided by the platforms and the underlying technology.

In assessing the investment managers, Lonsec looked at the communication between the managers and the operators of the SMA platforms. Lonsec also considered the suitability of the model portfolios for use in SMAs.

A key finding was that the SMA operators are not all alike in the ways in which they communicate with model portfolio managers: nor are they alike in the ways in which they communicate with advisers and investors.

“This new research defines the language and key concepts underlying SMAs in Australia and we expect the research to grow and become a sector in its own right over coming years,” Mr Elsworth concluded.

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Michael Elsworth, General Manager – Specialised Research, Lonsec, said that the current subdued global growth prospects meant the search for yield is strong and ETF issuers have sought to benefit from this trend. He cautions that investors need to have a strong understanding of what they are really investing in.

“High divided ETFs are designed to track indices that measure a filtered universe of stocks that hopefully provide above market average dividends,” Mr Elsworth said.

“It is essential for investors to understand that ETFs are not all the same and even high yield ETFs have different asset classes or sectors underpinning the investment. It is important to appreciate the different rules governing the construction of each index.”

Lonsec compared the governing rules of high yield ETFs from iShares, Russell, SPDR and Vanguard and found the portfolio of stocks held by each high dividend ETF at a specific point in time varied significantly, even though they are all considered to be in the same category.

Mr Elsworth observed:

• The Russell, SPDR and Vanguard funds all had in excess of 40% exposure to the Financials ex-Property Trusts sector.
• None of the ETFs had meaningful exposure to the mining sector given its traditional volatility and/or limited dividend history.
• The top 10 holdings of iShares were noticeably different to the other three ETFs, with by far the least exposure to financials.
• The iShares sector cap of 20% is lower than the other high dividend ETFs which promotes greater diversification and a skew to smaller cap stocks.

“The comparison illustrates there are subtle but important differences between ETFs, and the nature of each fund’s underlying investment – such as equities, debt or hybrid securities – means returns have the potential to be vastly different,” Mr Elsworth said.

Investors requiring greater certainty from income distributions could consider sacrificing some yield and investing in potentially less volatile fixed income funds.”

The findings come from the inaugural Lonsec ETF Journal, which was released today. The journal provides updates on recent changes to the Australian ETF market, Lonsec’s conclusions from recent ETFs sub-sector reviews (equity based, fixed income based, and alternative strategies based), as well as topical issues that advisers and investors need to be wary of when considering ETF investment options.

Lonsec’s research process involves two different approaches: one for actively managed funds and one for passively managed funds such as ETFs. As the ETF market in Australia continues to experience significant growth, the Lonsec ETF Journal will provide advisers and investors with consistent and reliable information in relation to a range of important and contemporary issues.

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David Erdonmez has been appointed General Manager – Managed Funds Research and will join Lonsec in early October. In this role, David will be responsible for managing the team of analysts undertaking core managed funds research, ensuring the continued high quality of Lonsec’s research material and ongoing enhancement of the research process.

Amanda Gillespie, Chief Executive of Lonsec’s research business, commented, “David’s strong technical background, knowledge of investment products and respect within the industry will make him a valuable addition to Lonsec’s research team.”

David joins Lonsec from Standard & Poor’s Fund Services where he was Head of Fixed Income Managed Funds Research. As well managing the fixed income research team, he had full accountability for all fixed income stakeholder relationships, client communication and analytical output.

Lonsec’s coverage of investment products is categorised into two sub-groups – core managed fund products – such as equity and fixed income funds – and specialised products, spanning structured products, direct assets, ETFs and SMAs.

As a result of this, Michael Elsworth’s role has been expanded to General Manager – Specialised Research.

“Michael has been responsible for undertaking and overseeing research across these specialised products for a number of years. As investor demand for research on specialised products has increased, Lonsec has boosted the number of analysts covering them,” said Gillespie.

“This expansion of Michael’s role will position Lonsec to continue delivering high quality research across these evolving sectors,” said Gillespie.

Other notable changes within Lonsec’s research team include Paul Pavlidis, who has been promoted to Chief Operating Officer, with overall responsibility for business management.

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Michael Elsworth, Research Manager, commented, “This change is based on Lonsec’s belief that index funds now have a critical mass in most asset classes.”

“We believe that different criteria are needed to ensure ratings fully capture the characteristics of index funds.”

Although using different criteria, Lonsec will continue to focus primarily on qualitative factors, which is the key focus of its research across all asset classes.

“There will continue to be a split of 80% qualitative and 20% quantitative factors, which is consistent with the research approach for active funds,” said Elsworth.

“The rating scale used for actively managed funds will be adopted for rating index funds – Highly Recommended, Recommended, Investment Grade and so on. The addition of superscript Index alerts advisers to the fact that different criteria have been applied to determine the rating.”

“Once an index fund has passed Lonsec’s initial research screens, funds will be assessed by conducting a peer relative assessment of people and resources, investment process, liquidity and performance,” continued Elsworth.

4 June 2012

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