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Is it the end of the bond barbell strategy?

P3TOP TECH TIPS: TESLA, ORACLE & BLUE PRISM

P4UK EQUITY INCOME

SECTOR MUST EVOLVE

P6ALTERNATIVES TO

BROKEN DURATION

As fixed income sectors become increasingly correlated, T. Rowe Price's Arif Husain questions the future of the bond barbell strategy (page 2)

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Arif HusainT. Rowe Price

ond market sectors are becoming increasingly correlated—and this is bad

news for fixed income investors seeking to manage risk through sector diversification.

Using monthly return correlations over a 3yr horizon, the correlation between treasuries and US IG credit was less than 0.5 in March 2008 and below 0.1 in March 2011, before rising sharply in 2013. It currently stands at just under 0.9 – almost perfectly correlated.

The pattern is the same in Europe, where the correlation between government bonds and IG credit also spiked in the autumn of 2013 before settling at its current level of just over 0.8. Correlation levels between bonds and currencies are also rising.

The primary reason for rising correlations has been QE, which has tightened spreads to such an extent the quality differentiation has been all but lost.

One approach under threat is the barbell, which typically divides a portfolio into two concentrated buckets of lower and higher-risk assets.

For a barbell to succeed, the two sides need to maintain low

correlation. When two sides are highly correlated – as is the case today – it ceases to be an effective way of managing risk and becomes highly risky.

A more flexible approach is likely to deliver better results – one that considers the full fixed income spectrum, in particular regions and countries less correlated to major markets.

One way to accomplish this is to divide holdings into three core components: core stable, return-seeking and defensive positions.

Core stable positions are those with small but steady income or gain potential and a low risk profile, and may include high-conviction positions in markets with a low fat-tail risk, as well as shorter-dated IG corporate products.

Return-seeking positions include high-conviction investments that have strong potential for capital gains or high income characteristics. They may include locally denominated EMD and select HY names.

Defensive positions, such as inflation-linked products and shorts in vulnerable currencies and sectors, will typically do well in a risk-averse environment.

The end of the bond barbell?

interflood Business Services (WBS) has

unveiled a new trading service set to revolutionise the ETF market in the UK. WBS' new service will offer clients trading and custody of ETFs on a fractional share basis from July 2016.

The automated fractional dealing proposition allows trading and holding of ETFs to four decimal places. The solution enables investors to fully invest into ETFs and ensures these instruments can be used effectively through model portfolios.

"Increasingly, both advisers and discretionary managers want to access the low costs and broad exposure that ETFs can provide – especially through model portfolios and on platforms," head of WBS Alex Kerry says.

"Through our automation and aggregation services, we have successfully reduced fees and improved access. The provision of fractional share dealing is removing a major barrier. We believe this a watershed moment.

"With increased understanding of the benefits ETFs can provide to clients and the trend for passives, there are now real signs the ETF market is poised to take off."

The new service will also undertake best execution requirements, transactional reporting and regulatory compliance. Custody of assets carry all CASS 7 permissions.

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Revolutionary fractional share service from WBS

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"When two sides are highly correlated – as is the case today – it ceases to be an effective way of managing risk and becomes highly risky"

Josh SpencerT. Rowe Price

Philip HarrisEdenTree

Colin McQueenSanlam FOUR

he macroeconomic landscape is challenging at

the moment, which is creating headwinds for companies to grow. This puts the impetus on trying to identify companies able to generate their own growth.

We see a number of companies with competitive advantages exploiting some of the mega trends in tech – such as cloud computing and other disruptive technologies.

e continue to have high conviction in the prospects

for Oracle, as it manages the migration of customers from license-based revenue to higher margin Software as a Service revenue.

Oracle is a stable company with a wide economic moat and good management, with free cash flow growing EPS at 15% per annum. It is currently being priced for zero to low growth.

e see a compelling opportunity in software

robots and robotic process automation, highlighted by one study showing 47% of US jobs could be automated within the next 10 years. The market leader is Blue Prism.

The investment case is that any repetitive task can be automated by rule-based processes. This presents huge cost and productivity savings. This

Tesla is one such name we are bullish on over the long term. We believe it is a revolutionary company addressing an enormous market with differentiated technology.

The consumer response to the recently-unveiled Model 3 has been fantastic, and we do not see any reason why Tesla cannot scale up production to meet the demand for its product and grow substantially in the coming years.

Even if Oracle's moat is slowly being eroded, it is too cheap.

The market is underestimating the stickiness of the customer base and the extent to which it has expanded its portfolio to encompass new technologies and new platforms, as well as the way it is managing its transition to the cloud. While it is in an earlier stage of its transition, we believe Oracle can repeat the same success as Microsoft.

recurring revenue stream licence fee model is the equivalent ‘wage’ of the software robot.

While there is limited patent protection, IBM's position as key partner underlines its technology is not easily replicable. The company maintains high gross margins. However, it is highly operationally geared with new customers and may be lossmaking while it grows rapidly. Earnings forecasts remain conservative.

"We believe Tesla is a revolutionary company addressing an enormous market with differentiated technology"

"While it is in an earlier stage of its transition, we believe Oracle can repeat the same success as Microsoft"

"The investment case is that any repetitive task can be automated by rule-based processes. This presents huge cost and productivity savings"

Top technology tips: Tesla, Oracle & Blue Prism

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Hugh YarrowEvenlode

he IA has launched a consultation into the criteria for UK Equity

Income sector membership. This follows the removal of several funds from the sector over the last few months – including Evenlode.

At Evenlode, we think an income fund works best when it delivers a balance between income today and income growth in the future. Both factors are important, and neither factor on its own is enough to generate a meaningful, sustainable and inflation-proofed income stream.

The IA has proposed three options in its consultation and we believe it should implement Option 3, removing the hard yield hurdle and replacing it with better and more consistent income delivery disclosure.

We currently quote Evenlode’s yield and dividend growth history on our factsheet. The IA’s idea to disclose the amount of income generated over 5yrs from a £100

investment is good, and we will add this to our factsheet.

A key advantage of this is it compares dividends produced to the initial investment value rather than current value. In this way, it does not 'punish' good performance. Over the 5yrs to February 29th, Evenlode produced a return of 44.7%, compared to 7.7% for the UK market. Ironically, if Evenlode had only performed in-line with the market, the fund's yield would have been 5.1% at end February, rather than the actual 3.8%.

Evenlode's natural home is the Equity Income sector. Whatever the result of the consultation, we expect to be reinstated in the future, once the current dividend anomalies wash through. In the meantime, we will continue to run Evenlode as we have done over the last six and a half years, and the provision of an attractive, sustainable and growing dividend stream remains a key long-term objective.

Equity Income sector must evolve

edington has been named the New Growth

Firm of the Last 20 Years at Financial News' prestigious 20th Anniversary Awards for Excellence in European Finance.

Since it was founded in 2006 by Dawid Konotey-Ahulu and Robert Gardner, Redington has earned widespread respect for having the confidence to stand out from the crowd.

It was among the early leaders in persuading pension funds to use derivatives to hedge against inflation and interest rate changes, while more recently it has made public its stance not to go down the fiduciary management route.

One judge said: "They have always had the client at the heart of their advice and they have not compromised at any stage in seeking to understand and come up with solutions for clients."

Despite enjoying considerable success in its first 10 years, the firm has refused to stand still. It launched a DC consulting business in 2015 in a bid to plug into what is set to be a fast-growing area of the UK market and in March 2016 promoted Mitesh Sheth to chief executive.

The judge added: "The firm has handled succession planning well – it has thought about the firm’s leadership for the next part of its journey."

* From Financial News

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Redington named New Growth Firm of Last 20 Years

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"An income fund works best when it delivers a balance between income today & income growth in the future"

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Neil WilliamsHermes

Joe AmatoNeuberger Berman

ur base-case remains Brexit can be avoided, given the unlikelihood of

wanting to risk weaker ties with our main trading partner and a diluted relationship with the US and other third-parties using the UK to access the Single Market.

Inertia could also play a part – as it did in 1975, when the UK survived its first in-out referendum. Turnout was 65%, with 67% voting 'in'. The turnout this June could be just as high, given emotively charged issues such as fiscal profligacy and immigration. Yet bookmaker predictions of a similar two-thirds/one-third vote look complacent against polls suggesting the 14-17% 'don't knows' will swing it on 23 June.

Should Brexit occur, getting

here is now clarity who will contest this year’s US presidential race.

Unfortunately, that may be the only thing clear in a campaign which has set new standards for unpredictability.

Donald Trump's candidacy was met with derision a year ago. Until his rivals quit, many were sure we were set for a contested convention. Why should the unpredictability stop now?

The distraction of a Hillary Clinton-Trump matchup could subdue sentiment over the next few months, but it may also direct market attention from the more important questions about what fiscal policies we should expect from this political transition.

At the moment, our concern is we will not get what would

to the next stage would be a long, drawn-out can of worms. Even a 'soft exit' – where trade relationships and freedom of movement are broadly maintained – would probably need several years just to end up close to square one. Greenland’s (EEC) departure in 1985 took three years. The UK – much larger and, after 43 years, more entwined in the European project – would need even longer.

Brexit would then risk a spillover into the remainder of the EU. A 'trap door' opened by the UK could well be approached by others. This questions the EU as a relative haven. In which case – given the second-round effects and the ECB’s ongoing QE – Brexit would probably benefit the US dollar and Japanese yen.

be helpful in supporting a fundamental earnings recovery – regardless of who wins.

Clinton's average 'strongly unfavorable' rating has been around 37%, Trump's has been a staggering 53%. No one else in recent history has alienated more than 32% of the electorate at this stage of a presidential campaign.

This matters because we believe when the president lacks a real mandate it reduces the likelihood of meaningful policy progress on a number of vital issues for corporates: corporate tax reform, infrastructure spending, and more rational regulatory and trade policy.

Fiscal gridlock and trade uncertainty could leave the Fed still doing all the heavy lifting to keep our recovery on track.

Brexit can be avoided

Presidential distraction

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Like Buffett, these investors are also bullish on Apple

"Brexit would risk a spillover into the remainder of the EU"

"Fiscal gridlock and trade uncertainty could leave the Fed doing the heavy lifting"

S hares in Apple received a boost this month on news

Warren Buffett's Berkshire Hathaway took a new $1bn in the company in Q1.

EdenTree's Thomas Fitzgerald says Apple shares have faced recent pressure on fears over future iPhone growth, which is 66% of its sales. However, like Buffett, Fitzgerald is bullish on the tech giant's long-term prospects.

"Beyond these near-term concerns, the anticipated launch of iPhone 7 will create fresh opportunity to take further market share," he says.

"There is also still a large upgrade opportunity within its existing installed base – with only 40% of iPhone users upgraded to the new generation 6 or 6S models."

Hermes' Geir Lode adds: "There is work to be done in product transitioning in the US and Europe, but if you look at the quality of its product lines versus the competition and the enormous cash pile, we believe Apple remains in a very strong market position."

But T. Rowe Price's Josh Spencer is less optimistic: "Like many others, we find the company and its products appealing. But there are signs the smartphone industry is starting to mature and Apple is trying to reinvent itself.

"We are currently seeing more compelling opportunities to generate returns in the tech sector in areas such as cloud computing."

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Claus VormNordea

s a consequence of the historically low yields offered by developed

market government bonds, the traditional role of duration as a natural counterbalance to equity beta is not efficiently working for multi-asset managers today.

The low yields in renowned 'safe haven' government bond markets – as evidenced by a 10yr German bund yield of just above zero – additionally bring sizeable drawdown risks.

Many DGF funds struggled during the volatility this year because managers failed to address this new fixed income paradigm and cannot identify truly defensive (anti-beta) assets. Many managers look to de-risk and limit drawdowns either by buying expensive protection, or try to time the market. This approach leads to inconsistency and proved to be insufficient for most funds during the drawdown and subsequent rebound in Q1.

Instead of the notoriously difficult task of repeatedly making accurate macro calls, multi-asset managers need to find alternative solutions to fill the role traditional duration can no longer fully serve.

One substitute to government bonds in protecting downside is quality low-risk equities. Stocks with robust fundamentals and more resilient earnings tend to behave better than overall global equities during negative periods – as witnessed at the beginning of this year. For example, stocks such as Verizon and Infosys rose

by 7% in January, a month where global equity markets plunged more than 10%.

In addition, a currency overlay based on Purchasing Power Parity principles also displays anti-beta behaviour. We select highly-liquid G10 pair trades on two main criteria. Firstly, trades are analysed for correlations with S&P and HY indices, to ensure the positions can offer protection during stressed periods. Each pair trade also has to be undervalued on PPP principles, to ensure the diversification benefits will persist. For example, a long JPY/ short GBP pair trade was able to return more than 10% during the volatile Q1 this year.

Despite the alternatives, duration can still play a role, but investors must find premiums offering attractive risk/reward characteristics, as well as decent protection. Which high-quality

Alternatives to broken duration

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government bonds offer the best protection and the most attractive expected return? Considering where yields are, we believe the answer is the UK and US. Both gilts and treasuries offer a higher buffer, as well as a higher coupon to compensate mild increases in yields.

Another overlooked area is covered bonds, which offer similar safety as sovereigns, but with an attractive yield pick-up.

Finally, with traditional assets displaying volatility this year, many investors may be tempted to seek alternative assets. However, real assets – areas such as infrastructure, private equity and real estate – often suffer from illiquidity and are artificially lowly-correlated to traditional betas. Efficient diversification is not about the number of assets, but rather a select number of truly uncorrelated positions.

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"Many funds struggled during the volatility this year because managers failed to address this new fixed income paradigm"