April 10, 2009 1:10 pm

An unhappy marriage of bonds and equities

Corporate bond funds have been recommended as a good buy for risk-averse private investors for the past six months, but advisers are now warning that some non-specialist funds do not offer good value.

Distribution funds, which combine equities and bonds, are coming under particular fire from financial advisers. These funds aim to hedge investment risk, working on the principle that equity and bond markets do not move in tandem.

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However, the events of last year, which saw almost all asset classes fall, have disproved that claim, at least temporarily. So, while conceding that 2008 was historically unusual, advisers are expressing doubts about the merits of distribution funds.

“Distribution funds have not delivered,” says Adrian Lowcock at Bestinvest. “In the past year, the different levels of risk in each bond have become more apparent and have required higher levels of expertise that can be better accessed through bond-only managers.”

Distribution funds are also viewed, by some, as being too limited in their investment scope. “I wonder why you would want to limit yourself to just two asset classes right now, when you’ve got much more at your fingertips,” says Mark Dampier at Hargreaves Lansdown.

Distribution funds have been sold to investors as a way of gaining exposure to both equities and bonds without having to worry about the allocation to each. Some still see a value in this.

Jim Stride, head of UK equities at Axa Investment Managers, argues that there is “plenty of room” for this approach in the market. “The investment performance of all our distribution funds over the long term has been perfectly acceptable for the kind of risk profile we’ve been taking,” he says. “They have been targeted at cautious investors. Whether they have been ecstatic or not is one thing, but they have been satisfied.”

Axa’s Defensive Distribution fund, which is only sold through financial advisers, has been attracting large inflows in recent months, according to Stride – rising from £60m last October to £105m this month.

Dampier suggests that distribution funds are popular with advisers because they are similar to with-profits funds, offering clients and advisers a “conservative base” for asset allocation.

He believes that some of them make sense – when the managers of both components of the fund are experts. For example, he likes Invesco Perpetual’s distribution fund for this reason – one of the managers it uses is the highly-rated income fund manager, Neil Woodford.

But Dampier suggests that, in general, investors could do the asset allocation themselves – or in conjunction with a financial adviser – particularly as the allocation to equities and bonds within managed distribution funds tends to be “fairly static”.

Investors who prefer to rely on a fund manager would be better off with a multi-asset fund, rather than a distribution fund, according to many financial advisers. Multi-asset funds are not dissimilar to distribution funds, but contain more asset classes, including property and often hedge funds or private equity.

Lowcock believes that the key distinction is the specialism of the managers. “Multi-asset is quite a big step away from distribution funds,” he argues. He points out that multi-asset fund managers tend to buy separate funds to gain exposure to the different asset classes, whereas distribution funds usually have an equity manager and an income manager working within the same fund.

And there are dangers in not using specialist managers – particularly given the recent surge of interest in corporate bond investment, says Lowcock. “The understanding and skills and expertise needed to manage bond portfolios has gone sky high,” he argues. “While you might have a bond manager in a distribution fund, you still have to have the conversation about how much to hold in bonds and how much to hold in equities. The distribution funds have been caught out in the wrong part of the bond market, and the bonds haven’t protected on the downside the way they should have done.”

Lowcock also says investors should look at where their distribution fund is invested. Some, for example, hold index-linked gilts while others have exposure to high-yield bonds.

DIY multi-asset investing cuts charges

One argument for buying a distribution fund is that it can provide exposure to equities and bonds while keeping costs down. Buying separate equity and bond funds, instead, would mean paying two sets of annual management charges, of around 1.5 per cent – rather than just the one fee.

“Distribution funds are a way for investors to keep costs down to get exposure to both asset classes and minimise risk,” admits Adrian Lowcock at Bestinvest. He points out that the Invesco Perpetual Distribution fund charges 1.38 per cent a year, while equity funds charge around 1.5 per cent.

However, Lowcock believes that investors can achieve better results by choosing separate funds themselves.

“By combining a good equity income fund, such as Invesco Perpetual Income, with a good hybrid bond fund such as Henderson Strategic Bond, you can replicate a distribution fund very effectively and beat the performance,” he argues.

Stuart Fowler, managing director of advisory firm No Monkey Business, also believes that a portfolio can be optimised using two asset classes: equities and index-linked gilts. He determines the allocation to each using a computer model – based on projections of equity market outcomes, derived from historical data – and implements it using four index tracker funds and individual index-linked gilts.

“You only need UK, Europe excluding UK, Japan and US trackers,” he says. “We use exchange traded funds (ETFs) and Legal & General trackers. But you have to control total exposure by dilution – that’s where index- linked gilts come in.”

Most equity ETFs have an annual charge of between 0.3 and 0.4 per cent, and Fowler buys duration matched index-linked gilts through Selftrade for £12.50 a trade. “It’s a cheap way to hold a portfolio,” he says.

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