Keiron Root's monthly review of developments in the investment fund markets

In recent months, these pages have been largely given over to consideration of which funds, if any, are making money in these troubled times. Perhaps unsurprisingly, there has been an increasing focus on yield, since this generally represents actual cash paid out to investors. 

There are some pretty impressive yields to be had from open-ended investment funds at the moment, and not just from bond portfolios either. The top 20 highest-yielding funds include a fair proportion of equity portfolios as well.

Choosing with care
The key question, of course, is how sustainable these yields are. Logic and experience tell you that, with base rates at one per cent, a doubledigit yield is both attention grabbing and suspicious.

Are these funds sitting on such exalted yields because their capital values have collapsed? Can the corporate bond fund returns be sustained if, as the markets are predicting, there is a dramatic increase in defaults? If companies slash their dividends, which again seems inevitable, surely equity income funds must do likewise?

The message from those who advise on such matters seems to be ‘pick your income funds with care’, while understanding the reasons for these attractive yields. Brian Dennehy, head of IFA firm Dennehy Weller, points out that ‘The trend to higher payouts by bond funds will surprise many, as base rates are still falling, but it shouldn’t do. Over the past year bond prices have fallen. This has created the opportunity for funds enjoying strong inflows to reinvest this cash into individual holdings with much higher yields.’

He adds, ‘The near-zero interest rate environment makes the yields on corporate bond funds enticing, but vigilance is required both on income payouts and the capital performance. The performance gap between the vast majority of mainstream bond funds across the whole of 2007 was just five per cent. The current ten per cent gap between the best and worst over just one month shows why investors must take extreme care, understand the risks and not be seduced by enticing yields. The yields are this high because the risks are vastly higher than in 2007.

‘For example, New Star Sterling Bond, and equivalent funds from Gartmore and Old Mutual, have suffered from their exposure to banks. If these were equity funds, we would say “sell”. But the dynamics in the bond market, and the scale of value, is very different, and we would want to hold funds like this for their potential, but only within a spread of such funds.’

Attractive yields
Justin Oliver, co-manager of the Collins Stewart Select Funds multi-manager range, argues that ‘Last year, the focus of investors was clearly centred on capital preservation and return of capital. This year, we believe income generation will become a key concern for clients.’

He argues in favour of sticking with the better-quality corporate bond funds. ‘We can see particular attractions in the investmentgrade corporate bond space at present. A look at the US, for example, reveals that investment-grade corporate debt has an average yield of over 7.5 per cent, suggesting that a bleak economic and investment outlook has already been more than discounted.’

Oliver adds, ‘Our favoured ways of accessing this asset class are via the M&G Corporate Bond Fund and Invesco Sterling Bond Fund. Richard Woolnough at M&G has read the economic situation fantastically well and has benefited from his aversion to financial issues. While selective purchases in this area were made towards the end of 2008, this fund remains underweight this segment of the market and has instead focused on exceptionally attractive industrials, which are offering yields at unprecedented levels.’

Oliver admits that ‘Invesco Sterling Bond Fund has maintained a higher weighting to financials and consequently has endured a more difficult year.However, we have high regard for this fixed income team and would argue that a combination of these two funds provides an appealing blend in terms of offering a diversified exposure to the corporate bond space.’

Equity income comeback
And he reports, ‘Equity income funds are also returning to our radar screen. After a difficult 18-month period for the majority of managers in the sector, relative returns generally started to improve in the final few months of last year. Our preferred method investing in this asset class is via the Artemis Income Fund and the Invesco Perpetual Income Fund.’

Oliver explains, ‘Admittedly, the latter is not a true income fund by official definition,however it has many of the attributes shared by this class and provides an attractive income flow. The manager, Neil Woodford, is one of the most highly rated UK equity managers. He has outperformed the UK stock market in each of the last eight years and his long-term investment horizon and quality focus should continue to serve him well in what is likely to remain a challenging investment environment in 2009.’

He adds, ‘The Artemis Income fund is co-managed by Adrian Frost and Adrian Gosden. The fund has consistently ranked highly against its peers, and Gosden and Frost have navigated the past 12 months extremely well. The managers also have the added ability to invest a portion of the fund in European equities, when similar stock or sector opportunities are not available in the UK stock market.We believe that this flexibility will prove to be extremely beneficial in 2009, as valuations and earnings expectations for European stocks are low on a relative basis and investors are very underweight the region.’

Bond addition
Interestingly, Skandia’s multi-manager team has recently added Invesco Perpetual Corporate Bond to its roster. Ryan Hughes, senior fund manager at Skandia Investment Group, explains that ‘The decision to include the Invesco Perpetual Corporate Bond was due to Paul Causer and Paul Read’s combined wealth of experience and exemplary track records in the fixed interest sphere. Their experience, coupled with their robust investment objectives, makes this fund an ideal addition to Skandia UK Fixed Interest Blend.’

For the record, Skandia’s current UK Fixed Interest line-up is Royal London Corporate Bond (16.7 per cent), M Optimal Income (14 per cent), Aegon Sterling Corporate Bond (16.7 per cent), Old Mutual Corporate Bond (16.7 per cent), Fidelity Moneybuilder Income (16.7 per cent), JP Morgan High Yield Bond Mandate (2.5 per cent) and Invesco Perpetual Corporate Bond 16.7 (per cent).

Hughes points out that ‘Causer and Read are highly experienced and well-regarded managers in their sector.Together they have over 40 years’ fund management experience and have highly successful track records.We have selected Causer and Read’s fund based on the vast experience they have, which will be of particular use in the current economic environment, and the complementary style their fund will bring to our UK Fixed Interest Blend fund.’

Going down
Also, adviser Chelsea Financial Services has recently released its latest ‘Relegation Zone’ this fund an ideal addition to Skandia UK Fixed Interest Blend.’ For the record, Skandia’s current UK Fixed Interest line-up is Royal London Corporate Bond (16.7 per cent), M Optimal Income (14 per cent), Aegon Sterling Corporate Bond (16.7 per cent), Old Mutual Corporate Bond (16.7 per cent), Fidelity Moneybuilder Income (16.7 per cent), JP Morgan High Yield Bond Mandate (2.5 per cent) and table, highlighting those funds that have consistently underperformed their peers.

A total of 75 funds make it into this list, accounting for more than £11 billion of assets. To make the list, a fund has to have spent at least three consecutive discrete years in the bottom half of its sector.

Aberdeen’s European funds figure prominently in this list. Chelsea argues that, while the group’s approach (developed by its Singapore-based head of equities Hugh Young) has proved highly successful in managed Far Eastern equities, translating this to European funds has been less convincing.

It points out that two of Aberdeen’s European funds have entered its relegation list and adds that ‘The group now says it will apply the same approach to the Credit Suisse UK and European funds it recently acquired. Will these funds follow Aberdeen’s European funds into relegation abyss? You are never too good to go down.’