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

Investors looking for an indication that stock markets have turned the corner will seize eagerly on the figures in this month’s IMA Sector Performance tables, which show positive numbers for the month of March across virtually all equity sectors, compared with negative returns for most bond sectors – and the Guaranteed/Capital Protected sector and Money Market sectors as well.

However, most fund managers are refusing to get carried away with what they see as a temporary bear market rally, arguing that it will be some time before we see a sustained bull run.

Risk taking rewarded
What does seem clear is that it is those investors who have been prepared to take risks who have been rewarded. In its review of fund performance for the first quarter of 2009, Morningstar’s director of fund research for Europe and Asia, Christopher Traulsen, observed that ‘Fund performance in the first quarter showed that investors are finding pockets of value among higher-risk areas, and that defensives may be waning.’

In particular, the report highlighted that high-yield bond funds, small-cap equity funds and Russia and Latin America funds all fared better than the norm during the first three months of the year. Traulsen explains that ‘The first quarter of 2009 was a difficult one, but there were some marked shifts from trends in 2008. Most notably, investors with a measured appetite for risk did well. Energy and mining shares firmed up, leading to strong performance from key emerging markets such as Russia and Latin America.’

He adds, ‘In contrast, funds overweight in financials and in property suffered. Defensive areas in favour in 2008 lagged, and funds that favoured healthcare, utilities and more defensive consumer issues tended to fall behind their peers this quarter.’

Traulsen also points out that ‘In the UK, the best news is found among small- and mid-cap funds. The UK Small-Cap Equity category lost just 1.98 per cent over the quarter, faring better than all other developed European equity categories except for Norway Equity. UK Mid-Cap Equity came in with a 6.7 per cent loss but this compares with UK Large-Cap Growth Equity losing 8.01 per cent UK Large-Cap Value Equity losing 10.8 per cent.’

And he concludes that ‘Away from equities, some good performances were found in the bond fund market. Strong performances from low-grade investment bonds buoyed results, with the Morningstar High-Yield categories easily beating other bond categories in their respective currencies. Government bonds also performed relatively well, and short-duration funds continued to outpace their longer peers. However, funds focused on investment-grade corporate issues lagged, held back by their high exposures to financials.’

Picking the right fund
However, for those investors still focused on the corporate bond sector as a source of relatively secure income in these troubled times, the research department at Hargreaves Lansdown has some sobering thoughts. The most recent review of the constituents of its Wealth 150 fund selection revealed that there is a difference of 57 per cent between the best- and worst-performing corporate bond funds over the last five years.

Nevertheless, Hargreaves Lansdown’s head of research, Mark Dampier asserts that ‘Despite speculation that the corporate bond market could be entering a bubble, we do not believe this is the case. Trading activity has only just picked up as liquidity has improved on the back of the government’s stimulus plans. The market, therefore, has significant scope to move upwards from current levels.

The latest addition to the Wealth 150 list is, in fact, a corporate bond fund. Dampier explains, ‘The M&G Strategic Corporate Bond Fund is managed by one of the industry’s top bond managers, Richard Woolnough, whose M&G Optimal Income Fund already features on the Wealth 150. He has made the right calls to stay away from the banks during their most troubled times. Our quantitative analysis also shows his credit selection has also been exceptional over time. The fund also differs from others in its peers with flexibility to deviate away from its core investment grade mandate.’

Still seeking income
Meanwhile, on the equity income side of the equation, HL’s list no longer includes Rathbone Income. ‘The fund has struggled enormously during the market turmoil and our analysis shows that the manager, Carl Stick’s stock picking has been poor,’ says Dampier. ‘A further hindrance has been the fund’s exposure to smaller companies, which have underperformed in this difficult climate.’

He accepts that ‘Carl Stick has been making changes to the portfolio and has concentrated the fund from over 80 stocks to currently 53. The initial signs are encouraging, however, until we conduct further analysis into the fund, we believe the fund should stay on ‘hold’ for the time being.’

Meanwhile the recent run of fund launches shows few signs of drying up, although most of the new entrants seem to fall into one of two main groups – overseas equity income portfolios (Allianz RCM European Equity Income, Standard Life European Equity Income) or absolute return funds (Argonaut European Absolute Return, SVM UK Absolute Alpha, HSBC World Selection, BlackRock European Absolute Alpha, Gartmore UK Absolute Return). This is perhaps unsurprising since both are relatively new areas of fund management endeavour and both have undoubted attractions to battered investors looking for a combination of yield and relative security.

Value in property
An increasingly attractive source of the former is to be found in some of the better-managed closed-end commercial property funds. This is an asset class which has been universally shunned by investors during the downturn, with the result that the more solid propositions have been marked down as severely as the basket cases.

Mike Taylor, investment manager at Midas Capital argues that ‘Rising yields in good commercial properties are beginning to make property an attractive investment opportunity again. Nobody questions any more whether property was overvalued two years ago. It undoubtedly was. However, while commercial property values have fallen significantly, the share prices attached to them have fallen much further. Even if underlying property values fell by a further 50 per cent from here, many investment companies would still sit on big discounts to their net asset values.’

He adds, ‘Despite capital values having fallen, the dividend payments have often remained the same, so yields have increased over 2008, meaning investors are now paid to take the opportunities offered in property. Only time will tell whether prices revert to the mean and jump towards the NAV or whether the NAV will fall to the share price. I would expect somewhere in between, but given that many commercial property companies offer an attractive dividend, investors are being paid to take this opportunity. If you find a property company that has little debt, a good rent roll, solid tenants and which pays a reasonable yield, you can afford to tuck it away.’

Taylor says, ‘One example held in the Midas funds is Puma Brandenburg Ltd. They operate in Germany and while the share price has been disappointing to date, they have a good management team with good business credentials. Puma is a mixed portfolio of residential and commercial investments. The last published NAV was at a discount of 68 per cent. They have ?99 million of cash on their balance sheet and last year paid a dividend of 2.6p, a yield of 6.1 per cent.’

He adds, ‘You are being paid to wait for the discount to narrow and, in addition, the German property market never reached anywhere near the highs of the UK market, and while the rewards will not immediately be apparent, investors will reap their reward when the time and the market allows.’

Still seeking sanctuary
But while yield is relatively easily identified, security is much more elusive. Referring to the table of sector performance again, you will notice that the embryonic Absolute Return sector still posted negative numbers for one month, six months and one year, albeit that the one-year fall was significantly less than the riskier equity sectors, even though the absolute return funds didn’t participate in the rally of the past few weeks.

Of course, the objective of these funds is to deliver positive absolute returns over the long term, and discovering just how long the ‘long term’ is in this context will be most informative.

As Ben Wallace, manager of the new Gartmore UK Absolute Return Fund, observed at his fund’s launch ‘it is important to have an adaptable strategy, particularly in these markets. We are seeing a great deal of volatility and we expect this to provide us with attractive entry points to build longer term strategic positions and good tactical opportunities.’

The key question, however, is which managers will make the most of those opportunities. With markets likely to remain volatile for some time to come, there will be nowhere for active fund managers to hide.