Spread things around

Recent events in the market have highlighted the need to have a properly diversified portfolio and importantly, the need to be able to change your strategic asset allocation in a fast and efficient way.

The classic flight to quality approach driven by the contagion from the US sub-prime market leading to a significant withdrawal of liquidity from the market has not been bad news for all segments of the market.

In July and August combined, the FTSE All Stock Gilt index had risen 4.08pc and, despite headlines of a credit crunch, it is interesting to note that while corporate bonds did produce smaller returns they were still positive for the same period. To put this in context, the FTSE100 index fell by 4.61pc over the same period.

It is without doubt that by adding an allocation to fixed income in your fund you can improve your efficient frontier.

However, many investors now appreciate further diversification can occur within a fixed income allocation. Investors who traditionally hold just government bonds should consider whether it is appropriate to add inflation-linked bonds and, despite all the headlines, the notion of considering corporate bonds – the question is how to get the best exposure?

Why indexed?
All fund managers have a niche, something that sets them apart from the rest. Therefore, it is important to concentrate on this individual skill to extract as much value as possible. It is also important this skill is not wasted by making poor choices in the rest of your fund.

While correlations in the bonds universe can be higher than other asset classes, the traditional arguments for a well-balanced diversified portfolio of bonds still hold true. If the allocation to bonds is filled with a laddered portfolio of single name bonds, without rigorous research done, it is probable the true risk in the fund may not be known.

It is important for any investor allocating money to an active fixed income product to appreciate what the “fees breakeven” is. By that we mean the active return (alpha) must be at least the difference in the fees between the two styles of similar benchmarked products for it to be considered a sensible investment choice. You also need to be confident your active manager will continue to produce the returns in the future that made them look so compelling today.

If you have neither the time to research nor the general belief that the fees charged by some active funds are not providing value for money, the sensible approach is probably to invest in a low-cost, pooled-investment indexed fund.

Why ETFs?
As with the variety of active funds to choose from, there are also a variety of indexed pooled products.

One such product becoming increasingly important in the market are exchange traded funds. These are pooled index funds that trade on national stock exchanges in real time – it is important to note in the current markets the real benefit of this intra-day trading versus the traditional once-a-day trading with most mutual funds. This implies you can trade when you want to, not when your fund allows you to.

With a broad, comprehensive suite of ETF offerings currently available, it is possible to implement nearly all fixed income views. Funds available to track include: government bonds, inflation linked government bonds and high grade credit bonds.

These are available not only in the UK market but are available on the similar European and US markets. These low-cost vehicles open up new avenues to fund managers and plan sponsors, thus ensuring they can implement an optimal asset allocation depending on their view of the market.

One final point to realise on ETFs is the volume on exchanges does not drive its liquidity – this is a function of what the ETF invests in.

Therefore, in the case of an ETF tracking UK government bonds, the liquidity of the ETF is the same as the liquidity of the gilts market. All things considered, this makes it a very attractive proposition which should be investigated further.

Alex Claringbull is senior portfolio manager at iShares