Since the arrival of Ucits III, a new breed of fund is enabling managers to short bonds and currencies within a regulated portfolio via the use of derivatives.Before Ucits III, the ability to sell short was open only to a select few such as hedge fund managers. Relaxing the rules means that groups such as Baring Asset Management, Ingenious Asset Management and UBS can create “directional” bond funds, which are portfolios that aim for positive returns in any market condition. In some ways, these funds are a stepping stone between hedge funds and long-only funds. Like hedge funds, they can sell short but, in contrast, they cannot gear and do not pose liquidity or transparency problems for investors. Debates within the industry about the end of the bull market for bonds has created uncertainty and many bond managers do not believe it is possible to ach-ieve returns as high as seen during the past decade. In this climate, an absolute-return strategy which takes away sensitivity to interest rates sounds ideal. However, this can also work in reverse so that a bond fund operating on an absolute-return basis would underperform long-only funds during a bull run. Ingenious Asset Management managing director Guy Bowles says managers are handicapped by the long-only strategy because they can only act if the market goes in one direction. He explains: “You cannot be a good manager without having a view on interest rates. Bond managers can sit in cash when they know interest rates are going to rise but that is all they can do. It is like they have one hand tied behind their backs.” Directional bond funds use futures to short markets and currencies when they think interest rates are increasing, which may lead advisers to wonder whether hedge fund experience is needed. Hedge fund experience may be useful because shorting differs from the more traditional buy and hold strategy of long-only funds but it does not appear to be essential. UBS head of UK sales Tristan Mawdsley says: “Managers do not need hedge fund experience. Many can use futures but have just not been allowed to do so in a regulated fund. “Bond futures are probably the most liquid asset class. We use them to contain and control risk while not diminishing the target return. They are heavily traded and the cost is negligible. It is often cheaper to buy bond futures rather than the bonds themselves.” Bowles says directional strategies are the future for bond funds and traditional long-only vehicles will gradually disappear but this will not happen quickly as many funds are not yet registered as Ucits III funds and so the less restrictive use of derivatives is not open to them. But Baring Asset Management marketing director Ian Pascal says long-only funds will always have their place. He stresses that greater interest in absolute returns should not be an excuse for providers to launch funds which claim to be different when in reality they are not. He says: “A lot of commentators, including ourselves, think traditional bond funds are at risk from capital erosion. Many companies are launching vehicles under Ucits III but we have to be clear about what is different between them. There has to be sound investment principles and a strong conviction. The company also needs to have a good reputation in the asset class it is promoting. If it has a strong brand name, it still needs to have credibility in fixed interest to launch a directional fund.” Bowles thinks there may be a lot of experiment in product design which means investors will have more choice. Mawdsley predicts that more bond fund managers will make use of the greater flexibility provided by Ucits III but this be will be a finite number as they need size and scale across a wide range of capabilities. “You are less likely to see small boutique managers launching these funds,” he says. However, New Star says it has no intention of offering a directional bond fund. It says it is an interesting concept but there is not enough demand for funds of this type. Marketing director Rob Page says: “What these funds do is protect against downside risk but they do not add value. We believe they will ultimately succeed because of the companies’ fixed-income capabilities, not because of the product construction under Ucits III.” The directional approach is still a new concept in the UK so it is understandable that some managers do not want to unleash it onto investors at this early stage. Page says he is concerned that these funds will confuse the average investor and believes they are more appropriate for the sophisticated end of the market. He says: “These funds are not rocket science but they are still pretty complex and beyond the large majority of private investors.” Mawdsley feels the onus is on the industry to explain. He says: “We are making a considerable effort to explain the fund to IFAs so they can pass it onto clients. We are doing a series of roadshows for the fund and the most consistent feedback is that people do understand it.”
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