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Sense of gilt

Gilts may have had a popular year in 2008 but it turns out that they have done better for longer than just that. According to the latest Barclays Capital Gilt & Equity study, they have provided the best average annual rate of return for the past 20 years, returning 5.5 per cent a year compared with a 4.6 per cent gain from the FTSE All-Share and 3.5 per cent for cash.

According to the 54th edition of the Barclays study: “Gilts have rarely outperformed equities over such a long holding period. There have only been three previous occasions over the past 100 years when this has occurred – 1932, 1939 and 1940.”

Within the UK funds market, the performance of gilts in recent months has certainly been remarkable and the sector has grown in popularity on the back of being one of the only fund areas to have made gains in the difficult fourth quarter of 2008. But even over the longer term, gilt funds are looking far better value these days.

The best return by a gilt fund over the five years to January 26 is by the Allianz Pimco gilt yield fund, with a gain of 28.5 per cent. The average return for the whole sector over five years was 20.2 per cent, with the worst performer returning 9.9 per cent. But even the worst- performing gilt fund looks good compared with the five year-average cumulative return in the UK All companies sector of just 1.7 per cent. Even the popular UK equity income sector underperformed gilt funds over five years, with an average total return of 7.8 per cent.

Of course, the statistics do not show the full picture and there were investors who saw incredible returns in these equity sectors over five years – had they selected the right managers. Within the UK all companies sector, the top 10 best-performing funds all posted five-year returns exceeding 27 per cent and the top three posted gains of more than 40 per cent.

The top 10 in the UK equity income sector exceeded 23 per cent over five years, with the top three funds featuring returns of more than 50 per cent.

An obvious example of the benefits of active management within equity markets, still the volatility of returns in these sectors highlights the importance of fund selection. While not a single gilt portfolio lost money in the five-year period, 94 out of 240 UK all companies funds did, the weakest falling by 47.7 per cent.

Gilts may be the safe option in times of stockmarket volatility but they have certainly proved that while dull, they have done exactly what they are supposed to do – make returns. Unfortunately, not all funds in any other sector could make the same claim – not even the new swathe of absolute return funds that have been the trend in recent years.

Mark Lyttleton, manager of BlackRock’s UK absolute alpha fund, admits that achieving positive gains in the recent equity market conditions has been tough. In 2007 and early 2008, the manager soared to popularity on the back of his solid, positive performance in an absolute return fund. But when his fund turned negative in the autumn, it was disapp-ointing to many.

Lyttleton, speaking at the recent Fidelity FundsNetwork Forum, told delegates that he was too geared towards global growth and was caught out being too slow to turn his portfolio around during the mess that was the autumn.

After restructuring his holdings, which he admitted cost him a bit, he ended the year on a positive note.

Despite the fall, Lyttleton said he remains convinced that absolute return funds can hold up and are a useful alternative to advisers in this market – albeit, selectively.

He said: “There are more that will be launched. Some will be great but others won’t. Advisers should not ignore these and work to understand what the product can do. Some may give the whole sector a bad name but others will not.”

Another form of total return being heavily touted at the moment is the ability of equity income funds to provide the cushion of dividend returns in such a difficult market climate. Although not as steady as gilt portfolios in terms of annualised returns, reinvesting dividend income certainly proves its point over the long term.

The Barclays study, which looks at UK asset returns since 1899, shows that £100 invested in equities at the end of 1899 would be worth £139 today in real terms. But if dividends were reinvested gross over the same period, the portfolio would have grown to £17,571 in real terms. On the other hand, a gilt portfolio with £100 invested from 1899 through to today would provide a real return of just £365.

Considering the state of the UK economy, some believe that dividend growth for the coming years looks uncertain, with dividend growth already falling by 7.8 per cent as companies slashed shareholder payouts to save money. But there remains optimism that many companies will be able to keep up.

The dividend derivatives market is discounting extreme falls in dividends, as in a range of 50-60 per cent for European companies this year. But there has never been a period in UK history where dividends fell off that much, according to Tim Bond, head of global asset allocation at Barclays. He says the biggest drop in dividends was in 1919 and that was by some 48 per cent.

Even during a period of low dividend payments, reinvesting has stood investors in good stead, even though it underperforms gilts. Today’s value of £100 invested at the end of 1990 in equities would be worth £235 in real terms and £308 in gilts. Corporate bonds would have turned the £100 into £323 over the past 20 years and even index-linked gilts would have moved up to £213, just under the equity return.

Investors may feel that they are without choice at the moment but there are proven opportunities to be found in the form of income reinvestment, funds geared towards absolute returns or the steady gains of gilts. Fund selection though, as always, will remain vital for advisers in this period.

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