Fixed income funds creating new uncertainties for investors

Fixed income funds in Europe increasingly are adopting trading strategies that are poorly understood by most retail investors and are creating wider disparities of performance, according to Standard & Poor’s Fund Services, the leading provider of qualitative fund management research and ratings.

Fixed income funds are traditionally viewed by investors as one of the most predictable and undifferentiated of fund sectors, with limited diversity of performance. However, in the last six months, they have started to make important changes in the way they trade, taking advantage of the new freedoms provided by UCITS III and mimicking some of the techniques employed by institutional fixed income funds.

Changes include widening their use of derivatives; introducing increasingly differentiated sources of alpha (risk-adjusted) returns, into their processes; and making small, uncorrelated (off-benchmark) bets, either outright, for example by taking local currency emerging market positions, or through relative value long/short strategies.

“Holders of a eurozone fixed income fund, for instance, could well find the manager has taken a position on the spread between 10-year US/Japanese interest rates via interest rate swaps, or to have bought US high yield bonds using credit default swaps,” said Kate Hollis, funds analyst at Standard & Poor’s. “Not surprisingly, many investors are left in the dark.”

Standard & Poor’s said investors may be confused by a fund’s emphasis on risk-adjusted returns relative to an index, rather than on absolute returns. At the same time, the new trading practices make it more likely that fund returns will diverge to a greater extent in future.

“There is an increasing likelihood that a fund’s returns can be affected by events in a completely different market in a way investors in the base asset class would not normally expect,” Ms Hollis noted. “A larger toolbox might help enhance returns, but it also increases the potential for things to go wrong. More alpha sources do not necessarily lead to better performance.”

Standard & Poor’s also noted that as uncorrelated trades became more widespread, there was a danger that they could become more correlated at times of market stress. At the same time, some of the derivative instruments being used by fixed income funds – such as credit default swaps – have a limited trading history and may prove illiquid in a severe market downturn.

Standard & Poor’s believes that given the additional tools that UCITS III presents to fund managers, investors need greater information and insight to ensure that a fund’s profile is appropriate their personal objectives and risk tolerance. “It is not always easy to divine from factsheets, the prospectus and the annual report precisely what new alpha sources and techniques a fund is resorting to.” Ms Hollis said.