Today’s investment environment warrants buying into funds that are shorting bonds, according to Schroders’ Marcus Brookes (pictured), who said the last regional “black hole” from an economic perspective – Europe – is finally starting to heal. 
As such, the head of multi-manager believes the inflationary environment has made longer-duration assets appear expensive.
“I think there is a lot of money in gilts sitting there because people are thinking that lower interest rates, lower inflation and lower growth is an outcome. That’s just started to get challenged now,” he said.
“It’s because you’ve seen Europe start to heal and Europe was the last black hole. Everybody realised there were various problems in the world and it started with the US.
“The US fixed its banks, then Europe decided to roll out austerity which made the situation worse. At this point, we didn’t know what was going on in emerging markets with the producers of oil suddenly going to budget deficits.”
Given the numerous economic problems being faced worldwide, Brookes said a lot of money was allocated to the US because its backdrop looked the most favourable. This meant US equities began outperforming stock markets located elsewhere.
“Whenever investors get bullish on something like the US they tend to say, ‘look, they have economic growth and inflation is picking up. But look at Europe, growth is still poor and unemployment in Spain is 25 per cent for the youth’,” he said.
“You have these competing factors of some inflation and growth in North America and a deflationary, stodgy growth outlook in Europe.
“Investors therefore became concerned that the forces of deflation would overwhelm the forces of inflation.”
As Europe has continued to reform itself, however, the manager said the last deflationary area is now generating enough inflation to do well.
“When everyone was hiding in bonds and willing to drive yields down, particularly with negative deposit rates at the ECB [European Central Bank], that made sense. You had emergency policy for emergency conditions,” Brookes continued.
Performance of indices in 2017
Source: FE Analytics
“The contention we have is there is no longer an emergency. So, for us, anyone that has decided that long duration is the place to be will probably really struggle.”
Given that Brookes’ £833m Schroder MM Diversity fund has to allocate roughly one-third of its portfolio to equities, one-third to fixed income or cash and one-third to alternatives, the manager is aiming to make money from bonds falling.
In the below article, Brooke’s discusses three multi-asset funds he is holding which are shorting government bonds and why he likes their management teams.
First up is William Littlewood’s £817m Artemis Strategic Assets fund, which aims to generate long-term capital gains while protecting on the downside in poor market conditions.
Over five years, it has returned 38.73 per cent compared to its FTSE All Share benchmark’s return of 58.8 per cent, but has done so with a lower annualised volatility and downside risk (which predicts a fund’s susceptibility to lose money during falling markets).
Brookes said: “[Littlewood’s] first bet was that the Japanese bond market couldn’t get any more crazy and of course it did, so it didn’t help his performance terribly. But we stuck with him.
“Then he was considering the fact that the peg between the Hong Kong dollar and the [US] dollar might have to break because of different levels of interest rates and different levels of inflation – I thought that was interesting.
“He also has some good quality equities alongside that and we were bullish on equities but we hated bonds – that’s a double tick.”
Aside from being 98.4 per cent short government bonds, Littlewood is also short the Japanese yen, sterling, offshore Chinese yuan and the euro. In terms of long positions, he holds 65 per cent of the overall portfolio in equities, almost two-thirds of which are based in the UK.
The manager also has a 15.8 per cent weighting in commodities, a majority of which is held in gold.
Artemis Strategic Assets has a clean ongoing charges figure (OCF) of 0.86 per cent.
Morgan Stanley Diversified Alpha Plus
Next up on Brookes’ list is the €1.2bn Luxembourg-domiciled Morgan Stanley Diversified Alpha Plus, which is headed up by Cyril Moulle-Berteaux.
The fund aims to provide an absolute return while managing risk through a highly-diversified multi-asset portfolio.
Performance of fund over 5yrs
Source: FE Analytics
Over five years, it has returned 9.2 per cent with a maximum drawdown – which measures the most money lost if bought and sold at the worst possible times – of 24.83 per cent and an annualised volatility of 9.18 per cent (the fund has no specified benchmark).
“These guys are on the same realm as us,” Brookes said. “They like Europe, they like Japan – not as much as we like Japan though – so they believe in the economic growth story and therefore they are starting to short assets like two-year government bonds in Germany.
“It has a negative yield so it’s a ‘positive carry’ thing; they essentially pay you to short their bonds.
“They also have a play on the Swedish krona – Sweden has been very concerned about its currency going up so it has kept its interest rates really low.
“That means there are some opportunities to utilise this and, when that moves, you can then utilise the bond market.”
Morgan Stanley Diversified Alpha Plus has a clean ongoing charge of 0.99 per cent.
Odey European Inc
The third and final fund on the list is Odey European Inc, which is a hedge fund domiciled in Cayman Islands.
Headed up by Crispin Odey, the £144m fund takes long and short positions in European bonds, equities, currencies and commodities.
Over five years, it has actually lost 40.91 per cent, suggesting it may not be best-suited to the more cautious investor. Over 10 years, however, it has achieved a positive return of 16.25 per cent.
Performance of fund vs sector over 5yrs
Source: FE Analytics
“In 2015, Crispin Odey was worried that China had a massive credit bubble that was going to burst and that it would inevitably have to devalue its currency and therefore anything China made, the price of that would decline. So, a deflationary pulse would be felt worldwide,” Brookes explained.
“That is a long bond environment. Halfway through last year, however, he changed his mind and said ‘actually, I’ve realised it is an inflationary problem with China’. So, he is now shorting a whole suite of bonds. He is net short long-duration assets, which is great.”
Odey European Inc has a clean OCF of 1.14 per cent.