We have written an extensive paper on the key advantages that active gilt managers hold over passive investors, which is available upon request from our sales department. This brief serves as an overview of the main points from the paper
1. Why the passive argument conceptually doesn't work
One of the main arguments behind passive investing doesn't work for gilt markets due to the market's participants. The argument goes that passive funds, by definition, hold the market. As such, active managers as a whole (the rest) also own the market. After fees, which are generally lower for passives, the returns on the market portfolio to passive funds are superior to those to all active funds. However, these aren't the only gilt investors, and more than half of the gilt market is owned by non-economic investors, such as insurance companies and central banks, who make their investment decisions without economic rationale. This creates opportunities that only active managers can exploit.
The degree of informational inefficiency that exists also allows active investors to generate excess returns. Academic papers have argued that it is logically inconsistent for markets to be informationally efficient, while also being perfectly arbitraged. If markets were perfectly efficient, there would be no profit to be earned from arbitrage, hence nobody would bother with the costly process of arbitrage.
2. Examples of non-economic investors' impact on the gilt market
Gilt market inefficiencies persist in part due to non-economic and passive investors, and this can be seen most clearly in the inversion of the UK yield curve, where you can get more yield for less risk. The Bank of England's Quantitative Easing (QE) programme has also contributed to distortions along the curve.
3. Inefficient gilt issuances
As with other bond markets, annual gilt issuance is a much larger proportion of the outstanding market relative to equity markets. There are often premia to be gained through new issues, but gilt syndications are a particularly persistent source of return for investors.
4. Gilt mispricing with regards to macroeconomic fundamentals and financial market conditions
The degree of inefficiency that exists in bond markets contributes to mispricing relative to fundamentals and financial markets. Depending upon these, and the ability of the manager, an active manager can generate outperformance through portfolio construction when the shape and level of the curve doesn't reflect the data.
5. A broader range of tools for active investors
Active managers often have some additional flexibility available to them which offer opportunities for generating excess returns versus both the benchmark and passives. These tools include off-benchmark gilts such as index-linked gilts, government-backed securities, cross-market bonds and gilt futures.
6. Passive gilt funds cannot outperform the benchmark
Passive gilt funds aim to replicate the benchmark, however after fees and transaction costs, passive investors will likely lag the benchmark over the long term. Using the median monthly returns of passive gilt funds since 2000, this small annual difference cumulated to 43.2% of underperformance versus the benchmark.
7. But what about the active fees?
While every active manager naturally says you should go active, the honest answer is not necessarily. The key is what the fees are. Over recent years, active managers have seen downward pressure on their fees, and those failing to add value to clients have been punished with outflows. The Allianz Gilt Yield Fund has low, competitive fees, ensuring more of the outperformance generated by the fund is returned to investors.
8. Not all active gilt funds are created equally
We believe the median performance of the active gilt funds within the IA sector should not be used as an indicator of whether active or passive wins the debate. Most funds have had a harmful bias to be short duration relative to the benchmark since 2010. While fees have come under pressure, historical fees were higher which also hampered performance.
9. A sector leader - the Allianz Gilt Yield Fund
The Allianz Gilt Yield fund exercises 5 core strategies in order to outperform the benchmark, the FTSE Actuaries UK Conventional Gilts All Stocks Index. These strategies are implemented through a repeatable investment process that takes advantage of the inefficiencies listed above on a consistent basis. This has proven to outperform both the benchmark and passive funds significantly over the last 23 months, when Mike Riddell and team started managing the fund.
Key components of our investment process
The fund manages duration within a band of 2 years around that of our benchmark. This allows us to increase or decrease the amount of interest rate risk that we take, depending upon the prevailing inefficiencies and market outlook. Duration positions should not, however, dominate relative performance.
The fund also holds full flexibility to invest anywhere along the UK government yield curve, providing us with the capability to position the fund to profit from the inefficiencies listed above.
This strategy involves assessing how bonds located next to each other on the yield curve are priced. A full understanding of what price differentials exist, and the cause of the differential, enables the fund to optimise yield, as part of the broader portfolio construction, following dislocations.
The fund's mandate allows it to hold inflation-linked bonds that are issued by the UK government, but which are technically not part of our benchmark. This allows us to incorporate aspects of our macroeconomic inflation outlook in a more accurate manner, as well as picking up premia from technical inefficiencies that we have highlighted above. At least 80% of the fund's holdings must be conventional gilts.
The fund's mandate also allows us to incorporate aspects of our global economic outlook, and express this in government issuers that are equally safe, or safer, from default. The fund is allowed to invest in any government bond of an equal or higher credit rating to the UK. At least 80% of the fund's holdings must be conventional gilts, and all foreign-denominated bonds are 100% hedged back to sterling.
For the full version of this paper please visit www.allianzgi.co.uk
1Grossman.S.J & Stiglitz.J.E, On the Impossibility of Informationally Efficient Markets, 1980, The American Economic Review, Vol.70 No.3,
Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. Investing in fixed income instruments may expose investors to various risks, including but not limited to creditworthiness, interest rate, liquidity and restricted flexibility risks. Changes to the economic environment and market conditions may affect these risks, resulting in an adverse effect to the value of the investment. During periods of rising nominal interest rates, the values of fixed income instruments (including short positions with respect to fixed income instruments) are generally expected to decline.
Conversely, during periods of declining interest rates, the values of these instruments are generally expected to rise. Liquidity risk may possibly delay or prevent account withdrawals or redemptions.
Allianz Gilt Yield Fund is a sub-fund of Allianz UK & European Investment Funds, an open-ended investment company with variable capital with limited liability organised under the laws of England and Wales. The value of the units/shares which belong to the Unit/Share Classes of the Sub-Fund that are denominated in the base currency may be subject to an increased volatility. The volatility of other Unit/Share Classes may be different and possibly higher. Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor's local currency.
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