The closure of the Baillie Gifford Active Gilt range has called into question whether an active approach to the asset class is worthwhile, especially with the Bank of England poised to cut rates as early as this month.
Despite all the positivity on domestic stock markets following December’s general election, UK gilt yields are facing headwinds after the BoE dropped strong hints that rates will be cut. The latest inflation reading on Wednesday revealed UK inflation dropped to 1.3% in December while UK GDP shrank 0.3% in November.
The bond market is pricing in a 65% chance of a cut following the latest inflation data.
Last week outgoing Bank of England governor Mark Carney told a conference in London there was sense in the bank adopting a strategy in which policy remains on hold – ie lower rates for longer – until inflation has returned sustainably to target.
Baillie Gifford is the first casualty of low rates in the active gilts space. It announced this week with the UK base rate likely to stay near record lows for the foreseeable future, it was in the best interests of shareholders to close its Active Gilt range comprising the Active Gilt, Active Index-Linked Gilt and Active Long Gilt funds.
The funds collectively had £200.4m assets, according to FE Fundinfo. The long-dated fund had an ongoing charges figure of 0.27% while the other two funds charged just 0.19%. The £67m Active Gilt fund had underperformed its index by 27.2% over the last decade, according to FE Fundinfo.
Few levers for an active gilts manager to pull
The move by Baillie Gifford has led fund buyers to question whether an active approach to gilt funds is worthwhile. With only about 45 individual gilts issues it is difficult for managers to outperform, plus fees make up a significant amount of the total expected return due to the impact of low rates.
“There are very few levers for an active manager to pull,” says Seven Investment Management senior portfolio manager Peter Sleep. “The credit risk is all UK government, the currency is all GBP and so on. This is exactly the sort of thing where you can either buy direct very cheaply or where a passive fund does well for as little as 4bps. Personally, I would always advise a low cost ETF in such a narrow market over an active manager.”
Octopus Investments senior investment analyst in the multi-manager team Tom Buffham notes passive ETFs can be bought for less than 10 basis points. He says with the 10-year gilt yield at 0.63% even the cost of a passive fund is greater than 10% of the total long-term expected return.
He adds: “When interest rates were 4-5% pre-crisis, an active management fee of 0.5% did not look so unreasonable, especially as passive alternatives were more expensive back then too. Now even a fee of 0.25% is called into question as it’s over 30% of the total return. These low management fees make it difficult for these teams to be profitable even when they have accumulated billions of AUM.”
What is the future for active gilt funds?
Does this mean other gilts funds are likely to bite the bullet over low rates?
“Over the long term, yes, this is very likely,” says Buffham. “Although I doubt a cut in interest rates will precipitate closures directly, I expect each firm will decide to close its desk as and when they become unprofitable, triggered by either client AUM falling, or being forced to cut fees.
“However, there will be a few managers that remain, those willing to take the tracking error required with repeatable skill, and the less competitive market should hopefully increase their opportunities to add alpha.”
Psigma Investment Management sold out of its gilts position, via the Allianz Gilt Yield fund run by Mike Riddell, entirely at the end of August last year when the 10-year gilt yield hit 0.5%. Head of investment strategy Rory McPherson describes the move as a good decision and sticks by it despite the big downward move in yields on Wednesday’s inflation data.
With the yield hovering around 0.65%, McPherson says: “You’re still in our view not getting paid for the risk because you’re getting 0.65% a year for owning something that could potentially lose you quite a lot of money if interest rates went the other way.”
While McPherson acknowledges the merits of a passive approach to gilts, the team at Psigma opted to put the money in the Allianz Strategic Bond fund, also run by Mike Riddell.
“This just gives him much more flexibility in terms of how he can position himself from an interest rate perspective, which basically means that he’s not beholden to the movements in gilt yields,” says McPherson.
Government bond opportunities in a low yield environment
Unsurprisingly, Riddell disagrees with the argument that in a low yield environment, you can’t make money as a government bond manager. He points to the fact that at 0.75% the current interest rate is higher than the low point after the Brexit referendum in 2016 when it hit 0.25%.
But while he is bearish on gilts he says even in the Gilt Yield fund he has levers to pull besides duration. These include taking views in other markets including in US treasuries and other government bond markets, and buying inflation-linked gilts as and when.
“One of our biggest sources of alpha last year was that cross market position. We actually thought everyone was panicking about the risk of no-deal Brexit and we thought gilts were actually very expensive last year.”
“So it’s absolutely not just sit there and pick up the yield and don’t actively manage it,” he adds.
When Riddell and the team took over the fund in 2015 it was about £800m AUM and this has grown to about £2.3bn currently, the majority of which is UK wealth managers and, directly or indirectly, advisers.
Overall however, a vast swathe of the £2trn gilt market is owned by pension funds for liability matching purposes, the Bank of England and overseas central banks.
Allianz and Baillie Gifford active gilt funds versus benchmark
|Allianz Gilt Yield C Inc TR in GB
|Baillie Gifford Active Gilt Investment A Acc in GB
|FTSE Actuaries UK Conventional Gilts All Stocks TR in GB