In celebration of the recent ten-year anniversary of Vanguard’s LifeStrategy range in the UK, we examine the value delivered by the funds directly to clients. In particular, we analyse the funds’ performance versus peer groups and the markets, before looking ahead to the next ten years using asset class projections based on the Vanguard Capital Markets Model.
By Mohneet Dhir, multi-asset product specialist, Vanguard Europe
We often receive questions about our LifeStrategy range and most recently the topic that keeps cropping up, again and again, is the impact of rising inflation on fixed income holdings.
It seems a growing number of investors are becoming more concerned that the possibility of greater or sooner-than-expected interest rate hikes could impact their fixed income holdings.
The concerns are understandable. Inflation is rising and central banks, the US Federal Reserve (Fed) in particular, are motioning towards tighter monetary policy. The tapering of bond purchases, which have supported the markets through the recent Covid-19 crisis, is imminent but interest rate rises are moving up the policy agenda too.
Many investors, judging by the questions we receive from clients, are concerned that while rising interest rates can be helpful for yields, they could spell trouble for long-dated bonds – the duration worry. So, what is this and how are LifeStrategy funds positioned?
Put simply, duration is a measure of a bond's sensitivity to interest rate changes – and the longer a bond’s duration, the greater its sensitivity. Bond prices generally fall as interest rates rise and in the current low interest rate environment this risk is amplified.
In the UK, with the Bank of England’s base rate at 0.1% – its lowest level in history, it’s a fair assumption to make that rates are only going to go in one direction – up.
And rate hikes are the main tool by which central banks aim to control inflation.
Rising inflation had broadly been predicted at the start of the year, but recent inflation readings in the US, UK and euro area were higher than most investors expected. This surprise caused bond prices to fall and yields to rise higher and faster than the market had anticipated.
To remediate the risk to long-dated bond returns, some commentators are urging investment managers to adopt a specific tactical position whereby they underweight duration. Managers might do this by reducing their bond allocation and shifting more of a fund’s assets into cash or holding fewer long-dated bonds and taking a more concentrated position in shorter-dated issues. This tactic is called duration-timing.
The success of duration-timing strategies rests on predicting the movement of bank rates before the market updates its expectations and shifting your allocation accordingly. However, the odds of getting the timing right aren’t favourable. Our analysis has found that Fed futures market expectations tended to overshoot the Fed’s actual target funds rate from 2000 to 20191.
In short, those who sell now – after the market has priced in shifting expectations – are locking in past losses and may forego a valuable buffer against other unexpected shocks to their portfolio. Going short on duration now would only make sense if you expect inflation to persist above target levels and central banks to raise rates sooner or further than expected.
Some managers might sell their longer dated bonds and keep the proceeds in cash. But then the value of your cash is in any case being eroded by inflation. With either approach, replacing longer dated bonds with a concentrated position in shorter duration bonds runs a greater risk of increased volatility, particularly in a changing interest rate environment.
At this point, it’s important to remember the primary role of bonds in a multi-asset portfolio is to offer stability against the volatility of equity markets. By taking tactical positions in fixed income, like going short on duration, multi-asset investors risk diminishing the stabilising effect bonds can bring to a portfolio when equity markets fall.
That’s why LifeStrategy Funds don’t make tactical calls in fixed income (nor equities, for that matter). The funds maintain a diversified exposure across the investment-grade debt universe, including government bonds and high-quality corporate debt across a range of maturities. The funds use Vanguard bond index funds as the building blocks in an attempt to provide a reliable buffer against equity market shocks, as well as a predictable stream of income.
With average durations of between 9.5 and 9.8 years2, the four multi-asset portfolios in the LifeStrategy range are closer to the longer end of the duration spectrum, driven primarily by their exposure to inflation-linked gilts, which bring an average maturity of 21 years to the portfolios. Despite their long duration, however, inflation-linked bonds bring a natural inflation hedge to the funds through inflation-adjusted interest payments and principal payment (repayment at maturity).
Ultimately, taking tactical positions introduces extra risk to your portfolio. Some investors may be comfortable with this idea, but in the case of LifeStrategy funds, the bond element is designed to offer a reliable hedge against equity market downturns and taking tactical positions would reduce this ability.
1 Source: Federal Reserve Bank, Bloomberg. Data between 31 July 2000 and 30 July 2019.
2 Source: Vanguard, as at 30 September.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
Investments in smaller companies may be more volatile than investments in well-established blue chip companies.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
The Funds may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Fund's net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.
Some funds invest in securities which are denominated in different currencies.
The Vanguard LifeStrategy® Funds may invest in Exchange Traded Fund (ETF) shares.
Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.
For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com
This document is directed at professional investors and should not be distributed to, or relied upon by retail investors.
This document is designed for use by, and is directed only at persons resident in the UK.
The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of [units/shares], and the receipt of distribution from any investment.
The Authorised Corporate Director for Vanguard LifeStrategy Funds ICVC is Vanguard Investments UK, Limited. Vanguard Asset Management, Limited is a distributor of Vanguard LifeStrategy Funds ICVC.
For further information on the fund's investment policy, please refer to the Key Investor Information Document (“KIID”). The KIID for this fund is available, alongside the Prospectus via Vanguard website https://global.vanguard.com
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
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