"We are pleased that the fund’s signal-based framework and systematic approach has resonated with our investors."
Jack Roberts, Fund Manager
We are pleased with the fund's first-year performance, delivering a return of +5.94%. With assets now exceeding £40m, we thank our investors for their confidence in the fund’s dynamic and differentiated bond investing approach. The fund performed as expected given the inflationary environment over the last 12 months. We remain confident that our strategy can deliver attractive outperformance compared to traditional government bond exposure over the market cycle. By leveraging a systematic, signal-based approach, we aim to provide a more predictable and consistent path to outperformance. True long-term success often comes from incremental gains rather than large swings of the bat. Roger Federer, arguably the greatest tennis player of all time, has won just 54.1% of the points in his professional career*. We believe our fund can serve as a valuable diversifier, offering a distinct approach to managing duration within client portfolios.
Fund and Benchmark Performance
Past performance does not predict future performance. Pricing is only indicative and not guaranteed. Source: Bloomberg 8/8/23 to 8/8/24. *Source: Ultimatetennisstatistics.com as at 08/08/2024
This note will cover:
A reminder of the fund strategy and signals used
How the signals operated throughout the year
Commentary on the funds performance
How might the signals and positioning change over the medium term
Why did we launch a systematic bond fund?
At Atlantic House, our primary focus is on crafting solutions that enhance our clients' multi-asset portfolios. Through our conversations with clients, two recurring challenges in their fixed income allocation emerged. First, both clients and third-party active managers found it difficult to consistently predict the direction of interest rates. As illustrated in the chart on the left, the market's track record for forecasting future interest rates is far from accurate. Second, clients felt that their existing toolkit was too limited. Index linked bonds which clients have historically used offer protection against falling real yields (inflation rising faster than interest rates). They do not provide explicit inflation protection and struggle when interest rates rise alongside inflation. The chart on the right highlights how poorly UK index-linked gilts have performed against the recent surge in CPI. Furthermore, strategic bond funds, to which some clients delegate their duration management, often have a high exposure to credit. This can weaken the diversification benefits that bonds typically provide during stressed periods in which credit spreads widen.
Source Right chart Bloomberg: 31/12/21 to 31/12/22, Left chart Bloomberg: 01/01/2009 to 01/11/2024
With that in mind, we set out to build a fund that could systematically adjust duration and offer true inflation protection over the cycle.
The Dynamic Duration Fund Overview
The fund is designed to outperform conventional bond funds across a variety of inflationary environments by employing a straightforward, systematic, and signal-based investment strategy. This fund offers exposure to UK and US interest rate and inflation markets implemented with just four underlying assets.
A key component of the strategy is the use of inflation swaps, which provide pure inflation exposure without the interest rate duration risk typically associated with inflation-linked bonds. This allows the Fund to generate positive returns during periods of both rising inflation and increasing interest rates.
Importantly, the Fund is not solely focused on outperforming during inflationary spikes. It is also highly adaptable, capable of shifting its exposure to meet different market conditions. At one extreme, the Fund can allocate up to 200% to bonds and 0% to inflation swaps, while at the other, it can be positioned with 0% in bonds and 100% in inflation swaps. This flexibility means that during periods of falling inflation and declining interest rates, the Fund can be double-weighted in bonds compared to a traditional long-only bond fund or ETF, enhancing its potential for outperformance.
Reminder of Signals
The fund utilises three signals to determine its allocation between rates and inflation. These signals are recalibrated monthly in response to the latest inflation data.
Signal changes over the last year
Each of the three signals produces a score of 0, 1 or 2 based on the underlying inflation data. These scores are then combined to produce an overall score out of 6. A score of 6/6 indicates a maximum allocation to bonds, while 0/6 signals a maximum allocation to inflation.
UK Positioning
At the Fund's inception, it held a neutral allocation with a score of 3/6—100% weight in bonds and 50% weight in inflation.
Source: inflation data from Bloomberg as of 9th August 2024.
Signal 1: The rate of change in CPI was negative over the six months preceding the Fund’s launch, with CPI rate falling 2.6% vs the 6 months prior reading. A decline of over 1% in the inflation rate over a six-month period increases the likelihood that the BoE may opt to cut interest rates sooner than expected. This signalled maximum allocation to bonds (2/2).
Signal 2: The real yield remained with the -1% to 1% range. A real yield of **% typically does not exert significant pressure on inflation, signalling a neutral allocation between bonds and inflation (1/2).
Signal 3: UK core CPI remained significantly above the Bank of England’s inflation target (6.9% vs. 2%). Indicating that the BoE were unlikely to cut interest rates and might even raise them to control inflation, signalling a maximum allocation to inflation (0/2).
Throughout the year, the Fund maintained its neutral stance, as inflation remained above the BoE’s long-term target of 2%, and real yields stayed within the -1% to 1% range.
US Positioning
At inception, the Fund had an overweight allocation to bonds, scoring 4/6, with a 133% weight in bonds and a 33% weight in inflation.
Source: inflation data from Bloomberg as of 9th August 2024.
Signal 1: Signal 1: The rate of change in CPI was negative over the six months preceding the Fund’s launch, with CPI rate falling 3.5% vs the 6 months prior reading. A decline of over 1% in the inflation rate over a six-month period increases the likelihood that the Fed may opt to cut interest rates sooner than expected. This signalled maximum allocation to bonds (2/2).
Signal 2: In spite of high inflation, US 10-year real yields remained above 1%. Historically, a real yield of this level has been sufficient to help bring inflation under control, signalling a maximum allocation to bonds (2/2).
Signal 3: US core CPI remained significantly above the Federal Reserve’s inflation target (6.9% vs. 2%). Indicating that the Fed were unlikely to cut interest rates and might even raise them to control inflation, signalling a maximum allocation to inflation (0/2).
In December, the fund's positioning shifted as the overall signal score changed from 4/6 to 3/6. The trigger for the change was the rate of decline in US CPI slowed to less than -1%. This suggested that inflation might be stabilising, potentially limiting the Fed's ability to cut rates aggressively. The fund shifted from a from 133% bonds and 33% inflation to 100% and 50% respectively. Interestingly, this shift occurred just as many discretionary managers were extending duration in their portfolios. Over the following six months, the UK 10-year yield rose by approximately 60 basis points, highlighting how a systematic duration management fund can provide valuable diversification compared to traditional discretionary strategies.
Performance commentary
Past performance does not predict future performance. Source: Bloomberg for UK and US 10 year rates.
We are pleased with the fund's first-year performance, delivering a return of +5.94%. With assets now exceeding £40m, we thank our investors for their confidence in the fund’s dynamic and differentiated bond investing approach.
The fund faced challenges in its first three months as stubborn services inflation and strong US growth kept rate cuts off the table and pushed yields higher. At inception, the fund was neutral on bond duration in the UK and slightly overweight in the US. While this US positioning initially hindered performance, the fund was well-positioned to benefit from the significant Santa rally in risk assets later in the year. From October to December, the fund returned 8.95%, more than offsetting earlier losses.
The US November CPI report, released in December, fuelled expectations of aggressive FED rate cuts in 2024. By year-end, the market was pricing in more than six rate cuts for the coming year, with similar expectations in the UK. Despite this, the same inflation report showed that the downward trend in headline inflation was beginning to flatline. This prompted the fund's first signal change, reducing bond duration from overweight back to neutral, a contrarian move at the time.
As 2024 began, 10-year swap rates stood at around 3.3% in the UK and 3.5% in the US. By April, they had risen close to 4.1% and 4.3%, respectively, a nearly 80bps increase. While the fund's neutral bond duration underperformed during this rise in yields, its inflation exposures provided meaningful offset, supporting returns and lowering volatility. This shift from underperforming bond exposure to outperforming inflation exposure at the first signal change was particularly encouraging.
April marked the peak in swap rates for the year, and yields began to reverse as lower inflation numbers published in May and June reassured markets that inflation was meaningfully declining, opening the door for potential rate cuts by the FED and BOE. The fund's bond duration exposures benefited from falling yields, and the narrative around declining inflation was positive for risk assets.
More recently, however, falling inflation has strengthened the recession narrative. Lower-than-expected payroll numbers triggered a technical sell-off in risk assets in early August, which, although recovered, continues to keep markets on edge. We were pleased to see the fund offer strong diversification benefits to equity during this period, as yields fell in response to risk-off sentiment.
Overall, the fund has delivered value and positive risk-adjusted returns over the year, and we are pleased that the fund’s signal-based framework and systematic approach has resonated with our investors.
Looking forward
The fund is currently neutrally positioned with a score of 3/6, reflecting a 100% allocation to bonds and a 50% allocation to inflation. Our positioning is determined solely by our rules-based, systematic approach, and as portfolio managers, we refrain from making predictions about the future. However, by analysing how close current data is to specific signal thresholds, we can offer an informed estimate of how the Fund's positioning might adjust in the coming year.
UK
**Green denotes current signal. Yellow possible next signal.
Source: inflation data from Bloomberg as of 9th August 2024.
Historically, the US has led the markets in monetary policy shifts, but this time, Europe has taken the lead. The Swiss National Bank and the European Central Bank were the first to initiate rate cuts, with the Bank of England (BoE) following suit in July, reducing rates by 0.25%—though the decision was narrowly passed with a 5 to 4 vote. Core CPI in the UK has steadily cooled, dropping from 6.9% a year ago to 3.5% at the time of writing. The BoE has been particularly concerned about the second-round effects of higher inflation, where rising prices lead workers to demand higher wages, thereby fuelling further inflation. However, recent data indicates that private sector wage growth and the more persistent services price inflation have begun to slow.
The next likely signal change for the Fund could be triggered by UK Core CPI falling below 3%—within 1% of the BoE's target—which would prompt an increase in the Fund's allocation to bonds and a reduction in its inflation exposure. If the BoE is slow to respond with further rate cuts, we might also see the 10-year real yield rise above 1%, which would trigger an additional shift into bonds. However, these moves towards bonds are likely to be partially offset by the rate of decline in inflation slowing to below 1%, signalling a shift back towards inflation. The expected outcome in the medium term is an increase in the Fund’s bond allocation to 133% and a decrease in inflation exposure to 33%, up and down from the current 100% and 50%, respectively.
Source: Bloomberg: 01/01/2020 to 08/08/24
US
**Green denotes current signal. Yellow possible next signal
Source: inflation data from Bloomberg as of 9th August 2024.
Unlike the Bank of England, the Federal Reserve operates under a more explicit dual mandate: to promote maximum employment and ensure stable prices. Balancing these objectives can often be challenging. For several months, the US labour market has been cooling, a trend initially viewed as positive for risk assets — a normalisation from previously overheated conditions. However, July brought a significant disappointment, with non-farm payrolls coming in at 114k versus the expected 175k, and unemployment rising to 4.3% compared to the consensus of 4.1%. Additionally, wage growth slowed to 3.6%, the lowest in over three years. While these indicators suggest emerging concerns, it is important to view them in the context of historical norms. Despite the recent uptick, a 4.3% unemployment rate remains historically low, lower than 90% of the time since 1949. If the July payroll miss proves to be an outlier, the 170k figure still aligns closely with the monthly average of 180k seen during the economic expansion from 2010 to 2019.
Looking ahead, the most likely signal change for the Fund will be triggered by US Core CPI falling below 3%. This would prompt a shift in the Fund's allocation from inflation to bonds. If inflation falls within 1% of the Fed’s 2% target, it could give the Fed the leeway to adopt a less restrictive monetary stance (i.e. cut rates).
Source: Bloomberg: 01/01/2020 to 08/08/24
Even with the anticipated signal changes in both the US and UK favouring a shift towards bonds, the Fund will continue to maintain a weighting in inflation swaps. From our perspective, inflation swaps are currently priced quite reasonably. UK inflation swaps price at 3.5% vs UK CPI core inflation at 3.5% and US inflation swaps at 2.3% vs current US CPI core at 3.3%.
If the market consensus proves incorrect and inflation resurges, preventing central banks from cutting interest rates, the Fund has the flexibility to pivot away from bonds and increase its allocation to the attractively priced inflation swaps.
In conclusion, the fund performed as we predicted considering the inflationary pressures over the past year. We are confident that our systematic, signal-based strategy will continue to offer attractive outperformance compared to traditional government bonds, achieving long-term success through steady, incremental gains.
CAPITAL AT RISK. This is a marketing communication. Past performance does not predict future performance.
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