Investors are being torn in two different directions at the moment. “Specialisation, that’s the key to alpha” shouts one consultant. “Diversification, that’s the key to less risk”, shouts another. So which does the investor choose – alpha with risk, or less alpha, less risk? Or is it possible that diversification, and therefore less risk, leads to greater alpha?
According to Bruno Crastes, deputy chief executive officer and chief investment officer at Credit Agricole Asset Management in London, absolutely. “In a nutshell, the more diversified your universe of fixed income securities, the higher the alpha – this is the rule.”
Crastes is beating the drum for global fixed income – a portfolio which would be able to invest in the entire fixed income universe, assuming the risk is normalised. Being able to invest in government bonds, corporate bonds, emerging debt, high yield debt, and quasi-sovereigns allows a better information ratio. In terms of diversification, it is hard to find a better ‘asset class’.
The creation of alpha is derived from the huge opportunities open to the investor. The sub-asset classes of global fixed income individually are offering less in the way of returns. Global government bond yields are extremely low, and Crastes says, have no real value for long-term investors. The corporate bond market is quite opaque and vulnerable to extreme risk. Emerging debt and high-yield debt have managed to remain of value, but are also vulnerable to extreme risks.
Says Crastes: “In the late 1990s, investors believed equities to be the long-term outperformer of every asset class. Now they realise this is not the case. Some say emerging debt could now be that asset class, but the truth is you will not find one single asset class that will consistently outperform all others on a long-term basis. The value is between them and being able to arbitrage.”
Guy Williams, chief investment officer of global fixed income at Fortis Investment Management points out the risk/return advantages of global bonds. “Over the past ten years, both domestic and global bonds have recorded returns not substantially lower than those of equities but at much lower volatility levels.” (see chart).
Currency plays are the most obvious way of adding extra performance. For an investor with money in US dollars for example, there is clearly an opportunity to be had. The dollar looks set to weaken against the euro further, so investing in euro-denominated bonds makes sense. But, points out John Beck, director at Franklin Templeton, “global fixed income means different things to different people.” Investing in foreign currencies may make sense for US investors, but for Euroland investors, foreign currencies would not be advantageous. Here European investors would need to hedge their position to remove concerns.
Says Beck: “Taking care of currency hedging is vital. The federal reserve has made clear that it will be looking at unconventional measures in its monetary policy. This could mean further interest rate cuts, or buying of longer dated bonds, which would result in a devaluation of the dollar. For Euroland investors in dollar bonds any local currency gain through appreciation of bond prices might be loss through weakness in the US dollar against the euro.”
Williams agrees that it is important to actively manage currency exposures within a portfolio. ‘Pure international and global portfolios generally have higher volatility because of their currency exposures, but currencies can provide an additional source of return for global portfolios.” (see chart for returns on hedged portfolios)
Mixing inflation-linked bonds and global bonds together is also advised. Inflation is bad for bond markets as it reduces the real value of the bonds at maturity. Adding global bonds to the melting pot will provide the alpha. Says Crastes: “Pension funds aim at outperforming inflation by about 4%. Inflation-linked bonds will give you inflation plus 2%, but where is it possible to pick up the 2% left? – in a very diversified investment universe.”
“If investors’ constraints allow them, they must expand their universe.”