Gaining ‘global alpha with domestic beta’ is a key theme that is driving the development of bond mandates among an increasingly sophisticated institutional investor base in Europe. As Aberdeen Asset Management’s Charles McKenzie points out: “The real demand is for higher alpha returns which requires a global universe, looking at global security selection covering areas such as the US bond markets, emerging market debt, high yield and also interest rate and currency overlays to give much wider opportunity sets. But the clients also need to pay close attention to their liability profiles so there is a lot of hedging out of global interest rate and currencies into a domestic beta exposure.”
The problem for any fund manager though, is finding alpha at an acceptable risk level given how low investors are being rewarded for taking on risks in any asset class, whether equities, emerging market debt or corporate bonds. At Standard Life Investment Management, Douglas Roberts sees the current scenario as “an accident waiting to happen” and argues that investors are mistaken in adopting global aggregate benchmarks that force managers to take on extra risks to attempt to emulate indices that may not be replicable at all.
The factors that underlie the ‘alpha hunt’ across the wider fixed income universe include, of course, the widespread application of the concept of liability driven investment (LDI). This has been driven by changing pension regulations that “have triggered more investment into the bond market at the same time as yields are low and credit spreads tight” as Michael Benhaim at Pictet Asset Management points out, adding that “we think demand will continue for the next couple of years. However, while the usual expected performance was between 30-50 basis points, we have seen more and more demand for total return products, not linked to a benchmark, tending to generate 100 to a 150 basis points.”
The global universe of investments is also rapidly changing in nature. Benhaim sees “the key theme for the next couple of years will continue to be that the emerging markets have actually emerged and are now investment grade. This is due to factors such as the wealth effect from oil and commodities prices. Even though these countries are called emerging they form a part of the global investment universe, the true emerging now is the local part of the emerging markets. This is adding a lot of investment opportunities and a lot of diversification.”
Jean Francois Boulier of Credit Agricole Asset Management (CAAM) sees that the major trend in the global bond markets is the rise of structured products: “Institutions are obliged to buy bonds but not obliged to buy government bonds”, leading to the wholesale transformation of financial exposures of all types into structured products that can form part of bond portfolios. Through such products Boulier sees that “a number of institutions are gaining exposure to areas such as high yield bonds and emerging markets that they would have been very defensive on the idea of investing in directly”.
He goes on to add that “for new markets such as leveraged loans, weather derivatives, insurance securitisations and so on, such products play a critical role in disseminating the exposures. Not everyone can be an expert in everything, but can gain exposures in a controlled manner through investing in structured products where the underlying exposures are managed by experts in that area.”
Such products widen the universe of investors by slicing, dicing and reconstituting financial exposures which would otherwise have a narrow investor base, into specific tranches appealing to individual classes of investor across a much wider universe.
In Europe, the asset-backed securities (ABS) market is growing very rapidly driven by a huge demand, which far outstrips supply. In 2004 and 2005, there was more issuance of ABS than corporate bonds, so with an average life of four to five years, the European ABS market will rapidly overtake the corporate bond market in size.
The sharp tightening of corporate bond spreads during the last few years has also led to many managers increasing their weightings to ABS, even though they are not as yet included in bond indices such as the widely used Lehman Pan European Aggregate.
As Pictet’s Benhaim points out: “If you look at the ABS with high ratings, AAA etc, you have a better spread than in the equivalent spread in investment grade, corporate area and these spreads tend to be less volatile by far. Of course it’s not for free, you give up some of the liquidity, though liquidity is becoming better and better, improving at a rapid pace given the number of issues we have in the market.”
A key component of the global alpha, domestic beta, approach to investment is the availability of liquid derivative markets encompassing a broad and increasing spectrum of the global investable universe. This itself is underpinned by the development of acceptable indices for sub-asset classes within the global fixed income universe.
This process is still in transition, with many deficiencies in the coverage particularly of European markets. For example, there are no European ABS indices that have gained widespread acceptance by fund managers. Even the European government bond markets, now ranking alongside the US debt markets as a key international ‘safe haven’ for investment and a source of liquidity for global investors, did not have any pan-European futures contracts before this year. The German Bund futures was acting as a proxy for the total marketplace, despite significant and rising fiscal disparities between major countries within the EU leading to a growing credit divergence as evidenced by the downward re-rating of Italy last year.
Using the complete range of debt and currency derivatives available enables a fund management firm to focus on the markets where it genuinely has the ability to generate excess returns, and hedge out the market exposure while simultaneously taking on a domestic index or liability benchmark exposure through a separate set of derivative transactions.
Such alpha transport techniques are becoming mainstream amongst fund managers. They also lead to the situation that what matters is not to be reasonably good at all markets within the global universe to outperform, but rather, to be exceptionally able in a few.
A narrow focusing on LDI can give rise to the view that the relative impact of duration matching is many multiples of some extra return for a bond mandate. While Standard Life’s Malcolm Jones sees that that the UK is still really in the process of aligning bond benchmarks to liability interest rate sensitivities, institutional investors more generally in Europe are also increasingly seeing the benefits of allowing fund managers the freedom to seek alpha wherever they can, even for domestic mandates.
Aberdeen’s McKenzie finds that “we are increasingly seeing clients who are more domestically focused in the UK and Europe saying that rather than just accessing a domestic universe, why not access the global universe?” As a result, “a fund would be managed against say the Lehman global aggregate index and generating global alpha and then taken back to domestic beta exposures through hedging out the characteristics of the Lehman global aggregate index via a series of interest rate swaps and into the preferred index of the client. This could be very specific eg, the Euro 20-year swap index.
“Many funds are also asking, do we need a capitalisation-weighted benchmark? My real liabilities are a 20-year duration liability. So clients are getting very sophisticated,” he says.
Benhaim adds that: “If you have a benchmark mandate the client will expect to generate alpha on the top of the benchmark. So to build a portfolio you have to have exposure to the underlying benchmark and that is managed in a beta approach. We wouldn’t take a strong duration or curve view, just try to optimise the carry or yield of the portfolio using the inputs of our specialists. That gives us the structure of the beta part of the portfolio.”
There is also demand though, for global bond mandates and a key decision has to be whether the benchmark should be a government bond index only, or a global aggregate index that includes a wide variety of investment grade bonds.
Roberts sees the debate as often being flawed, with global aggregate index results being compared with a global government bond indices that invariably show higher returns for the aggregate index. The problem though is that an aggregate index such as the Lehman Global Aggregate is often uninvestable, with the Lehman index, for example, having over 7,000 bonds.
If managers are benchmarked against a government bond index but allowed to take off-index positions, then performance comparisons of actual portfolios become much fairer. Given the low rewards being given for taking on risks in the current environment, they would argue that investors are better served by such an approach.
iven the current low yields available in bond markets worldwide, what are the risks that investors should really be concerned about? McKenzie sees three key risks:
o Firstly how much is global growth going to slow down?
o Secondly, how big an impact is the demand for longer duration bonds by pension funds in terms of flattening of the yield curves and will there be a greater flattening ahead as pension funds decide to continue buying regardless of yield?
o Thirdly, the lack of volatility in the markets, which means that managers have to be more imaginative in how to get more alpha. This gives rise to more highly structured products such as CDOs in credit markets etc and there is a danger that a significant distressed issue will lead to real concerns as volatility is priced very cheaply at the moment.
Historically, it has been the US firms such as Pimco that have dominated the marketplace for global bond mandates, drawing on their ability to combine historic US strengths with more recently developed European capabilities across virtually all fixed income sectors and derivative markets. But in a world of compressed spreads, is the value of that capability diminished?
Indeed, Roberts has an approach that views European ABS as not worth the extra risk when compared to German Pfandbriefe, when it comes to taking off-market bets. Where such capabilities do come into their own is in the more broader based products that take advantage of diversification to reduce risk, while benefiting from investment in more risky but higher yielding subclasses.
Principal Global Investor’s Strategic Fixed Income Fund for example, aimed at European investors invests in a diversified portfolio of high yield, preferred securities and CMBS and ABS around the world, predominantly short duration with a cash benchmark. With 350 or more bonds in the portfolio, trading is undertaken predominantly through taking advantage of cash flows from maturing bonds and new inflows to change the asset allocations within a pooled fund according to Nick Lyster, the CEO of the London office.
While the fund is structured to take account of opportunities in debt markets around the globe Lyster explains: “There is a predominance of dollar securities in the fund at the moment reflecting not only the greater depth of research for the firm in the US at the moment, but also what we perceive as greater opportunities in the US in the mortgaged backed securities and high yield markets which are less developed in Europe.”
Many European firms are developing their capabilities across a wider range of markets and some are embracing the concepts of global alpha and local beta. Pictet for example, according to Benhaim “is a portable alpha organisation, we have highly specialised people operating in the different sub classes of fixed income covering one particular aspect of the market. We currently have 10 alpha engines concentrating on specific areas of the market; duration and yield curves; foreign exchange; relative value; emerging debt hard currency; emerging debt local currency; inflation linked; ABS; volatility; investment grade credit; and high yield credit (two separate engines). These specialists are able directly to implement their positions into separately defined portfolios, which requires a strong IT infrastructure to define all the different constraints (eg, currency).
“We have such a system into which we put all the portfolios we are running, it analyses whether it is reasonable to run a certain type of trade, is it ok to buy this kind of currency etc. So all the constraints are put in the system and then we also define in the system all the standard trades and we have a risk management team in charge of implementing on a weekly basis the volatility of these instruments.
“Then for a risk taker it should be easy when he has an idea to put it on the system, and ultimately the system will take the volatility associated with the trade, will compute the risk budget, which will be applied on a certain portfolio. This means that we are able to be responsive to any market move. The key word here is diversification, the possibility of generating alpha, not on a single strategy, not on a single market but really spread in different universes.”
With the ability to transport alpha, it is also worth ensuring that unless a benchmark constraint forces you to do so, it is not worth taking positions in markets where a firm has no real competitive advantage.
Benhaim makes the point that in the US, the key areas are credit and mortgage backed securities (MBS) and “as we are in Europe, we do not compete with them in those areas”.
Aberdeen in contrast, has a strong US team inherited from its incorporation of the Deutsche Asset Management fixed income operations. “The US team has always had as their core skill, US credits going back 15 years. The focus is on investment grade but they also cover high yield,” according to McKenzie, who goes on to add that as a result “when we look to build up global portfolios, the core area is security selection in investment grade credits”.
In contrast, Pimco, according to William C Powers, is underweight in investment grade bonds seeing spreads tightened to levels that they think limit the likelihood of further tightening. “We see asymmetric risk in corporate bonds. The cost of underweighting investment grade corporates is minimal given today’s tight spreads, the likelihood of additional tightening is only modest, and the chances that spreads could widen is actually quite good, or at least a lot more likely than spreads remaining here or tightening further.”
European firms facing the challenge of competing with the US fund managers who have set up operations in Europe, have always had the competitive disadvantage that such US managers are able to combine their more recently developed European ‘alpha engines’ with the ability to utilise their expertise in the US bond markets to additionally transport alpha across the Atlantic for bond mandates for European clients.
Those European firms that will succeed in offering global mandates in the longer term, may either have to acquire US debt capabilities, or be able to focus on sub-sectors of the non US markets where they can see themselves and persuade their clients that they have the ability to continuously generate alpha over the very long term.