Risk and Portfolio Construction: Absolutely clear
In a world of all time low bond yields and short term interest rates, it is not surprising that investors should be concerned about setting investment strategies that are positioned for an environment of rising yields.
“We saw growth in assets accelerate after Bernanke talked about closing QE in 2013,” says Ian Winship, manager of the BlackRock Absolute Return Bond fund. “[This was] mainly from investors who were in cash but getting negative real returns for a long period, looking to move into fixed income but wary of the fixed income story. There have also been more traditional benchmark investors looking for the greater flexibility afforded by total return objectives.”
Investors have also been shortening duration in their bond portfolios – the step before absolute return, adds Bill Street, global head of fixed income alpha strategies at State Street Global Advisors.
“For example, we launched a high yield short duration fund in the US which has grown exponentially, more than matching outflows from our long duration fund,” he says. “The amount of spread reduction this incurs is far outweighed by the reduction in interest rate volatility it achieves.”
The final outcome of this trend, as Street points out, is for investors to move to a cash benchmark and allow bond managers to be agnostic as to the course of interest rates.
One problem with cash-benchmarked bond strategies is that there is confusion over what the universe consists of, and where conventional strategies overlap with hedge funds. Some would argue that there is no difference between the two apart from fees; Street more charitably sees the distinction in terms of leverage, distribution channels and alpha, with fee levels being a function of alpha. Similarly, Winship sees anything targeting above Libor-plus 5% as more of a hedge fund than a traditional absolute return mandate.
Kommer van Trigt, head of the Fixed Income Allocation team at Robeco, divides the universe into two clear categories: absolute-return strategies where managers can essentially do anything, including adopting negative duration to take bet on rising yields; and total-return funds whose duration can go to zero but no further.
Street sees the first step as dynamic asset allocation (between as many asset classes as possible) without short selling – what Van Trigt would classify as a total return strategy. The next step would be long/short absolute return, allowing negative duration. This then overlaps with macro hedge funds, which may have major fixed income components but could also include other asset classes. For example, Amundi’s fixed income team is managing multi-asset products with a global macro approach and seeing ongoing demand for absolute return bond and currency strategies with different risk profiles.
At a glance
• Low-but-rising rates are pushing investors into short-duration, duration-agnostic and absolute-return bond strategies.
• These cover a huge range of strategies with very different risk profiles, some of which look more like hedge funds than traditional bond mandates.
• Investors can begin to think about categorisation in terms of the balance between diversification and the ability to sell short and apply leverage.
• Relaxing benchmarking constraints often leads to tighter absolute risk limits, especially around downside risk.
• Investors and practitioners need to make sure they communicate expectations clearly.
“This strategy can be short on certain risk factors, such as duration, but it is not a market neutral long/short strategy – it is based on active management of the different risk factors in portfolios,” explains Laurent Crosnier, CIO of Amundi London.
What is clear is that the terminology being used is not of much help when it comes to investors understanding what an absolute return strategy actually represents.
Multi-asset pure debt portfolios are perhaps the most straightforward of the cash benchmarked strategies. Insight Investment launched its version in 2006 with a target of LIBOR-plus 2%.
“It had a client base of both LDI investors requiring a floating rate asset with alpha for swaps and also insurance companies and other investors who had historically invested in bonds and were looking for low volatility assets that would not be so exposed to the interest rate cycle,” explains Andrew Wickham, head of UK and global fixed income. “In the fund’s worst year in 2008, it was down just 44 basis points.”
Insight subsequently launched LIBOR-plus 3% and LIBOR-plus 4% strategies.
“We found that for a long period, most of the demand was in the UK institutional space for LIBOR-plus 2% or so,” says Wickham “The LIBOR-plus 4% has been exclusively by UK and European institutional investors and was launched off the back of more recent demand in 2012 for higher returns.”
To achieve LIBOR-plus 2% the fund does not have to be fully invested in risky assets: around 40% of the portfolio is held in cash (Insight’s own money market fund). The LIBOR-plus 4% has no cash. “You can double up the return target from LIBOR-plus 2% but we cannot go beyond that without introducing leverage – and we don’t want to go for hedge fund style return targets with this broad diversified approach,” Wickham says.
Running very broad, hugely diversified portfolios is clearly the key to producing low volatility, but also lower returns than more concentrated hedge fund styles. As Gregor MacIntosh, manager of Lombard Odier Investment Management’s Absolute Return Bond Strategy explains, it requires pursuing a global opportunity set, allocating to both developed and emerging markets across the credit spectrum and utilising a range of security types, including derivatives.
Many firms, including Lombard Odier, employ a multi-portfolio manager structure: independent processes and approaches help to ensure low correlation across sub-portfolios. Typically strategies employ directional, relative value and arbitrage trades and can actively short-sell to hedge out undesired risks or generate alpha. Liquidity and risk management are key factors and managers dynamically manage risk allocations and employ strict volatility and drawdown limits.
Amundi see two types of strategy that fund managers can exploit to extract value from market inefficiencies: strategic positions that allocate risk among different market betas, which accounts for two-thirds of the Amundi’s risk budget; and secondly, tactical positions such as relative value strategies, momentum, credit and issuer selection, and volatility management, which account for the remaining third.
“Combining these two strategies, strategic and tactical, allows us to add another layer of diversification in our portfolios by mixing different investment horizons,” says Crosnier. “Historically, these strategies have shown very low or negative correlation, adding alpha into the portfolio for the same risk budget.”
There are no theoretical limits to the number of strategies that can be employed in an absolute return portfolio and given the requirement to minimise volatility, there are advantages to be gained by maximising the number of uncorrelated asset classes that can be included.
For example, Lombard Odier’s strategy consists of a macro book, run by the two co-lead portfolio managers to reflect the team’s top-down views, combined with five sub-portfolios that are run independently by individual portfolio managers, each with a specialised area of investment. Risk budgets are allocated to each book, in terms of volatility limits and stop-loss limits rolling over a range of time periods, and are monitored by Lombard Odier’s independent risk team to limit drawdowns.
BlackRock’s Winship lays claim to having the ability to access 50 different sources of alpha in strategies from across all of BlackRock’s debt groups. These are a mixture of both market-neutral and long-only strategies, targeting a gross return for their absolute return fund of LIBOR-plus 3-5%, and a net excess return to investors of 2-4%. He is currently using between 24 and 28 different strategies within the fund.
“I do not want to rely too much on any one team so I get a number of teams with a small alpha target and spread the risk that way,” says Winship. “The flaw for many funds of this type is that there is too much reliance on just a few asset classes. If the market becomes more volatile, you are basically stuck.”
Winship differentiates the strategies he invests in by style and by sector. There are 40 market-neutral quantitative model based strategies and in addition credit based strategies across different geographies and including market-neutral and foreign exchange; Asia specialists covering Asia credit, Asia duration and Asian currencies; emerging market corporate bonds, macro and currencies; and other areas such as UK mortgages.
“What I am looking for are more market neutral long/short strategies – it is tough as yields look very volatile,” he says. “I am looking for more flexibility away from the benchmark-driven styles that have been driving the industry for the past 30-40 years.”
For multi-strategy portfolios, risk management is key.
“What I am aiming for is small, positive consistent returns every month,” says Winship. “If there are any strategies that are starting to underperform, we cut risk. If all the strategies fell simultaneously, we would lose a maximum of 3.5%.”
For investors, absolute return funds can make a lot of sense as they remove all constraints on a manager’s investment abilities. That does place an onus on both the fund manager and the institutional investor to make clear to one another exactly what they should be expecting.
The challenge for investors may be on how best to monitor a manager’s risk profile on an ex-ante basis when there is no tracking error measurement against a benchmark to fall back on.
Just because something can be measured, that does not make it the better choice: absolute return funds may have to argue that point with their clients.