/34 Focus: Absolute Return Bond Funds. Source: Getty Images

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1 /34 Focus: Absolute Return Bond Funds Source: Getty Images the markit magazine Summer 2010

2 Focus: Absolute Return Bond Funds /35 An investment vehicle that proved to be flawed when the crash came has picked itself up and reshaped for a new generation. Joseph Mariathasan says now could be the time to welcome back absolute return bond funds Second time lucky? Absolute return bond funds appear to be returning to investors favour, after the calamities suffered during the market crash. Benno Weber, head of fixed income at Swisscanto, Zurich, has seen the rise and fall of absolute return funds and now a potential revival: I understand the suffering of investors. In Switzerland, absolute return funds have a bad reputation as many people lost money. Five years ago it was much easier to sell them but now people want to see what is inside them. Currently, investors are in a defensive mode, but interest could come back as investors try to protect themselves against rising interest rates. Many commentators would argue that they are a good strategy for the environment that we are heading into where the opportunity for a simple beta play is over. Now there is a requirement for more capability to extract alpha for more conservative portfolios and to provide a diversifier for more neutral or aggressive portfolios. Removing the shackles of an index benchmark opens up a wealth of new opportunities for fund managers. Crédit Agricole Asset Management s bestselling product, according to Jean- François Pinçon, head of international client development, is a high alpha global bond strategy: It is a top-down, global macro, multi-strategy based on diversification and risk allocation between various strategies based on value at risk (VAR). It includes all asset classes and fixed income approaches, such as duration and bond selec tion. The approach can be tailored to work within different risk budgets although the strategies are the same. Insight s approach to emerging market debt (EMD) is to take a total return approach. As senior fixed income product specialist April LaRusse explains: Our EMD team invests from a total return perspective, so they are trying to outperform a cash benchmark. The Summer 2010 the markit magazine

3 /36 Focus: Absolute Return Bond Funds François Pinçon, head of international client development, Crédit Agricole Asset Management message that this sends to the fund manager is to only buy things that they actually think are going to perform well, without being distracted by benchmark weightings. They do not hold things that they don t like because they re in the benchmark, and they protect the downside using credit default swaps (CDS) or holding high cash weightings if they think the market is vulnerable. Current almost zero short-term interest rates look set to continue for some time, while the consensus view is that bond yields have only one direction to go now, and that is upwards. Both these factors provide a strong stimulus for institutional investors to consider absolute return bond funds. There are also longer-term structural reasons. Consultants argue that with LDI strategies slotting into place, the current way that bond managers manage money may change within the next few years, replaced by some sort of an LDI structure. This would imply interest rate and inflation exposure with a cash benchmark portable alpha approach on top that will substitute a bond index benchmark. Absolute return strategies fit into a LDI strategy of a swap plus an absolute return fund. This trend will continue longer term as schemes mature and move more into bonds and are more interested in hedging out interest rate and inflation risks. But the new generation of funds being launched are likely to be very different in structure from those that performed badly as a result of the credit crunch. The evolution of thinking The rationale for absolute return bond funds can be seen in the factors that led to their introduction and the growth of the market. The collapse in equity markets in 2001 had led to considerable investor dissatisfaction with index benchmarked exposures where managers could claim outperformance against their benchmarks, while incurring substantial losses for their clients. As a result, there was increased interest in absolute return approaches which encompassed strategies across a range of asset classes including bonds. This also coincided with a movement by some pension Our EMD team invests from a total return perspective, so they are trying to outperform a cash benchmark. The message that this sends to the fund manager is to only buy things that they actually think are going to perform well, without being distracted by benchmark weightings. Benno Weber, head of fixed income, Swisscanto funds, particularly in the UK, away from government bond benchmarks to benchmarks that incorporated credit. This led to a number of issues as the larger bond managers tried to reconcile the new benchmarks such as the Lehman aggregate with the techniques they were using to add value that were based on trading government bonds. If all the physical cash was put into credit instruments, how was it possible to undertake duration trades, yield curve shifts and cross-market trades, which require more trading and are much more high frequency transactions? Dealing in credit instruments is highly inefficient as they have high bid offer spreads. The growth and increasing coverage of the derivatives markets with the corresponding decline in transaction costs both within and across markets introduced a new opportunity for fund managers in managing their portfolios in a cost-effective manner. The derivatives markets were seen to often have greater liquidity and much finer spreads than the underlying physical markets. It became clear that the risk exposures of portfolios could be managed far more efficiently using the derivative markets rather than the underlying physical markets. The more sophisticated managers incorporated many of the ideas and techniques used by hedge the markit magazine Summer 2010

4 Focus: Absolute Return Bond Funds /37 funds into their own processes, albeit in a lower-risk environment. The use of derivatives in this way profoundly changed the philosophy and the implementation of active management of bond portfolios. These do not have to be restructured to make changes to interest rates and currencies in particular. Having short positions becomes just as easy as having a long position, enabling managers to move from the position where they could only benefit from having positive views to having at least the opportunity to benefit equally from negative views. Separating one set of return drivers such as interest rates and currencies from another introduced the concept that outperformance, the alpha, could be transported from one set of markets to another as derivative overlays could be added to any underlying physical position. This led to the idea of portable alpha and global fund managers being able to exploit their full expertise across global markets, irrespective of the local benchmark. This translated to global alpha, local beta. The impact led to a differentiation between credit teams that were focused on exploiting perceived abilities at bond selection, and the more macro-based managers focused on the more liquid interest rates and currencies. Interest rate teams were focusing on April LaRusse, senior fixed income product specialist, Insight Absolute return bond funds as a class failed miserably during the global financial crash. The underlying cause was of course credit, and the fact that many strategies turned out to be nothing more than leveraged positions on credit spreads. delivering alpha, while credit teams with a long-only benchmark inevitably were delivering mainly a beta exposure to spread levels with some alpha through their bond selection. Confusion with cash A fundamental source of confusion for investors has been that absolute return bond funds have covered a variety of niches across the risk spectrum from what the proponents called enhanced cash to products targeting double-digit returns with a commensurate volatility. Clearly, the absence of an accepted nomenclature for different strategies has led to confusion and controversy. Unfortunately, this situation is not likely to be resolved very easily and institutional investors need to have a very detailed understanding of the characteristics of any particular strategy before investing in it. In particular, there is a clear distinction that needs to be made between cash and absolute return products, which may encompass strategies that are sometimes described as enhanced cash. As some consultants have argued, absolute return products and cash have nothing in common except that they both have a Liborrelated target. Absolute return products are much more aggressive, while cash should be very conservatively run with risk being managed on a shortterm horizon. In this respect, strategies targeting Libor + 1 or 2 per cent should not be seen as cash products as experience has shown that they often use leverage and become illiquid in times of market stress. Without an accepted terminology to classify and differentiate the strategies, the experience of the last few years has shown that there has often been a considerable mismatch between what investors were expecting and what they were getting. This has been exacerbated by the lack of a suitable taxonomy to describe and differentiate between the products on offer. This mismatch between expectations and reality persists today. But ultimately, while any attempt to classify absolute return funds is arbitrary, the broad ranges can be seen in terms of outperformance against a short-term cash benchmark such as Libor: Sub-Libor strategies that can truly be described as cash Outperformance in the range 25-50bp, sometimes and possibly erroneously described as enhanced cash The range 2-3 per cent has become very popular for absolute return bond funds, sitting above traditional bond targets of per cent over a bond benchmark, and the diversified growth multi-asset funds that target 4 per cent or higher 4 per cent upwards representing diversified growth funds, targeting equity type returns with lower volatility At the most aggressive end, macro hedge funds targeting per cent. What has become very clear after the financial crash is that Libor itself is not a risk-free rate. So absolute return bond funds targeting anything above Libor should be regarded as riskseeking assets rather than some form of enhanced cash. Summer 2010 the markit magazine

5 /38 Focus: Absolute Return Bond Funds Money Market Risk/Return Trade-Offs Expected Risk (%) Short-Term Corporate Bond ABS Corporate FRN Commercial Papers Bank Papers Treasury Bills Time Depot Expected Return (%) Overnight Rate 1 Month Libor 3 Month Libor Dawid Konotey-Ahulu, Co-CEO, Redington Source: T. Rowe Price Where absolute return went wrong Absolute return bond funds as a class failed miserably during the global financial crash. The underlying cause was of course credit, and the fact that many strategies turned out to be nothing more than leveraged positions on credit spreads. But the packaging of these investments meant that their nature was not appreciated. In 2005, lots of trustees asked the question, so in trying to outperform cash using an absolute return fund, where should I invest? They then invested in assets that they misunderstood, explains Dawid Konotey- Ahulu Co-CEO of Redington. Not just a misunderstanding in terms of confusing asset-backed securities (ABS) with cash funds. Many pension funds did not appreciate what they were getting into, he adds. In particular, many investors found themselves with a very high exposure to credit risk and to property in the AAA-rated subprime tranches of RMBS and in CMBS. In hindsight, what is staggering is that the UK prime mortgages were paying 10bp over Libor and Californian subprime was paying 50-60bp, says Konotey-Ahulu. So, for the sake of just 40bp more, people took on that much greater risk. But back then, risk margins were so compressed that every extra basis point was seen as worthwhile chasing. Pension funds now had exposure to assets that just paid cash plus a bit, but were way too low down the capital structure. The most obvious lesson to be learnt from the experience is the mismatch between what investors were expecting in terms of risks and the actual nature of the portfolios. In hindsight, many In hindsight, what is staggering is that the UK prime mortgages were paying 10bp over Libor and Californian subprime was paying 50-60bp products were totally unsuitable for the purposes they were being put. But more significantly, many managers had products that were essentially taking credit spreads which require no manager skill, and could therefore be regarded as beta positions in credit, and effectively claiming fees for alpha. If the credit teams had a 50/50 benchmark government/credit, they would go overweight on credit, say by 70/30, so it was a credit beta play. Investing in ABS at the time enabled funds to outperform the index benchmarks by moving away from the index universe. The biggest upset in 2008 was in any strategy that was based on carry such as incremental gains on coupons on credit. This applied right across the board to investment-grade, high-yield ABS and MBS and emerging market debt anything that was yielding more than a government bond or cash. The issue that was brought to the fore was that credit managers had been overweight on credit at the wrong time, for example, when investment-grade was yielding less than 1 per cent over government bonds. The temptation had been for absolute return bond managers to have a lot of credit when credit was very expensive universally. But credit spreads are not normally distributed and can severely deteriorate. the markit magazine Summer 2010

6 Focus: Absolute Return Bond Funds /39 Understanding the risks For institutions, understanding the risks inherent in absolute return funds is critical. However, this is not as easy in practice, when many funds have opaque strategies and no real benchmarks for risk assessment. The key for understanding and implementing absolute return bond strategies that can survive the sort of turmoil seen in the last two years is managing the downside risk. Christopher Rothery, fixed income portfolio manager at T. Rowe Price, argues that there are three risks that need to be managed. First, market risk, which will remain the most important: At T. Rowe Price, we use VAR but we also have our own risk system where we slice and dice risk in order to better understand how our investments would react at times of market stress, he says. Second, counterparty risk, which was highlighted in the Lehman collapse. Fund managers need to be able to trade with high-quality counterparties and the number available is going down. Finally, there is liquidity risk. The credit crash was essentially a crisis of liquidity, not of defaults. A lot of structures and securities that were thought to be liquid, turned out to be anything but that in a crisis. Managing downside risk during a crisis of the kind experienced in 2008 Christopher Rothery, fixed income portfolio manager, T. Rowe Price At T. Rowe Price, we use VAR but we also have our own risk system where we slice and dice risk in order to better understand how our investments would react at times of market stress. means having very controlled or no exposure to credit to ensure liquidity is there when you need it. The most critical aspect of risk management in absolute return funds is liquidity management and whether a manager can get out of losing positions when he needs to, to limit the potential downside. Hedge funds with their trading background claim that this is one of their key competitive advantages. But traditional managers also vary in their approach to liquidity management. The fatal flaw in many of the absolute return bond funds was their emphasis on illiquid credit instruments, where trading virtually ceased during the credit crunch. Despite no significant change in actual defaults in many cases, the securities were not able to be either valued or traded. Ultimately, there is a trade-off between liquidity and credit. Higher-yielding bonds are inevitably less liquid, and more suited to a buy and hold strategy. Absolute return strategies that use very liquid derivative markets to produce alpha combined with investing only in liquid cash instruments will be more liquid than strategies that encompass higher-yielding credit instruments such as ABS. The most liquid strategies will be those that only utilise the major developed government bond markets, but this will be at the expense of what can be achieved in terms of return. As a result, in the new generation of absolute return bond products, there will be more of a separation between those strategies that use credit and those that do not, for example diversified alpha approaches and pure sovereign bond strategies. Diversified alpha is probably the most popular approach and encompasses strategies that are diversified across a range of alpha sources. Managers look to make bets including credit, duration, currency and yield curves. They will have no explicit country bias, although with the US being such a large percentage of the global bond market, they will inevitably have a large percentage in US bonds. They are likely to give a smoother absolute return profile by incorporating many different strategies and would typically seek to achieve 2-3 per cent over cash. Such strategies appeal to a wide range of clients ranging from pension funds to insurance companies and foundations, etc., who could use it as part of an LDI strategy or as a standalone product. Sovereign bond strategies products have no corporate credit exposure and therefore do not have the issues associated with a lack of liquidity as is the case with some distressed corporate credits. Some firms have launched products that involve generating alpha solely through playing within and across G4 or G10 government bond yield curves; such macro funds have found favour with investment consultants in the current environment. For institutional investors, selecting managers for absolute return strategies is not as straightforward as choosing managers for specialist investment areas such as emerging market debt or high yield. The key issue to appreciate is that although the benchmark remains constant in that it is pegged to Libor, the strategies used can vary. It can therefore make sense for an institutional investor to have diversification across a few different strategies within their fixedincome allocation. Summer 2010 the markit magazine