Redefining Core Fixed Income

Transcription

1 July 2014 WHITEPAPER World Bond Fund Symbols: A: HWDAX C: HWDCX I: HWDIX R3: HWDRX R4: HWDSX R5: HWDTX Y: HWDYX Redefining Core Fixed Income Hartford World Bond Fund Historically, investors believed that desired investment characteristics (diversification, liquidity, and lower volatility compared with equities) of their core fixed-income allocations would be adequately addressed by the domestic fixed-income markets. These assumptions may no longer hold true over extended periods of time for several reasons. First, the U.S. government in the past few years has become a bigger participant in the domestic fixed-income market through various assetpurchase programs. From a credit-risk-concentration perspective, it might make sense to diversify this default risk-free exposure across a variety of sovereigns with relatively healthy credit profiles. Second, across the world, various countries and economies exhibit varying interest-rate and credit cycles. Skillfully managing exposure to global bond markets has the potential to enhance returns in a diversified and efficient manner. Given this expanded opportunity set, it might be time for domestic fixed-income investors to reconsider their home-market bias in the context of their core fixed-income allocation. Third, the global monetary system has undergone a dramatic change due to the unprecedented monetary and fiscal stimulus measures initiated by policy officials worldwide. As a result, investors should actively reconsider the ebbs and flows of the U.S. dollar and other global currencies in their fixed-income allocations. Finally, opportunistic allocations to global bonds on an unhedged basis act as a hedge against the potential long-term structural decline of the U.S. dollar (Figure 1). FIGURE 1 U.S.Dollar Spot Price The U.S. Dollar s Long-Term Decline (Trade-Weighted U.S. Dollar Index Spot) 80 12/99 12/01 12/03 12/05 12/07 12/09 12/11 12/ Source: Federal Reserve Economic Data, December 2013 Trade Weighted U.S. Dollar Index: Broad (TWEXB) which is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners. Insight From Our Sub-Adviser: KEY POINTS Robert L. Evans Director, Partner Fixed-Income Portfolio Manager Professional Experience Since 1980 BA, Duke University MBA, Dartmouth College Mark H. Sullivan, CFA, CMT Senior Vice President and Partner Fixed-Income Portfolio Manager Professional Experience Since 2002 BA, Colgate University A core fixed-income strategy should not only be able to potentially generate total returns, but also help reduce portfolio volatility during periods of market stress. Hartford World Bond Fund is designed to capture global investment opportunities and help reduce the volatility of returns across a variety of investment environments. The World Bond Team is part of the larger Bond Investment Team which manages $80.7 billion of the $394 billion in fixed-income assets under management at Wellington Management (as of 12/31/13). NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC. 1

2 The New Core Hartford World Bond Fund has an innovative investment approach that is redefining the core fixed-income space (Figure 2). The Fund, sub-advised by Wellington Management, seeks capital appreciation with income as a secondary goal. It offers potential for total return, a low correlation to equities, and less volatility relative to equities during times of market stress. The Fund has the flexibility to identify and capture the most attractive investment ideas from the global fixedincome and currency markets without being constrained to a benchmark. The portfolio managers believe that the global fixed-income markets provide ample opportunities to exploit market inefficiencies and extract returns. Dedicated global macro and currency strategists work in conjunction with the firm s experienced credit research teams to provide independent, uncorrelated sources of returns from interest-rate, credit, and currency strategies. Their investment strategy and process has a full-marketcycle mentality that seeks to reduce the volatility of total returns across a variety of investment environments. A Distinctive Team Focus One of Hartford World Bond Fund s differentiating characteristics is its team-oriented approach. The team, led by Portfolio Managers Robert Evans and Mark Sullivan, is structured to take advantage of three key concepts: specialization, diversification, and risk management. The Fund has 19 specialized investors and seven dedicated strategists each with their own expertise across 64 different countries, 32 different currencies, and multiple sectors. The World Bond Team combines macro, currency, and quantitative investors with dedicated professionals who cover global, corporate, high-yield, structured, and emerging-market debt. The portfolio managers allocate risk to the investors on the World Bond Team to allow them to take advantage of opportunities in their areas of specialization, and then focus on combining it in such a way to help ensure that the risks they re taking in the Fund are consistent with its objectives. The World Bond Team is a part of the larger Bond Investment Team which manages $80.7 billion of the $394 billion in fixed-income assets under management at Wellington Management (Figure 3). FIGURE 2 Hartford World Bond Fund s Investment Approach An integrated approach to research enhances investment decision-making The team utilizes multiple resources to gain exposure to domestic, foreign developed, and emerging fixed-income and currency markets The portfolio managers utilize three main levers to generate potential returns: interest rates, currency, and credit Daily risk management helps portfolio managers avoid unintended risks in pursuit of potentially attractive risk-adjusted returns 1 Research 2 Macro Analysis Credit Analysis Fixed Income Strategists Country Analysis Technical Analysis Industry Analysis Quantitative Analysis Currency Analysis Exposure Monitoring Idea Generation Government Macro Emerging Markets High Yield 3 4 Interest Rates Correlation Analysis Return Sources Return Drivers Currency Risk Management Currency Country Rotation Securitized Corporate Analysis Stress Tests Credit Portfolio Construction Portfolio Managers of the Hartford World Bond Fund Sensitivity/ Scenario 2 FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC.

3 The Approach in Action To better understand the Fund s unique approach, let s examine how the Fund reacts to, and attempts to mitigate, the risks associated with fixed-income investing such as rising interest rates or rising inflation. Let s assume that good inflation would typically be accompanied by stronger growth, while bad inflation would occur in an environment of relatively stagnant or even lower growth. In the extreme, higher interest rates could even somewhat reflect the market s fear regarding sovereign risks. Wellington Management believes the art of investing is to interpret these shifts in the market, and to use this understanding to be proactive in their investment management process rather than reactive. Based on the skill and depth of experience of their Bond Investment Team, their investment strategy may reduce, eliminate, or provide negative duration exposure in countries where higher government bond yields are likely to materialize. The currency markets could provide similar opportunities. Depending on the specific country, policy officials might allow their respective currencies to appreciate in order to soften the impact of rising prices. In this case, the Bond Investment Team would seek to increase exposures to such currencies in order to benefit from their appreciation, and avoid exposure to currencies which are expected to experience downward pressures. Similarly, some corporations have a higher ability to pass on increasing cost pressures to their consumers while others don t. In this situation, the portfolio managers would opportunistically allocate to the corporate bonds of companies which have a favorable credit profile in such interest-rate environments. FIGURE 3 Wellington Management s Fixed-Income Asset Distribution $394 Billion in Fixed-Income Assets Source: Wellington Management Statistics as of 12/31/13. Unique Portfolio Construction US Corporate 23% Fixed Income 14% Core Duration 11% High Yield/Bank Loans 9% Emerging Markets 8% Mortgage 8% Long Duration 7% Credit 6% Short Duration 6% Inflation-Linked 2% Municipals/Crossover 2% Other 4% Hartford World Bond Fund utilizes three main levers to generate returns: interest rates, currency, and credit. These factors are taken into consideration when the portfolio managers or specialized investment teams identify what they believe to be attractive investment opportunities. The Fund has a core allocation to high-quality global sovereign debt based upon Wellington Management s proprietary research. Over a full-market cycle, the portfolio managers expect 50% of the returns to come from this core holding of select high-quality countries and 50% to come from opportunistic allocations. To be included in the core, these countries have to be viewed as high quality by Wellington Management, and have to offer an attractive combination of value, credit quality, and stable or improving fundamentals. In addition to this, each country in the core must also display that they can be highly liquid in times of market stress. When necessary, the portfolio managers want to be able to readjust the portfolio, and, in order to do so, the sovereign debt must have sufficient liquidity. This is especially critical since there is a premium on liquidity within the fixed-income market. More recently, liquidity in bond markets has generally become more constrained since the 2008 financial crisis, and the subsequent changes in U.S. and global financial systems. The Fund s focus on managing risk and reducing volatility is evident through this core allocation to high-quality global-sovereign debt. The portfolio managers have the flexibility to increase or decrease the core allocation based upon market conditions. They monitor these credit characteristics frequently and will make adjustments if any of the individual countries have credit, liquidity, or FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC. 3

4 valuation characteristics that start to become negative. In fact, since the Fund s inception, several countries have been added or removed based upon their analysis of the underlying credit, liquidity, or valuation characteristics. Hartford World Bond Fund sources the majority of returns from liquid sectors in the global bond market sector (interest rates and currencies). The investment process is designed to have no systematic bias to be consistently long market risk (i.e., overweight spread product), while still utilizing the strength of its credit research capabilities to avoid defaults and downgrades. This core allocation to high-quality global-sovereign debt is complemented by additional opportunistic, uncorrelated sources of return (Figure 4). This diversification can help to limit the Fund s downside risk. These opportunistic sources of return are sourced from investment teams focusing on country rotation, emerging markets, global securitized debt, global currency, global macro, global corporate, and global high-yield strategies. The team s starting point for currencies is to examine capital flows in order to understand, for example, why people are investing in the Norweigan krone rather than the euro. The portfolio managers run their currency analyses along three lines: structural, cyclical, and technical. Structurally, they look at long-term valuation measures, such as purchasing-power parity, and compare a currency s relative valuation to its long-term valuation. Cyclically, they assess how the cycle is reflected in a currency s valuation, and whether there are reasons, based on forecasts of where the cycle is headed, for the currency to move from undervaluation to fair value, or vice versa. They examine interest-rate differentials, the relationship to the equity market, and other cyclical factors that drive currency valuations over time. Currencies, unlike many other asset classes, exhibit strong trend characteristics, allowing the portfolio managers to utilize technical analysis. With these three lines of analysis, the portfolio managers believe they can manage the world s tradable currencies in a way that will add value over time. The specialized teams only invest when the risk-return ratio is favorable. When one of the investment teams has an idea that they think will benefit the portfolio, they run it through Wellington Management s proprietary risk management software to determine the probability of success. They only implement ideas that fit within their desired risk-return framework and have a strong potential of producing positive returns for the Fund. A holistic approach to risk management that combines quantitative tools and qualitative judgment helps them to balance upside potential with downside risk. FIGURE 4 Portfolio Construction: The New C.O.R.E. RISK MANAGEMENT Country Rotation C ore Allocation to Quality High Yield Emerging Market O pportunistic Sources of Return Corporate Government Securitized R isk Management E xpertise Macro Currency EXPERTISE 4 FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC.

5 Where Research Meets Opportunity In the period immediately preceding the global financial crisis in 2008, Wellington Management s global strategists believed the U.S. housing market was becoming a point of vulnerability not only for the U.S. economy, but also for the global economy. At the same time, the work of their financial industry analysts, who cover both equity and debt securities of banks, helped them grasp the potential for a global financial crisis given the fragilities of banks balance sheets if the U.S. housing market were to slow down. Once the crisis hit, their global strategists focused on central-bank actions that might change the downward trajectory of asset prices. When their strategists saw a significant rise in the base money supply, they alerted the Bond Investment Team that this was the signal they were looking for, representing a radical shift in Fed policy that would be very supportive of asset prices. From that point on, the Bond Investment Team started to add to their investments in the credit markets, in order to take advantage of the expected rebound in the mispriced credit markets. An Integrated Approach to Research Proprietary research is at the heart of Wellington Management s investment process. The World Bond Team relies heavily on Wellington Management s proprietary research to source ideas and add value to the portfolio (Figure 5). They seek inputs from a variety of perspectives. Wellington Management s investment platform consists of research analysts across a variety of disciplines including fixed income, equity, quantitative, technical, and macroanalysts. In addition to central research, they have a collection of investment teams that are led by one or two senior portfolio managers, and each investment team has their own team of analysts that apply the team s investment philosophy or lens. They are incented to not only be experts in their own areas, but to also share that expertise across the organization. Wellington Management s unique firm structure values specialized investment teams in the belief that specialization leads to expertise. Each portfolio manager on the Bond Investment Team is ultimately responsible for all investment ideas within their respective specialized strategy. Their fixed-income analysts views, and the views of other analysts across Wellington Management, are key inputs into developing the World Bond Team s broad investment strategy. They believe that taking a more diversified approach to idea generation (i.e., using multiple sources of research), helps them gain exposure to opportunities across a wide range of global fixed-income and currency markets. FIGURE 5 Fixed-Income Capabilities (as of 12/31/13) Avg. Yrs. With Wellington Management Avg. Yrs. of Experience Number of Professionals Fixed Income Portfolio Management Fixed Income Strategists Credit Analysts Quantitative Analysts Product Management Portfolio Analysis Total Average Years Central Research Industry Analysts Quantitative Analysts Derivatives Macroanalysis Technical Analysis Portfolio Coordinators Total Average Years Equity and Fixed-Income Trading Management Research Associates Total Investment Professionals 378 FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC. 5

6 Multi-Layered Risk Management Risk management is a term that is often used in the financial world, but its importance cannot be overstated. Daily risk management is an important component of the Hartford World Bond Fund s investment approach, and it helps the portfolio managers avoid unintended risks in their pursuit of attractive risk-adjusted returns. Wellington Management believes that effective risk management contains both qualitative and quantitative elements, and requires an open culture with a strong sense of ownership across functional lines. Their functional structure is augmented by their robust committee culture, with key risk-related committees including Counterparty, Risk Management, Product Panel, and Investment Review Groups. A Sharper Way to Invest To the portfolio managers of the Hartford World Bond Fund, risk management means mitigating drawdown risk. A drawdown is any decline in the market value of a portfolio and it lasts until the value has fully rebounded from the decline. Most investors want the smoothest ride possible from their fixed-income allocations, with minimal drawdowns. The keys to achieving this objective is a focus on risk-adjusted return, and diversification through careful management of correlations across multiple managers and within each component of a portfolio. The Sharpe ratio is widely recognized as a measure of risk-adjusted return. This metric is important because it can illustrate whether a portfolio s returns are due to smart investment decisions or a result of excess risk. The Sharpe ratio is useful not only in evaluating a manager s performance, but also in signaling the severity and duration of a portfolio s future drawdowns. The key to maximizing risk-adjusted return potential and minimizing drawdowns is to keep cross-manager return correlation low. The portfolio managers of the Hartford World Bond Fund allocate risk to various specialist portfolio managers in different parts of the market which should exhibit low correlations with each other over time. The portfolio managers choose specialized teams to run portions of the Fund because they believe these teams have unique, repeatable investment processes. In addition, the portfolio managers assign risk budgets to each specialized team and carefully monitor risk along many dimensions, including correlations across and within the underlying strategies. The portfolio managers also examine ex-post underlying manager correlations daily, and guard against excess correlation by examining the underlying portfolios sensitivity to a variety of macro factors for example, whether an underlying manager s returns are becoming closely tied to U.S. Treasury yields or to bond yields in general. The portfolio management team monitors correlation at two levels: within each individual manager s portfolio and across managers. The portfolio management team will adjust the risk profile if the aggregate portfolio develops a concentrated risk exposure for example, a duration exposure that could cause a significant drawdown if conditions turn adverse. Such steps are taken to reduce downside risk, even at the cost of potential upside. FIGURE 6 Risk-Management Process Allocate Risk Adjustment Idea Generation Monitor Risk Evaluate Risk Implementation 6 FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC.

7 In addition, Wellington Management has a set of sophisticated proprietary systems that support their portfolio managers, analysts, risk professionals, and supervisory committees to build and manage portfolios (Figure 7). Their Fixed Income Portfolio Management Tool, or FI-PMT, is their front-end portfolio construction system. It allows them to do a wide range of what-if analyses pre-trade to estimate the impact on performance. The Liquidity Evaluation Framework, or LiEF sm, helps them assess and manage the impact of changing market liquidity conditions on portfolios. Their Fixed Income Risk Engine, or FIRE, lets their managers see exactly where risk resides in portfolios, across many different dimensions, and estimates the potential impact of proposed trades. Wellington Management also uses third-party risk management systems. They utilize this information to compare and contrast what risks or opportunities Wellington Management s systems show versus the market consensus. Risk management is critical to the Hartford World Bond Fund because it helps to ensure the portfolio managers only take intentional risks with attractive risk-adjusted potential returns. They strive to allocate risk to various experts in different parts of the markets that, over time, should exhibit low correlations to each other. They also seek to uncover drivers of returns by running what-if scenarios to identify the market factors they are exposed to and the magnitude of potential losses from a shift in those factors. FIGURE 7 Risk-Management Tools Fixed Income Portfolio Management Tool (FI-PMT) Liquidity Evaluation Framework (LiEF SM ) Fixed Income Risk Engine (FIRE) Allows portfolio managers to monitor exposures by country, currency, sector, credit quality, and duration range, in real time, in both absolute and benchmark relative terms Enables what-if analyses to gauge impact of potential trades Linked to Wellington Management s compliance system for immediate pretrade testing of guideline compliance Creates a point-in-time estimate of a portfolio s liquidity Based on simulations that draw on issue-specific characteristics and historic patterns of trading activity Estimates transaction costs under normal as well as fire sale conditions Provides a comprehensive array of risk statistics at portfolio, sector, and individual-security levels Daily data on more than 160,000 securities Over 400 risk factors incorporated into the model, allowing a highly detailed picture of risk exposures by strategy Active-Trading Risk: Actively trading investments may result in higher costs and higher taxable income. Derivatives Risk: Investments in derivatives can be volatile. Potential risks include currency risk, leverage risk (the risk that small market movements may result in large changes in the value of an investment), liquidity risk, index risk, pricing risk, and counterparty risk (the risk that the counterparty may be unwilling or unable to honor its obligations). Fixed-Income Risk: The Fund is subject to interest-rate risk (the risk that the value of an investment decreases when interest rates rise) and credit risk (the risk that the issuing company of a security is unable to pay interest and principal when due) and call risk (the risk that an investment may be redeemed early). These risks also apply to the Fund's investments in U.S. government securities, which may not be guaranteed by the U.S. government. Foreign Investment & Emerging Markets Risk: Investments in foreign securities may be riskier than investments in U.S. securities. Potential risks include the risks of illiquidity, increased price volatility, less government regulation, less extensive and less frequent accounting and other reporting requirements, unfavorable changes in currency exchange rates, and economic and political disruptions. These risks are generally greater for investments in emerging markets. Sovereign debt investments are subject to credit risk and the risk of default. Junk-Bond Risk: Investments in junk bonds involve greater risk of price volatility, illiquidity, and default than higherrated debt securities. Market, Selection, and Strategy Risk: The Fund s share price may fluctuate due to market risk and/or security selections that may underperform the market or relevant benchmarks. If the sub-adviser s investment strategy does not perform as expected, the Fund could underperform its peers or lose money. There is no guarantee the Fund will achieve its stated objective. Mortgage-Backed Securities Risk: Mortgage-backed securities are subject to interest-rate risk, credit risk, prepayment risk, extension risk, and the risk that an investment s value may be reduced or become worthless if it receives interest or income payments only after other investments in the same pool. Non-Diversified Risk: The Fund is non-diversified, so it may be more exposed to the risks associated with individual issuers than a diversified fund. FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC. 7

8 Why Hartford Funds? We Think Independently Hartford Funds offers investors a different perspective through our sub-adviser Wellington Management one of the nation s oldest and largest investment managers with $869 billion in assets under management (as of March 31, 2014). Wellington Management distinguishes itself through global collaboration, specialized research, and a private partnership structure. We Invest Actively In today s complex and interconnected global markets, we believe that active management is a smart strategy for uncovering opportunities and managing risks. Our diverse line-up of more than 40 funds covers the spectrum of equities, fixed income, multi-strategy, and alternative investments. We Believe in the Power of Partnerships Navigating today s increasingly complex global markets requires a high level of sophistication and expertise. That s why we believe every investor can benefit by partnering with a trusted financial advisor who can help you build a diversified portfolio that s customized for your needs and goals. Think Independently. Invest Actively. Investors should carefully consider the investment objectives, risks, charges, and expenses of Hartford Funds before investing. This and other information can be found in the prospectus and summary prospectus, which can be obtained by calling (retail) or (institutional). Investors should read them carefully before they invest. The views expressed here are those of Wellington Management s portfolio manager(s) and should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. Hartford Funds are underwritten and distributed by Hartford Funds Distributors, LLC. Wellington Management Company LLP is a SEC-registered investment adviser and an independent and unaffiliated sub-adviser to Hartford Funds. All information and representations herein are as of 6/14, unless otherwise noted. WP140_ FOR FINANCIAL ADVISOR OR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH THE PUBLIC. hartfordfunds.com hartfordfunds.com/linkedin HARTFORDFUNDS