Fixed income managers: evoution or revoution Traditiona approaches to managing fixed interest funds rey on benchmarks that may not represent optima risk and return outcomes. New techniques based on separate apha and beta management shoud improve portfoio performance. Susan Buckey is Managing Director, Active Management Division, QIC. Emai: s.buckey@qic.com In an increasingy competitive investment environment, fund managers need to meet cient objectives and contribute meaningfuy to overa portfoio outcomes. Whie most investment institutions sti rey on the reativey static strategic asset aocation (SAA) framework deveoped in the 1990s, there is an emerging trend away from the traditiona approach to techniques that achieve cient objectives more effectivey and efficienty. The traditiona approach uses fixed income assets mainy as risk-reducing aocations tied to an ineffective benchmark. Subsequenty, the active return target is generay ow and even when a fixed income manager strongy outperforms their benchmark, their weighted contribution to the cient s tota fund eve is negigibe. Aside from currency markets, the fixed interest market is the argest and most iquid securities market in the word, providing a wide and ever-increasing range of investment options. This breadth of opportunities faciitates the deivery of scaabe and capita-efficient pure apha strategies that can sit over any beta return. This paper outines weaknesses of the traditiona approach. It discusses evoving techniques to separate activities aimed at achieving apha and beta, and argues that these wi ead to the eventua diution of the traditiona stye of management. Goba fixed income markets Fixed interest investing continues to evove from traditiona government and corporate bonds to more innovative subasset casses and derivative instruments. Investors have typicay hed bonds in their portfoios for three reasons: most bonds provide a eve of fixed income; diversification: bonds and equities are generay owy correated (that is, with interest rate risk athough, over the recent past, this correation has increased with the expansion of credit markets); and protection against economic sowdown or defation: in periods of strong economic growth, infation typicay 46 jassa the finsia journa of appied finance specia issue 2008
rises and a fixed income portfoio s stream of income becomes ess vauabe; the converse appies in periods of weak economic growth or defation. However, through the deveopment, innovation and evoution of fixed interest markets, investors are now abe to target specific fixed interest risk premiums and to structure a portfoio to effectivey meet a variety of investment objectives at a meaningfu eve. Underpinned by deep and broadening fixed income physica or cash markets, there has been strong growth and deveopment in over-the-counter (OTC) derivative securities incuding interest rate swaps, infation swaps and, particuary, muti-name and singe name credit defaut swaps. The Bank of Internationa Settements (May 2008) estimates that notiona outstandings in CDS at the end of 2007 was US$58 triion. Traditiona approach The traditiona approach to active bond investment typicay invoves managing a dedicated fixed income portfoio reative to a specified benchmark. For Austraian investors, the UBS Composite Index is the most popuar benchmark. Active management entais managing portfoio risks within specified constraints to retain the overa market characteristics that the fund is aso seeking. The focus of active risk management incudes: the portfoio s duration and yied curve positions reative to benchmark; the credit quaity of the portfoio reative to benchmark; the maturity structure of the portfoio, based on the expected changes in the reationship between bonds with different maturities; the mix of fixed interest asset casses and countries depending on the investor mandate; and tracking error. In genera, fixed interest benchmarks present a number of compex issues. Issues arise because these benchmarks are capitaisation weighted and a-incusive. The two major inefficiencies reate to the duration probem and the bums probem. The first probem stems from the fact that the duration of the benchmark comes from issuer preferences and does not necessariy refect the best interests of a given investor. The proportions of bonds in short, intermediate, and ong-term categories refect the maturity or duration preferences of issuers seeking to minimise their cost of capita. Moreover, an investor usuay has specific timehorizon preferences that make one duration more advantageous than another. These preferences do not necessariy match those of issuers in the aggregate, whose preferences are refected in the benchmark. Second, the bums probem is that the biggest debtors (either companies or countries) have the argest weight in the benchmark the biggest bums so the benchmark is not ikey to be mean-variance efficient. If a manager is tracking such a benchmark, when a security is issued they have to buy it in proportion to its capitaisation weight to minimise tracking error, even if the quaity of the security is ony just high enough to make it into the index. Such securities woud seem to be the most ikey to be downgraded or to defaut. Another issue reated to fixed income benchmarks arises from the recent growth in the size of the credit market. The recent trend incudes a reduction in the size of Treasury debt and an increase in corporate issues. As a resut, broad-based bond benchmarks are more exposed to tai events than they have been in the past. Disappointing bond returns As the downward trend in infation and interest rates abated over the past few years, fixed interest market (beta) returns have disappointed Austraian investors. It is not unusua for one-year Austraian Bond Indices (UBS Composite Bond Index) returns to underperform cash. Figure 1 iustrates the ong-term decine, foowed by stabiity of cash returns, and faing returns and voatiity for the Austraian and goba fixed interest benchmarks. With the prospect of higher goba infation and interest rates, the potentia for extended fixed income capita gains within traditiona fixed income benchmarks wi be imited. For investors focused on traditiona benchmark returns this approach may not be an optima strategy. Historica anaysis of managers returns highights that whie fixed interest benchmark returns have been decining, many managers have strugged to outperform the benchmark. We beieve that this is due to a reiance on strategies that are tied to benchmark characteristics and often do not represent the optima risk/return structure for investors. Comparing the 12-month roing correations of the UBS Composite Bond Index (Austraian benchmark) and the Lehman Goba Aggregate Bond Index (goba, hedged in Austraian doars) with the median fixed interest manager returns, the foowing observations can be made: Another issue reated to fixed income benchmarks arises from the recent growth in the size of the credit market. The recent trend incudes a reduction in the size of Treasury debt and an increase in corporate issues. As a resut, broadbased bond benchmarks are more exposed to tai events than they have been in the past. there is very strong positive correation between the benchmark and median manager returns for the Austraian fixed interest universe; 1 jassa the finsia journa of appied finance specia issue 2008 47
FIGURE 1: Bond benchmark returns versus cash Sources: Mercer Investment Consuting, QIC and Boomberg. there is greater variabiity in correation between goba benchmark and manager returns 2 compared to Austraian fixed interest; and overa, active fixed income management has not been evident (unti very recenty) in traditiona portfoios in the ast decade. Weaknesses of the traditiona approach for fixed interest investment management incude: a preoccupation with benchmarks and a reuctance to hod significant aocations of assets that fa outside the benchmark; SAAs tend to be static for ong periods, even in the face of significant changes in market vauations; active mandates are aocated in accordance with SAA weights so some managers are reduced to making insignificant contributions if they manage within an asset cass that has a sma aocation; and active managers tend to be anaysed by investors on an unweighted basis. There is sedom any trade-off between a good equity manager and a good fixed interest manager as they vie for a share of the overa portfoio s (apha) risk budget. The estabishment of an investment framework of independent apha and beta poicy decisions to achieve ong-term cient investment objectives wi address these weaknesses. Separate apha and beta Depending on composition and construction, fixed interest portfoios can provide significanty different risk and return outcomes to investors. By operating independent apha and beta poicies fund managers can better refect the investment objectives of their cients. Beta poicy is deveoped to provide a market return stream (not necessariy a benchmark return). Typica aocations incude setting sector exposures (for exampe, government bonds, corporates, high yied, emerging markets), country aocation, credit imits, infation exposure and overa duration. The structure shoud refect the investment objectives and risk preferences of the cient. Apha poicy is aimed at constructing an absoute return portfoio that provides diversification (mutipe apha sources), a consistent return stream, and an outcome that is not tied to any changes to beta (market) returns. For exampe, in traditiona portfoios the seection of benchmark virtuay predetermines the sources of apha regardess of their quaity. Over the medium term, the apha portfoio shoud not be subject to the direction of markets. The abiity to impement ong/short strategies via derivatives aows skied managers to outperform in a environments. The most important step in buiding beta and apha poicy is to understand the investment objective of the portfoio. Beta risk and return Broady speaking, the returns from the fixed interest asset cass refect four fundamenta risk premia: rea interest rate risk infation uncertainty credit risk ikeihood of defaut iiquidity risk term premium shape of the yied curve credit premium risk of hoding 48 jassa the finsia journa of appied finance SPECIAL issue 2008
The traditiona approach to accessing fixed interest returns has been through benchmarking. These benchmarks often do not represent the optima risk/return structure to manage physica assets for investors. There are currenty more than 12,300 securities in the Lehman Goba Aggregate (LGA) portfoio. Many of these bonds were issued years ago and are consequenty iiquid. Thousands of these issues are ocked away in ong-term bond portfoios and coud ony be purchased by paying extremey high prices. For this reason, fu repication of a broad bond index is highy compex. Enhanced indexing invoves investing in a arge sampe of bonds such that the portfoio risk factors match the index risk factors (namey, cash fows, sector weights, duration and quaity). This portfoio wi have higher tracking error than fu repication but can be impemented and maintained at much ower cost. Some investment managers estimate that owning bonds from 175 issuers wi repicate the LGA with acceptabe tracking error. By using many of the market innovations, investors can effectivey repicate most sources of fixed interest return (incuding credit) via synthetic repication. It is possibe for investors to guarantee gross benchmark performance through a tota return swap with an investment bank or counterparty. Significant credit risk exists as the investor is tied to the counterparty who offers the swap (generay the owner of the benchmark). The other instruments avaiabe to syntheticay repicate benchmark performance are bond futures, interest rate futures, interest rate swaps, mortgage futures and credit defaut swaps/indexes. Fixed interest apha is meaningfu Instrument innovations aow skied active managers to generate high apha returns for investors. We expect that highy active strategies in fixed interest investments wi become more prevaent as market returns continue to disappoint. At tota fund eve, fixed interest apha is meaningfu because it provides the foowing features: Depending on composition and construction, fixed interest portfoios can provide significanty different risk and return outcomes to investors. By operating independent apha and beta poicies fund managers can better refect the investment objectives of their cients. the fexibiity to adjust underying betas without disrupting apha sources; improved diversification of apha sources with the switch to absoute return from fixed interest benchmarks; ow correation to beta; greater capita efficiency with the use of derivatives and overays (which are generay iquid and have huge capacity in fixed income markets); the abiity to manage apha costs incuding the use of derivatives to ower transaction costs and use of performance fees to aign managers to cient objectives; and apha becomes more scaabe. FIGURE 2: Fixed interest apha opportunity set Source: QIC. jassa the finsia journa of appied finance specia issue 2008 49
Tota apha shoud be approached as a singe, integrated stream of return (ideay as an absoute returnabove-cash concept). It shoud form a materia part of overa risk taking (at eves we above those currenty embedded in typica Austraian superannuation fund risk budgets). It shoud be unconstrained in structure and sourced from as many independent sources as is efficient. The apha stream shoud be evauated on an after-fee, after-tax basis. In determining opportunities to generate meaningfu apha, fixed interest managers need to aso consider a variety of fixed interest sectors via a thorough anaysis of the broad goba opportunity set. This anaysis shoud expore an unconstrained universe of fixed interest sectors, focusing on those opportunities with the greatest potentia for apha. Athough the opportunity set is arge, it may be further expanded to incorporate a variety of additiona subsector market opportunities. Figure 2 dispays the fixed interest apha opportunity spectrum; typicay the higher the apha the greater the risk. Figure 3 shows the potentia strategies used by a fixed interest manager to drive apha risk budgets. Scaabiity Scaabe fixed interest is reativey easy to achieve due to the depth and iquidity of goba interest rate and credit derivative markets. Impementing strategies through synthetic instruments provides access to exposures with minimum cost and ow tracking error. The derivatives market aows a fixed interest manager to impement short and ong positioning across country yied curves, indices and individua corporate securities. The key risk with derivative-based strategies is that the price may differ from that of the underying physica assets. During the 2007 08 credit crisis, derivative credit spread indices and singe-name contracts maintained significant voatiity whie physica securities spreads did not move with the same voatiity. This is highighted in Figure 4 which shows the credit spread movement of Commonweath Bank securities with simiar maturity. Whie the market outook for fixed interest returns remains reativey subdued, instrument innovations have aowed skied active managers the faciity to generate high apha returns for investors. We expect that highy active strategies in fixed interest investments wi become more prevaent as the market return continues to disappoint. Using the returns from goba benchmarks, it is cear that goba fixed interest apha can be uncorreated to fixed interest beta, highighting that it is a pure apha source of return. A skifu manager transates research and portfoio construction into apha by taking advantage of inefficiencies and breadth of opportunities within fixed interest markets. Tabe 1 shows that fixed interest apha is aso uncorreated to equity beta. This ow or negative correation to equities makes an aocation to fixed interest apha attractive for a baanced fund as it reduces risk at the tota portfoio eve. TABLE 1: Goba fixed interest apha correations Goba Fixed Interest Apha Correation vs Austraian Equities (S&P/ASX 200) -0.09 Internationa Equities (MSCI Word ex-austraia) 0.02 Austraian Fixed Interest (UBS Composite Bond) -0.29 Internationa Fixed Interest (LGA) -0.16 Sources: Mercer, QIC based on 2004 08 returns. Goba Fixed Interest proxy is derived from QIC GFI Apha Fund and QIC Diversified Fixed Interest Fund Overay. FIGURE 3: Diversified apha pie Source: QIC. 50 jassa the finsia journa of appied finance SPECIAL issue 2008
FIGURE 4: Commonweath Bank physica and synthetic credit spreads Sources: QIC, Boomberg, UBS. Concusion Whie the market outook for fixed interest returns remains reativey subdued, instrument innovations have aowed skied active managers the faciity to generate high apha returns for investors. We expect that highy active strategies in fixed interest investments wi become more prevaent as the market return continues to disappoint. This paper has briefy touched on the intricacies and compexities of managing a fixed interest portfoio. The key themes are: the importance of understanding cients tota fund objectives and structuring mandates that wi deiver beta (market) and apha (active) returns most effectivey and efficienty; fixed interest benchmarks commony used by investment managers often do not represent the optima risk/return structure for investors because duration and composition is impacted by the issuers; synthetic repication of fixed interest benchmarks has been shown to be effective. By using many of the market innovations it is possibe to repicate most sources of fixed interest return; fixed interest apha offers investors great opportunities to improve returns and reduce risk across their portfoio due to the ack of correation to equity beta; and the breadth and scaabiity of fixed interest markets aows deivery of capita-efficient apha at fund eve. For the traditiona fixed income portfoio manager, evoving separate apha and beta management capabiities and products may fee revoutionary, but it wi provide techniques to improve cients portfoio performance. The aternative to this evoution away from traditiona fixed income management is to fa behind those asset casses and managers who can construct beta portfoios and deiver meaningfu apha returns. Notes 1 Mercer Survey of Austraian Fixed Interest to 30 September 2008. 2 Mercer Survey of Goba Fixed Interest (hedged in AUD) to 30 September 2008. References Bank of Internationa Settements 2008, OTC Derivatives Market Activity in the Second Haf of 2007, Monetary and Economic Department, May. Mercer Investment Consuting 2008, MPA Whoesae Survey Historica Returns, May. jassa the finsia journa of appied finance specia issue 2008 51