WHITE PAPER February 2015 For professional investors Navigating through flexible bond funds Risk management as a key focus point Kommer van Trigt Winfried G. Hallerbach Navigating through flexible bond funds 1
Flexible bond funds Flexible bond funds have become increasingly popular. Being benchmark unaware, flexible bond funds escape from the constraining risk-reward profile of an index. Their portfolio allocation can shift quickly over time and across fixed income asset classes and sometimes beyond. The greater diversity and dynamics in the allocations of flexible funds warrant a special focus on transparency and risk management. In this paper, we present focus points that facilitate the comparison and evaluation of flexible bond funds. In addition, we evaluate Robeco s flagship total return bond fund Rorento against these focus points. Flexible bond funds: why invest in them? The global fixed income market is broad, covering many different asset classes, sectors and regions. The returns and risks differ greatly, both across asset classes and over time (see Exhibit 1). This offers great opportunities when a portfolio manager has the flexibility to attune his portfolio to the different prospects the fixed income market offers. In addition, the current low yield environment has fueled the broad desire to widen the margin to maneuver. Exhibit 1 Returns of selected fixed income classes Calendar years, source: Barclays Capital. 1 The value of your investments may fluctuate. Returns obtained in the past are no guarantee for the future. 1 For comparability, all returns (except for local currency emerging market debt) are hedged to USD. Navigating through flexible bond funds 2
Flexible bond funds can invest over the full spectrum of fixed income markets: across fixed income asset classes, geographical regions, sectors, tenors and seniority. As a result, they form a heterogeneous fund category and are known under various names, such as unconstrained, strategic income, diversified (income), go-anywhere, total return and absolute return. Although the landscape of flexible bond funds is very diverse, their shared target is to generate positive total return and to preserve capital while using strategies that fully exploit different opportunities in different parts of the bond market. Their flexibility in investment policy signifies an important advantage over: 1. funds dedicated to only a segment of the market (such as government bonds, investment grade or high yield credits, or emerging debt), and 2. funds that are tied to an index under a tracking error constraint. Indeed, the investment flexibility of flexible bond funds does not relate to over- and underweighting specific segments of the market but instead to the composition of the whole portfolio. Being opportunity-driven, their portfolio compositions can be very diverse and change quickly over time. This has important implications for both the scope and the complexity of the investment process. Key focus points Although we acknowledge that the investment philosophy, process and team are important considerations for any fund, we zoom in on characteristics that are especially relevant for flexible bond funds. Since flexible funds enjoy more leeway than traditional bond funds, their risk profile is markedly different. Consequently, when evaluating flexible bond funds, this risk profile warrants increased scrutiny. In addition, we argue that it is important that flexible bond funds fully integrate risk management in their portfolio decision process. We consider it equally important for flexible bond funds to provide disclosure and transparency, not only on the composition of their portfolio but also on the potential dynamics of the risk profile and on the risk management process. In this paper, we present arguments to sustain these statements as well as a list of focus points that offer guidelines when evaluating a flexible bond fund. A more extensive paper on this topic is available on request. Flexible bond funds can profit from return differences between fixed income asset classes Diversity and flexibility in investment strategies Special focus on risk management and transparency How to recognize a flexible bond fund? These funds are not linked to benchmarks so there is no default or benchmark allocation, nor is there a tracking error constraint to limit portfolio positioning. Hence, the focus is on total return instead of relative return. These funds are not committed to a single fixed income asset class. Instead, they can exploit the opportunities offered by all fixed income classes. What about Rorento? Since its inception in 1974, Rorento covers the full global bond universe. It can invest in all fixed income asset classes, including high yield bonds, inflation-linked bonds and floating rate Asset-Backed Securities (ABS). By being benchmark agnostic, Rorento has the flexibility to tailor its portfolio towards the most attractive investment opportunities across the global fixed income asset classes. The focus is on total return and not relative return. Navigating through flexible bond funds 3
The implications for managing a flexible bond fund The greater flexibility to allocate across the fixed income markets offers flexible bond funds more opportunities to position the portfolio towards superior risk-return trade-offs. On the flip side of the coin, it is up to the portfolio manager s skill and resources to successfully pick up the challenges implied by this broader investment scope. Holistic view The portfolio manager s focus is on the full composition of the current portfolio and hence on the portfolio s total return and risk. The target is not the return relative to the index (alpha) but instead the total portfolio return. Consequently, (1) tracking error is replaced by total portfolio return volatility as a relevant primary risk measure, and (2) risk-adjusted performance is no longer measured by the Information Ratio but by the Sharpe Ratio. Hence, the scope of risk management is broadened from the fairly limited alpha portfolio (partial) to the composition of the overall portfolio (holistic). Holistic versus partial perspective Transparency on total risk profile To evaluate the current choices of the portfolio manager in terms of risks and returns, investors may desire flexible bond funds to offer increased disclosure of the portfolio s current composition and risk profile. Because a flexible strategy has no index-based anchor for its risk profile, a relevant question is whether a flexible bond fund maintains a (downside) risk profile that investors associate with the global bond market. Portfolio shifts require more transparency The flexibility to shift the portfolio composition over time and across investment opportunities makes the risk profile of a flexible fund dynamic over time. This broader and dynamic context of total return risk poses a challenge to the risk management process. Moreover, in order to prevent negative surprises to investors, we consider it important that a flexible bond fund manager not only discloses the fund s current total risk profile but can also provide clear insight into its potential dynamics. This calls for adequate transparency about the processes and systems that monitor the risks of future portfolio shifts. Investment universe and risk exposures Being unconstrained, it can be tempting for a flexible bond fund manager to also invest in non-fixed income asset classes. Indeed, some flexible bond funds carry significant exposures to foreign currencies or venture outside the fixed income markets by investing in equities. Although some of these markets may offer attractive return and diversification opportunities, their risk profile is of a different order than that of the bond market. When adding these assets to a fixed income portfolio their risk contributions can be very large and hence change the portfolio s risk profile significantly. Large risk contributions lower the degree of portfolio diversification and they change the sources from which the return fluctuations come in a material way. So in addition to the level of portfolio risk, we also deem the composition of portfolio risk insightful when evaluating and comparing flexible bond funds. Current and potential future risk profile The level and composition of risk Navigating through flexible bond funds 4
Focus points: Flexible bond fund risk profile monitoring Is the fund a real bond fund or are there excessive exposures to foreign currencies, or to other asset categories outside the fixed income market, such as equities? What transparency is provided about the fund s current risk profile? What are the fund s exposures to risk factors such as interest rates and credit spreads? Regarding market risks, does the fund provide information about (ex-ante, or realized) total return volatility (as opposed to tracking error)? How is the overall risk level of the fund monitored? Does the fund provide information about additional risk measures, especially downside risk measures, such as Value-at-Risk and drawdowns? What disclosure is provided on the flexibility regarding future portfolio compositions? How is the fund s dynamic risk profile tracked over time (process) and how fast are market dynamics incorporated in ex-ante risk estimates (methodology)? What about Rorento? Rorento is a flexible bond fund but remains a bond fund. It does not invest outside the fixed income markets (e.g. no equity holdings) and it has no excessive exposures to foreign currencies. Its modified duration is limited to the range between 0 and 10. Focusing on total returns, Rorento s objective is to maximize the Sharpe Ratio. Rorento s ex-ante volatility is targeted to the range between 2% and 6%, so on an ex-post basis Rorento will offer its investors a bond-like volatility and limited downside risk. Downside risk is monitored by drawdowns and Value-at-Risk. Exhibit 2 lists Rorento s historical volatility over the period 2004-2014. Rorento example: risk Over the 10-year period from November 2004 through October 2014, Rorento s ex-post monthly total return volatility was 3.6% per annum. During this period, the 36-month volatility moved between 2.4% and 4.8%. This is well within the targeted ex-ante range of 2%-6%, see Exhibit 2. Exhibit 2 The historical range of Rorento s 36-month volatility Source: Robeco Navigating through flexible bond funds 5
The need for integrated risk management Monitoring the overall risk profile as a resultant of the fund s positioning is not enough. We argue that risk management should be an integral part of the investment process. Not simply as an add-on, but instead embedded in the full decision cycle, ranging from ex-ante evaluating investment opportunities to ex-post performance evaluation and attribution. Slicing and dicing risk Capital preservation is traditionally considered one of the main objectives of a bond fund; hence, significant negative performance swings and significant drawdowns are considered undesirable. Avoiding pockets of excessive risk contributions in the portfolio ( hot spots ) will help in attaining this objective. A fund manager will therefore often walk a fine line between being outspoken and not too outspoken in his portfolio and risk allocation. It is therefore important for the portfolio manager to know where the risk sensitivities of the portfolio lie. Excessive risk concentrations can lead to large drawdowns, while over-diversification will dilute portfolio positions and their impact on portfolio return. Finally, the attribution of portfolio risk to risk factors such as interest rate risk and credit risk can provide valuable insights. and reward Risk, however, is not only a danger but also an opportunity. After all, without taking risks one cannot expect to reap rewards in excess of the risk-free rate. The trade-off between risk and reward on the overall portfolio level is measured by the Sharpe Ratio: the reward (or risk premium) divided by the standard deviation of the excess return (risk). Maximizing the portfolio s Sharpe Ratio requires aligning the contributions to risk and reward within the portfolio. The portfolio manager faces the challenge to make the overall portfolio composition consistent with perceived risk-reward trade-offs. An adequate risk tool box can support the fund manager in this complex task. Relevant questions when evaluating and adjusting the portfolio are: what are the risk contributions within the overall portfolio? Are these risk weights matched with expectations for future rewards? Is the portfolio optimally geared to reap the expected rewards? Risk management through the full decision cycle Atributing risks to positions and risk factors Balancing contributions to risk and reward Focus points integrated risk management Is the fund able to present a risk management framework? Is risk management embedded in the full decision cycle, in other words: does risk management permeate in each step of the investment process? What different types of risk measures are used (total and downside risk, risk horizon)? Is there insight into the risk contributions within the portfolio, across different dimensions (positions, sectors, regions, foreign currencies, as well as risk factors such as interest rates and credit spreads)? What tools are used to monitor risks on the overall and dissected levels? How are ex-ante risk-reward trade-offs evaluated? How is this information translated into the fund s positioning? Is the ex-post performance attribution also performed on a risk-adjusted basis? Navigating through flexible bond funds 6
What about Rorento? For Rorento, we developed a SMART integrated risk management framework, involving: Systematic monitoring and evaluation of risks, using a Multidimensional risk concept with complementary risk measures. Risks are Attributed to positions and risk factors and Risk-reward trade-offs are systematically evaluated. Various Tools are used to continuously monitor Rorento s ex-ante risk profile. Risk management covers the full decision cycle. Ex-ante, the risk contributions across positions and factors are evaluated and the portfolio is tilted towards risks that offer above-average attractive rewards. Dedicated quant researchers challenge the portfolio manager about his positioning. Ex-post, the success of the investment decisions is being judged by means of a risk-adjusted performance evaluation and attribution. Rorento example: money weights versus risk weights One way to assess ex-ante portfolio risk is to examine the portfolio s duration and credit spread exposures on a volatility basis. In this view, we distinguish between interest rate risk (driven by changes in government bond yields) and credit risk (driven by changes in spreads over a risk-free curve). Indeed, credits (all instruments with a spread over a risk-free curve) and government bonds do not necessarily flourish in the same economic scenarios and a major allocation decision in the fixed income markets is shifting between these asset classes. As an illustration, we consider the Barclays Capital Multiverse index (the broadest available global bond index and Rorento s reference index) as per ultimo October 2014. At that time, its total market capitalization is composed of 52% Treasuries, 13% government-related, 20% corporates and 15% securitized. So in terms of money weights, the index offers quite a balanced exposure to government bonds and credits. However, credits are not only exposed to credit risk but also to interest rate risk. Conversely, Eurozone periphery government bonds do not only carry interest rate risk but also credit risk. Hence, in terms of risk weights the picture can be completely different. Indeed, the Multiverse s risk profile was highly skewed: a whopping 104% of its ex-ante volatility is due to interest rate risk and -4% due to credit risk (see Exhibit 3). Exhibit 3 Attribution of total return volatility, as per 31-Oct 2014 Source: Robeco. All positions (except FX) are hedged to EUR. A decomposition of Rorento s ex-ante volatility (also ultimo October 2014), instead, shows that the interest rate and credit risk contributions were about equal. This is consistent with the roughly equal reward opportunities we perceived at that time for bearing interest rate risk and credit risk. Finally, in line with the aim not to have excessive exposure to foreign currencies (FX), the risk contribution from FX is indeed modest. Navigating through flexible bond funds 7
Summary Investing in flexible bond funds appears to have appeal. After all, their flexibility allows them to steer to those segments of the fixed income market that are most promising given the prevailing economic conditions and valuations. At the same time, however, the diversity in flexible bond funds and the dynamics in their investment strategies make it difficult to evaluate them and compare them against each other. In this paper, we listed a number of focus points that can assist when navigating through the capricious landscape of flexible bond funds. We summarize the key focus points below: Holistic view Flexible bond funds are not tied to an index. Instead, a holistic view applies and the portfolio manager can steer the full portfolio towards the areas where he sees most opportunities. The primary risk measure is total return volatility. The diversity and the dynamics in the investment strategies of flexible bond funds warrant greater demands on their risk management process and transparency. Transparency Transparency will mitigate negative surprises to investors. This transparency does not only relate to the investment universe and the current risk profile (is it bond-like?), but also to investment strategies, potential dynamics of the total risk profile, and risk monitoring systems. Integrated risk management When evaluating and comparing flexible bond funds, we also deem the composition of total portfolio risk insightful. A risk attribution reveals what asset classes or risk factors are likely to generate portfolio returns. The relative size of the risk contributions impacts the degree of portfolio diversification and reflects the relative views and convictions of the portfolio manager. The Sharpe Ratio is the risk-adjusted performance measure of total returns. Maximizing the Sharpe Ratio requires aligning the contributions to risk and reward within the portfolio. Fully integrating risk management in the investment process allows for evaluating risk-reward trade-offs within the portfolio, balancing the risk contributions of positions and controlling overall portfolio risks. Kommer van Trigt Lead portfolio manager Rorento Winfried G. Hallerbach Quant Fixed Income Research Navigating through flexible bond funds 8
Important information This publication is intended for professional investors. Robeco Institutional Asset Management B.V. (trade register number: 24123167) has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This document is intended to provide general information on Robeco s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com. Navigating through flexible bond funds 9