Strategy primer: Absolute return fixed income

Strategy primer: Absolute return fixed income AUGUST 2012 Yoel Prasetyo, CFA, CAIA, Senior Research Analyst Robert Moore, CPA, Research Analyst Absolute return fixed income ( ARFI ) investment products have been around for some time. While the underlying securities and strategies of these products are not new, recent investor focus has moved the concept of benchmark-agnostic, absolute return investing from the fringes of the investment landscape toward more acceptance of its use in fixed income portfolios. Introduction One of the key features of ARFI is that it releases investment managers from the inherent restrictions of inefficient benchmarks and enables them to operate within an unconstrained, absolute return framework. In the absolute return space, the mandate to invest only in line with the risks and securities within traditional benchmarks is relaxed, such that managers are not restricted as to the location and type of a fixed income risk application. This benchmark-agnostic aspect provides an alternative approach for the many investors dissatisfied with traditional fixed income benchmarks, where portfolio exposures can become significantly weighted toward the largest issuers (e.g., the recent large sovereign bond issuance occurring globally). There are also many other reasons for the recent increased focus on absolute return fixed income approaches. With many global bond rates at historically low levels, there is significant fear among investors that at some stage, plain vanilla bond investments will suffer through a rising rate environment. Hence many investors are looking to shift their fixed income investments toward return-generating sources that are less correlated with interest rate levels. Further, investors can consider ARFI in isolation either as a stand-alone method of seeking returns, or as a portable alpha strategy whereby ARFI returns are ported to some core investment, such as a core vanilla fixed portfolio. Our paper explores this unconstrained fixed income framework, provides an overview of absolute return fixed income and discusses how the addition of this strategy can potentially benefit broader fixed income and equity portfolios. First, we define absolute return fixed income and describe the heterogeneous approaches within the strategy. Next, we discuss the key risk and return characteristics of this strategy. Finally, we evaluate some of the potential benefits and risks of including ARFI in fixed income and equity portfolios. Absolute return fixed income defined There is little market consensus on defining the absolute return strategy for fixed income. Our preference is that absolute return fixed income is an unconstrained fixed income based strategy that aims to produce positive returns regardless of market Russell Investments // Strategy primer: Absolute return fixed income

direction. Several distinguishing features of an absolute return fixed income product thus are: 1. its active alpha-based strategies represent the manager s best ideas and are independent of traditional market betas; 2. it aims to generate positive returns regardless of the stage in the market cycle; and 3. it is not managed against a specific index or benchmark, but rather as an absolute target or a fixed spread to Libor. Many, though not all, absolute return strategies involve relative value strategies, whereby a short exposure is matched against a long exposure. The many forms of absolute return fixed income products The absolute return fixed income products offered in the marketplace come in many forms and are not exactly new to bond investors. When investors ask investment managers for a representative absolute return fixed income strategy, the products they are shown reflect a return objective (absolute return, total return, Libor plus); an opportunity set (global alpha, global opportunity, credit arbitrage); or a trading strategy (relative value, opportunistic, unconstrained). Some of the absolute return products are moving in their investment styles toward the strategies employed within the alternative investments space. At the portfolio level, however, the volatility in ARFI is expected to be on the lower end of the risk/return spectrum, comparable to that in traditional fixed income indexes. Further, ARFI comprises exclusively fixed income strategies; it is not a multi-asset class approach. Multi-sector strategy Absolute return fixed income strategies are best deployed across multiple sectors in the investing landscape by skilled investment managers who have demonstrated the ability to deliver sustainable alpha by identifying anomalies, mis-pricings and inefficiencies in the markets. Because of the benchmark-agnostic nature of ARFI products, investment strategies are not bound by exposure to a beta, which enables managers to be more selective in determining portfolio composition. We have observed that relative value is a significant component of ARFI. When released from benchmark and trade restrictions, a skilled manager can adopt relative value based strategies in a wide choice of areas. Thus, trades such as relative value credit (matching managers strongest buys to their strongest sells ) become available within an ARFI product, much more so than within a traditional fixed income framework. Portfolio construction can also be more creative, at times utilizing a blend of systematic (model-based or quantitative-based) and discretionary (qualitative- and judgmentbased) investment approaches, with return generation coming from strategies within one or more of the following sectors. DEVELOPED MARKET SOVEREIGN The global government bond market is the most liquid of fixed income markets. Strategies here can include macro-driven (those based on fundamental macroeconomic themes), and can be expressed in interest rate, yield curve and currency positions. The trades are typically relative-value in nature, based on the richness/cheapness of one government bond or sector relative to another. Other strategies in this space can be quantitative model based, where analyses are derived from internal proprietary models designed to uncover perceived mispricing. Since the profit margins in these trades can be relatively small, managers tend to use varying Russell Investments // Strategy primer: Absolute return fixed income / p 2

amounts of leverage to magnify the trades a strategy that can be effective in the futures or derivative markets. EMERGING MARKET DEBT ( EMD ) EMD strategies typically focus on hard and local currency sovereign debt. Countries with positive economic growth prospects and improving fundamentals have made emerging market debt a growing sector of the fixed income universe. There have been significant improvements in liquidity in this sector, and managers are attracted to the potential higher yield and improving credit stories. Further, with the development of a deeper credit default swap (CDS) market, relative-value trading has become possible in this space as well. CREDIT Corporate credit strategies often take exposure to investment-grade, high-yield, convertible, distressed, event-driven, municipal and emerging markets corporate bonds. This can be a bottom-up process, with inputs coming from a fundamental credit analysis or a quantitative-based relative value model. Managers can express their positive or negative views on a particular credit or sector through the use of cash bonds and derivatives, typically either in a single name, in baskets or in indexes of credit derivatives swaps. This flexibility is an attractive feature that is common among the credit-focused managers. STRUCTURED ASSETS A mortgage strategy will typically invest in residential and commercial mortgage-backed securities. Managers specializing in this area see opportunities in agency and nonagency residential mortgage backed securities (RMBS), mezzanine and lower-quality commercial mortgage-backed securities (CMBS) and private CMBS. Expectation of stabilization and rebound in real estate prices has enticed many managers into some of the most distressed RMBS structures, which offer attractive opportunities for lossadjusted yield. INFLATION-LINKED BONDS Linkers for developed and emerging markets countries are a growing bond category. Global bond managers commonly invest in inflation-linked bonds. The United Kingdom was the first major sovereign issuer to issue an inflation-linked bond, in 1981. U.K., U.S, Eurozone, Mexico and Brazil are among the primary issuers of inflation-linked securities. For U.S. investors, the most common instrument in use is the Treasury Inflation Protected Security (TIPS). Bond market size has risen significantly in the past five years, in both developed and emerging markets. Many of the fixed income strategies in this space will focus on break-even inflation-rate trades, real-yield trades and cross-market inflation trades. CURRENCY Foreign exchange strategies are traditionally based on carry, momentum and value models. A new breed of active currency managers considers that traditional models constitute a more beta exposure to currency, and have adopted new ways of considering active currency investment as an asset class. Managers often cite currency s low correlation with fixed income and equity as being its most attractive feature. Absolute return products strategies can be classified as multi-sector, single-sector, or multi-sector with a dominant sector. A true multi-sector strategy has a balanced Russell Investments // Strategy primer: Absolute return fixed income / p 3

approach among its sub-strategies, with no single sector dominating. However, some multi-sector strategies have a bias that could tilt the performance of the product toward one sector. Risk and return characteristics Proponents of the absolute return fixed income strategy have often claimed to be able to generate positive returns regardless of the market s direction. In assessing such claims, we were able to review the performance of 13 multi-sector absolute fixed income products from July 2006 to March 2012. These products target either an absolute return of 4% to 15%, or a relative return of Libor plus 100 bps to 1,000 bps. This paper s analysis was conducted on multi-sector fixed income products. We chose multi-sector products because in the period we studied, they often represented large fixed income managers operating across the full spectrum of fixed income strategies. We found that by allocating only to multi-sector absolute return fixed income managers, portfolios can gain the full benefit of such managers freedom from any particular sector or benchmark constraints, and of their ability to choose their best ideas across the whole fixed income space. As well, the managers have the option to dynamically tilt the risk budget to the sectors offering the highest information ratios. Over the past five years, the risk and return profiles of our ARFI composite were comparable to those of the Barclays U.S. Aggregate Bond Index and Barclays Global Aggregate Bond Index (Exhibit 1). Exhibit 1 Return and volatility comparison (July 2006 March 2012) Volatility (Standard Deviation) Annualized Returns (%) ARFI Composite1 4.57 6.81 1.49 J.P. Morgan Emerging Markets Bond Index Global Diversified 10.21 10.05 0.98 Barclays U.S. Aggregate Bond Index 3.48 6.66 1.91 Barclays Corporate High Yield BB Index 10.29 10.17 0.99 Barclays Global Aggregate Bond Index 6.58 6.75 1.03 Russell 1000 Index 18.30 5.97 0.33 Information Ratio Source: Russell Manager Research database The ARFI composite produced an annual return of 6.81% with an annual volatility of 4.57, or a 1.49 information ratio. While this is lower than U.S. aggregate returns, the ARFI composite s return and volatility represent a wide range of investment opportunities and risk/return characteristics. Further, the time period analyzed, July 2006 March 2012, saw very strong returns from U.S. bond markets as U.S. 10-year rates fell from 5.25% to 2%. Because ARFI aims for positive returns regardless of market direction, it should perform better than the broad markets during periods of rising interest rates. 1 ARFI composite is an equal weighted of 13 ARFI products in Russell Manager Research database Russell Investments // Strategy primer: Absolute return fixed income / p 4

Exhibit 2 Individual ARFI product correlation with major asset classes (July 2006 March 2012) Barclays U.S. Aggregate Bond Index Barclays Global Aggregate Bond Index Russell 1000 Index Barclays Corporate High Yield BB Index Product 1 0.03-0.13-0.36-0.06-0.17 Product 2 0.19 0.27 0.49 0.83 0.66 Product 3 0.51 0.59 0.55 0.71 0.73 Product 4 0.36 0.41 0.63 0.87 0.72 Product 5 0.53 0.70 0.75 0.85 0.89 Product 6 0.05 0.04 0.23 0.52 0.40 Product 7 0.09 0.09 0.46 0.65 0.57 Product 8 0.37 0.32 0.53 0.51 0.55 Product 9 0.46 0.58 0.76 0.90 0.88 Product 10 0.13 0.04 0.03 0.06 0.01 Product 11-0.08-0.04-0.04-0.14-0.12 Product 12-0.30-0.26-0.18 0.06-0.20 Product 13 0.05-0.06-0.08 0.11 0.05 Minimum -0.30-0.26-0.36-0.14-0.20 Maximum 0.53 0.70 0.76 0.90 0.89 Source: Russell Manager Research database J.P Morgan Emerging Markets Bond Index Global Diversified Absolute return fixed income benefits Among the other potential benefits of adding an absolute return product to a portfolio is ARFI s low correlation with the traditional fixed income indexes. In data collected from 2006 2012, the ARFI composite has a high correlation with High Yield and Emerging Market Debt (EMD) This should not be too surprising, since some of the managers invested extensively in these sectors in their absolute return fixed income offerings (Exhibit 3). The correlation persists in the short term (2009 2012) for High Yield, but not for EMD. This was resulted from half of the products in the ARFI composite having bias to High Yield as the main-source-of-alpha engine. Further, these are the managers who have the longest return series more recent absolute return products have a lower correlation to High Yield and EMD, which should add to the diversity of ARFI products going forward. Exhibit 3: Correlation between ARFI composite and other asset classes July 2006 March 2012 J.P. Morgan Emerging Markets Bond Index Global Diversified 0.72 0.55 Barclays U.S. Aggregate Bond Index 0.29 0.16 Barclays Corporate High Yield BB Index 0.85 0.77 Barclays Global Aggregate Bond Index 0.34 0.47 Russell 1000 Index 0.57 0.51 Source: Russell Manager Research database March 2009 March 2012 Russell Investments // Strategy primer: Absolute return fixed income / p 5

In terms of a fixed income portfolio, the ARFI composite allows materially higher levels of return to be targeted, without material additions to risk. This is because of the natural diversification benefits achieved between ARFI and traditional fixed income. In examinations of the returns histories of absolute return managers, a common theme is that strong risk-adjusted returns were delivered across many market environments, but that the managers seemed to contemporaneously underperform in extremely stressed fixed income environments (i.e., global market stress events such as the Global Financial Crisis and the European Credit Crisis, which affect most markets). It appears that in stressed environments, correlations that are often relied upon tend to break down, severely impacting performance. Underperformance within such environments does make sense. Many of the absolute return managers are high-conviction managers, who attempt to diversify some of their portfolio risk by spreading out their convictions across a wide diversity and number of trades. However, within a much-stressed market environment, many different exposures can be seen to move toward a beta of 1 (i.e., trades that were diverse suddenly behave very similarly). Further, those managers who are biased to High Yield or EMD exposures also significantly underperformed in a stressed-market environment. Also, in some of the strategies they follow, absolute return managers rely on liquidity in order to enter and exit positions efficiently. In a stressed environment, the level of market liquidity can be seriously diminished. It can thus be argued that a proportion of ARFI returns are a liquidity premium capture, and that in times of severe illiquidity across investment markets, ARFI managers tend to experience diminished returns. However, by combining the ARFI portfolio with a more traditional bond exposure, very significant diversification benefits can be achieved, most notably from the duration protection bonds provide in stressed markets. Empirical evidence shows that when markets become stressed (rapid widening of credit spreads, severe diminishment of liquidity, etc.), nominal rates fall, as governments/monetary authorities seek to offset adverse macroeconomic effects by cutting short term rates, and as market participants exit growth assets and buy sovereign fixed income securities. Oftentimes, fixed income beta replication is more complicated than replication of equity indexes, where the futures market is more established. Multi-sector fixed income beta management is not costless, with fixed-income derivatives offering a more efficient way to obtain beta exposure. When beta exposure is not easily replicated, a combination of total return swap, government bond futures, baskets of credit default swaps, and cash bonds should be able to accomplish the goal. The fixed income beta can be in cash or derivatives, and alpha can also be in cash bonds and derivatives. To address the challenges in replicating bond indexes by use of derivatives, a number of approaches to creating synthetic beta replication for broad fixed income indexes have been developed, including the use of a combination of total return swap and liquid derivatives (futures, credit default swaps (CDS), and mortgage To Be Announced (TBA). Alpha from liquid fixed income instruments generally has relatively low correlation with higher-risk assets, which may result in risk-reducing diversification when paired with higher-risk market exposures (i.e., equities, commodities, etc.), or when beta replication is not an issue (i.e., matching asset/liability management, Liability Driven Investment). In this discussion we have argued that the most effective way, in the risk/return context, of utilizing ARFI in a portfolio is by combining the alpha from ARFI with, or porting it into, a traditional fixed income beta portfolio. The principal benefit of this strategy is in the diversification (risk reduction) a core fixed income portfolio can provide in times of market stress, when illiquidity and correlation breakdowns occur that can impact an Russell Investments // Strategy primer: Absolute return fixed income / p 6

Returns (%) ARFI manager s performance. Exhibit 4, below, is an attempt to depict how such market stress periods impact the two different components. It shows three-month rolling returns from ARFI superimposed upon three-month (one-month shifted) rolling returns from bonds (Barclays Global Aggregate Index). The bonds returns are shifted one month in order to exemplify how strong positive bond returns can often follow periods of extreme market stress. The highlighted areas are periods when ARFI managers in general experienced negative returns. However, these drawdowns were offset by strong positive returns from the core fixed income portfolios in the current and/or subsequent periods. Exhibit 4: ARFI Composite against Barclays Global Aggregate Bond Index 10 5 0-5 -10-15 3m Sum ARFI 3m Sum BGAgg t+1 Exhibit 4 shows rolling 3-month total returns of ARFI plotted against rolling 3-month returns of Barclays Global Aggregate Index 1 month shifted. Source: Source: Russell Manager Research database and J.P. Morgan Leverage Leverage within the absolute return space can be difficult to conceptualize, given that ARFI managers subscribe to many different definitions of leverage. In the broadest sense, explicit leverage is often thought of as borrowing money in order to invest more into a fund than was initially allocated. None of the underlying ARFI managers conduct explicit leverage; it is here that perhaps we will see ARFI s greatest differences to traditional hedge funds. However, there is also the concept of implicit leverage, where the notional exposure of positions (both physical and derivative) is larger than the net asset value (NAV) of a fund. Some managers calculate net notional exposure as their measure of leverage, offsetting long positions in securities with short positions in other, similar securities. However, other managers compute gross notional exposure, whereby leverage is computed as the sum of the gross long or short positions. It is here that the relative value strategies (long versus short) of ARFI will be most evident, with gross notional exposure varying greatly among products and strategies. Given managers varying definitions of leverage, it is perhaps more useful to look at leverage as adding to the level of risk; hence, a better measure for comparing ARFI products is the examination of volatility levels. As discussed above, and despite the use of implicit leverage, the volatility of ARFI, particularly at the portfolio level, is expected to be comparable to the volatility of traditional fixed income. Russell Investments // Strategy primer: Absolute return fixed income / p 7

If ARFI is being used in the alpha stream as a portable alpha strategy, the degree of exposure can be adjusted by varying the extent of allowable leverage. As previously discussed, it should be noted that in practice, the levels of leverage in ARFI products are likely to be lower than the levels in many alternative investments in hedge funds. Investor considerations It should be noted that given the nascent nature of many absolute-return products, ARFI has a somewhat limited performance history. Where possible, we have used five years of return data, which included some of the most stressful market environments conceivable for fixed income products. We view as very positive the fact that these products, in combination, showed very strong risk-adjusted performance in turbulent market conditions. That said, other points of caution for investors considering ARFI products are volatility and leverage levels, as well as management fees. ARFI by nature comprises highconviction/high-volatility products. Implicit leverage (but not, as previously noted, explicit leverage through borrowing) is quite common among managers who seek to magnify small profit margins in fixed income products and generate reasonable levels of returns. Thus, investors considering ARFI need to be comfortable with the use of derivatives to seek enhanced returns, as well as with the potential increase in volatility an allocation to ARFI may bring to a fixed income portfolio. Furthermore, commensurate with the higher returns, ARFI products most often involve higher management fees. Absolute return products are often marketed as premium products, which carry performance fees atop the usual management fees. Investors would need to stay cognizant of these performance fees. Finally, there can be liquidity constraints in some strategies. Some ARFI products could entail the risk of being gated into the fund for a certain period of time. It should be noted, however, that many of the larger ARFI products have improved their liquidity over time, and that some are now even offering daily liquidity versions. Conclusion Overall, we believe ARFI can play a useful role as a potential source of return within a fixed income portfolio. ARFI products can be compelling complements to the broad market fixed income indexes, particularly fixed income beta indexes such as Barclays Global Aggregate or any domestic fixed income beta index around the world. Alternatively, ARFI can be an attractive proposition for investors seeking fixed income returns that are less correlated with traditional investment drivers in particular, fixed income returns that will not be cancelled out in a secular rising interest rate environment. Investment managers are offering a variety of forms of absolute return fixed income products. It is imperative that investors building ARFI allocations into their portfolios understand the underlying strategies and how those strategies work together when they are combined. As we have pointed out, even in a multi-sector product, sector biases can persist. Construction of a well-balanced ARFI portfolio can be achieved via investment decisions that take into consideration not only historical correlations but also the depth of underlying ARFI managers skill and knowledge. We believe that absolute return fixed income products heterogeneity offers attractive risk/return features and thus can complement traditional fixed income products and lead to positive investment outcomes. Particularly attractive are the benchmark-agnostic approaches and the potential for skilled managers to add consistent positive returns regardless of market cycles. Russell Investments // Strategy primer: Absolute return fixed income / p 8

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