Introduction The current interest rate environment has been well chronicled; respected portfolio managers, economists and academics alike have made public proclamations about bond bubbles, the end of the secular bull market in bonds and a pending rise in interest rates. These low levels of interest rates are linked to low expectations for future asset class returns, which pressure many investors to aggressively seek yield and total return through more dynamic and higher risk strategies. This is, in fact, one of the main goals of central bankers in providing monetary stimulus; to encourage the deployment of investment capital by making it unproductive for investors to hold cash and other low risk investments. The proliferation of unconstrained bond strategies has been one of the responses promoted by the money management community as a way to navigate the post-2008 yield environment. While there is a wide range of underlying strategies that fall in this group, most managers, when compared to traditional core bond strategies, run dynamic portfolios with lower duration risk and greater exposure to non-core investments such as emerging markets debt and bank loans. The tactical nature of these strategies allow them to hold considerably more or less duration than traditional bond strategies, but in practice their normal portfolios typically reflect significantly lower duration exposure. Capitalizing on the risks described above, unconstrained bond strategies have gathered approximately $100 billion in assets since 2008, which represents a roughly ten-fold increase in their combined asset base. The Current Use of Unconstrained strategies Many investors have found a place for unconstrained bond strategies within the core bond component of their portfolios. These actions are supported by an interest in providing managers with the flexibility to tactically avoid duration exposure in a rising rate environment while nimbly shifting risk into shorter duration and non-core investments that can capitalize on other non-duration fixed income return contributors as well as excess return from active management. While this seems to be a wholly appropriate approach to current market challenges and the prospects for rising rates, we have some concerns with the practical implementation of this approach and would
caution investors to consider the underlying risk trade-offs being made. Unfortunately, we suspect that decision makers may not fully appreciate the potential consequences of making a shift into unconstrained bond strategies within the core fixed income bucket of their portfolios. The unconstrained label suggests broad investment freedom for managers to go anywhere and shift portfolio positioning in anticipation of market opportunities. Most unconstrained bond strategies are managed against a cash-plus return objective rather than against a core fixed income index such as the Barclays U.S. Aggregate, for example. Despite the usual underlying objective to outperform the core fixed income market, the cash-plus bogie has important implications for manager positioning. While this goanywhere construct suggests little importance for benchmarks or market indexes, it is precisely this ambiguity of target exposures that drives much of our concern in utilizing an unconstrained bond strategy within the core fixed income allocation. To illustrate the point, consider a manager running an unconstrained bond strategy against both a cash-plus benchmark and a traditional core fixed income index. It is the market benchmarks themselves that impose the discipline upon managers to judiciously utilize the considerable flexibility provided them in delivering attractive investment results. While this wide active risk budget may enable the manager to stray far from the target index, making the portfolio s risk characteristics almost unrecognizable relative to that index at times, when the manager lacks a strong view on duration or other market characteristics, they will naturally return to their mandated benchmark. As such, the traditional core fixed income benchmark imposes the discipline for managers to deploy their active freedom around an object that appropriately represents the risk characteristics deemed desirable to the investor when setting asset allocation policy. By contrast, substituting a return bogie that is so dissimilar in risk characteristics from the asset class policy benchmark can contribute to undermining the primary diversification role of that asset class. Core fixed income allocations play an important role in a total fund; often serving as a diversification stabilizer during periods when growth assets such as stocks are in duress. In our 2010 Bucket List paper 1 we described the value of grouping asset classes into broad buckets based upon the common role investments can play in a portfolio. In that discussion, we presented an example framework where core bonds served as the anchor asset class in a safety bucket. As the name suggests, the primary role of this group of assets is to counterbalance risks from growth assets and, secondarily, to provide income to the portfolio. Tinkering with this asset class in ways that can alter its ability to play the role of a diversifier in times of economic stress can produce unexpected consequences through various economic regimes; most notably slow-growth or deflationary periods. We do not mean to suggest that all unconstrained strategies are run similarly, in fact they are not, but, in the current environment many of these approaches have swapped out of 1 Wilshire Associates Incorporated (2010). The Bucket List: Utilizing Broad Investment Groupings in Asset-Liability Studies: Foresti
duration risk into non-core and credit risk. From a total return standpoint, these relative trades may prove to be absolutely correct and value adding to investor wealth; however, they may not fully appreciate the related risks embedded in other areas of a total fund. When one examines the factors that drive core fixed income returns, it is specifically the duration component that provides their diversification properties. Simply put, scaling back on duration with core bonds reduces their diversification potential. To make matters worse, since duration risk is often replaced with greater exposure to credit through noncore investments, the diversification properties of duration are replaced by securities with high correlation to growth assets such as stocks during times of stress. Readers need only think back to the core-plus experience of the 2008 global financial crisis to imagine how this might play out during an economic slowdown or shock environment. A Better Way Forward To be clear, the concerns raised above are neither an indictment of unconstrained bond strategies nor are they in anyway meant to suggest that we are making a market or interest rate call (i.e. that rates won t go up, for example). Instead, we have concerns that these strategies are being deployed without sufficient consideration of how they may affect risk characteristics at the total fund level. We would advocate two primary implementation approaches for the consideration of including unconstrained bond strategies in institutional portfolios; one at the asset allocation level and another at the asset class structure level. Our preferred approach to considering the inclusion of unconstrained bond strategies is during the asset allocation policy development process as a component within an unconstrained or opportunistic credit bucket. In this approach, the risk characteristics of unconstrained bond strategies can be more directly evaluated when making trade-offs against other asset class groupings. While the go-anywhere nature of unconstrained approaches make them difficult to model within this process, the opportunistic credit construct imposes a discipline for us to recognize these uncertainties and address their potential impact on total fund risk. The possible reduction in diversification properties discussed above is best captured at the asset allocation level where decision makers can implement the risk trade-offs most appropriate for their fund. We have assisted several clients in this implementation approach and believe it is ideally suited for accommodating the use of unconstrained bond strategies. A second approach to incorporating unconstrained bond strategies is to consider their implementation at the asset class level within an investment structure analysis. While we won t reiterate the concerns articulated above, we will point out that this approach is best served by keeping the manager s target benchmark consistent with the fixed income asset class policy benchmark. In such a deployment, the manager is provided with all the leeway demanded by an unconstrained bond strategy, but is held accountable to add value to an index that appropriately represents the investor s asset class objectives. We suspect that some proponents of unconstrained strategies will suggest that our interest in maintaining the integrity of the policy benchmark is evidence that we don t fully appreciate the goals of an unconstrained approach. We would note that managers are not
in any way tied to the risk characteristics of that target index. If a manager believes that duration risk is not worth taking, they are provided with a nearly unconstrained active risk budget to reflect that conviction. However, it is important that their ability to add value be judged against the client s core fixed income policy benchmark. This approach will prevent a situation whereby a manager significantly underperforms the asset class benchmark (perhaps during a period of disappointing growth where duration exposure pays off), but points to their slight outperformance versus cash. This inherent discipline, even in a go-anywhere investment approach, should help protect against the asset class not fulfilling its role in the total fund. Despite our preference for the asset allocation approach noted above, we recognize that such an approach may impose practical limitations on some investors. For clients with an interest in quickly implementing an unconstrained strategy in the current environment, for example, the practical impediments of conducting an asset-liability study may make the investment structure approach more feasible. Investors who choose to follow the investment structure approach within their core fixed income allocations will improve their chances of implementation success by acknowledging the systematic factor risks that may be embedded in unconstrained bond strategies. Conclusion Institutional investors face many risks when constructing investment portfolios. The impact of the global financial crisis, coupled with the low level of interest rates and aggressive intervention by central bankers further serve to contribute to future uncertainty. As we recently discussed in our Implications of Rising Rates paper, 2 Wilshire advocates a diversified approach to portfolio construction, even for those investors with a strong view on the future direction of interest rates. The dynamic and tactical nature of unconstrained bond strategies delivered by institutional quality fixed income managers may prove to be a valuable tool within the total fund in navigating current market risks. However, as discussed above, the unconstrained strategies themselves bring risks that must be properly understood and managed to maximize their full potential. 2 Wilshire Associates Incorporated (2013). Implications of Rising Rates on Asset Performance: Foresti and Kirakosyan
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