Q: What is the history of the fund?

This fund has just over a three-year track record, though the firm has engaged in the same fixed-income style since 2001. We have run portfolios with different strategies, ranging from core fixed income—which this is—to short duration, very high quality, and multi-sector broad-based funds. 

Total assets under management across all fixed-income investment strategies are $100 billion among the variations in core fixed income. 

Q: How do you define your investment philosophy?

We are one of the few managers, if not the only one, that adheres to the school of behavioral finance and its tenets. Our philosophy was developed in the late 1990s to early 2000s, and is based on the work of the psychologist Dr. Danny Kahneman. Though not an economist, Kahneman won a Nobel Prize in economics for his contributions to decision theory, specifically how it affects investment decisions. The substance of behavioral finance is that investors—whether individuals or institutions—value avoiding loss more than they value what is now termed “alpha.” Avoidance of loss filters through everything we do and is particularly relevant to fixed-income investing.

A key characteristic of our philosophy is fixed-income markets are inefficient, which is contrary to what many others believe. The U.S. fixed-income market is about $37 trillion, made up of investment alternative choices, but fewer than half—just $17 trillion—are contained in the Barclays U.S. Aggregate Bond Index, our benchmark. It is impossible for this to be efficient; no one can know every single security or have complete information on all of them. We have physically set up our organization differently to take advantage of these market inefficiencies.

Another belief is that investors trade too often. The industry tends to make knee-jerk reactive decisions regarding sector allocation and individual security selection. In contrast, and in following the school of behavioral finance, we are buy-to-own investors—not buy-and-hold investors. We do not trade as often as other asset managers and have a lower turnover in our portfolios. 

A third point of our philosophy is that though benchmarks are investable they are not designed to maximize risk-adjusted returns. Our portfolio looks very different from the Barclays Aggregate Index in terms of its design, structure, and allocation, though we will turn to the benchmark for guidance in determining a duration target. 

Any major index has an inherent weakness because all are based off the largest debtors—the largest debtors are the biggest issuers. When indices get overweight in a sector, a flashing yellow light flips on to warn us that particular part of the market may be taking on too much debt. It is a good sign something is going on from a risk-management perspective.

The last two elements of our philosophy resonate with fixed income. First, the important part of fixed income is income. If an investor buys a bond Day One of its issue and their holding period is the maturity of the bond—say 10 years—their rate of return over the entire time is their coupon, and they want to get the highest level of coupon income possible. By its nature, fixed-income investing is asymmetric. Investors either “clip the coupon,” and get paid off in maturity, or they simply do not. It is unlike equities, which have an opportunity for big price appreciation.

So the final element of our philosophy is avoidance of loss. This is the heart of our risk-management process, ties back to behavioral finance, and is critical in fixed income. By having a buy-to-own mentality coupled with an avoidance-of-loss mentality, our philosophy toward fixed-income is unlike others and our portfolio looks very different from the index in terms of its design, structure, and allocation.

Q: What is your investment strategy and process?

Many portfolio management processes share the same weakness: They are vertically integrated and set up around a star system. A sole portfolio manager may make decisions about security selection, have a view on interest rates, handle client communications, and also talk and trade with the Street.

We believe no one person can do everything well for an extended time. Adhering to behavioral finance, our portfolio is managed with a team-based approach, which ultimately leads to better decision-making outcomes. For instance, each sector team has its own investment committee and research members to review and support individual decisions and recommendations. While this slows the investment process, it ensures the portfolio will not be subject to a single person’s intuitive or natural personal biases. 

Other teams include the macro-economic team, which provides a top-down overlay to the fund’s bottom-up asset management, and teams that oversee portfolio management and portfolio construction. The portfolio construction group focuses on strategy and risk management; they do not trade or manage portfolios. 

Every two weeks a formal meeting is held and all the sector teams and the macro-economic team discuss strategy. Two days later, the portfolio construction team assembles to coalesce this information into model allocations. These become roadmaps for portfolio managers to execute while working directly with sector teams.

Q: What informs your research process?

Our process, in part, is informed by our macro-economic and sector views. History suggests once the Fed starts to tighten, spreads tighten and the yield curve flattens. We do not foresee any macro-economic downtown or a recession. Credit fundamentals remain strong outside of the energy sector. A lot of this noise is seasonal, and in the first quarter there should be a trajectory of spread tightening.

Last summer we raised cash in anticipation of volatility. Approximately half was reinvested into the credit sectors—in particular non-investment grade—because it was cheap. Cash and Treasuries were increased to about 12% of the portfolio. 

Our sector teams identify potential investment areas. One that is super rich now is agency residential mortgage-backed securities (RMBS). However, we avoid these because one significant buyer—the Fed—drives that market. But there are good non-agency RMBS securities in our non-investment grade bucket; some are floating rate. We believe it is a good sector because it has a different risk profile than corporate credit and offers good value.

To take advantage of the flattening at the long end we want to have long assets that take the form of municipal securities, preferred securities, and other government securities. 

Q: Can you provide an example of how your process works?

Sector teams select from the plethora of assets in our investable universe to find the best and most suitable for the portfolios. Inside our asset-backed security team, they use a stress test developed in-house for collateralized loan obligations (CLOs), which basically assumes the worst level of corporate defaults ever, which happened in 1937 when the default rate in the U.S. reached about 16%.

The stress test supposes a CLO’s underlying collateral must withstand a 16% default every year for the rest of its life, and that the recovery level of any asset is basically zero. If a CLO withstands that analysis in our modeling, the security passes on to the next set of criteria for review.

Then the asset manager confirms it is structured properly. The CLO’s documents must support the investment thesis, and its payment waterfall must make sense. Several groups look at the security to ensure we have adhered to risk-management procedures.

An analyst spearheads the research process by reaching out to our corporate credit group to find out how they feel about that asset manager. Individual securities are then vetted in the collateral pool. The credit team works in tandem with our asset-backed securities team to evaluate that transaction.

Further, on staff are about a dozen transactional attorneys who offer added value. They sit on the trade desk with the sector team managers, helping them to verify that the documentation, prospectus, and the indentures are aligned with what we believe the bond should do. 

Finally, each security recommendation is reviewed by the sector team investment committee. So, an asset-backed security undergoes rigorous analysis that engages at least three separate teams prior to an investment in it. This goes back to the buy-to-own mentality we have. 

Q: What is your portfolio construction process?

Because avoidance of loss is critical to our organization, we are very thoughtful to individual position sizes and sector allocations, and believe a key element in risk mitigation and loss avoidance in fixed income is using a high degree of issuer diversification. If a specific name makes a substantial weight in the index, we may not own any of it, or if we like the name, we may own a small amount. Our position sizes—no larger than 1%—are very small relative to other portfolios. Usually, anything with a 1% position will be collateralized to protect us in a downside risk scenario. 

We have no sector limits and generally look to relative value and diversification rather than adherence to a benchmark. Our portfolios have more sectors than most core fixed-income peers. In any given year a particular sector may have the best returns while others do more poorly. Assuming the poor returns do not reflect fundamentals, to capture the next set of value opportunities it makes sense to go out of an area with great returns and into one with potentially great returns.

Individual securities simply receive a “thumbs up” or a “thumbs down”: they either belong in our portfolios or not. We look to relative value and do not under- or overweight securities based on their holdings in the Barclays Aggregate or any index—our portfolios are structured differently. Right now about one third of the portfolio is in asset-backed securities—in our case, mostly commercial such as aircraft finance and railcar leasing, or corporate asset backed securities, which are generally CLOs—where we have a strong legacy skill and knowledge base. 

To take advantage of the flattening of the yield curve, the portfolio is currently positioned to be short the duration target and has a heavy emphasis on floating-rate securities. We also want to have long assets like municipal securities, preferred securities, and other government securities to capitalize on the yield curve shifting without taking credit risk. Our philosophy of avoiding loss means we will not hold long corporate credit, in particular long BBB corporate credit.

Q: How do you define and manage risk?

The conventional thought is that standard deviation is risk, but we do not believe standard deviation is the best measurement tool. A portfolio that performs well will have fairly significant standard deviation relative to an index, but that also means it has upside return relative to that index.

Tracking error relative to our benchmark is also not something we find relevant to measuring risk, though it is very useful as an internal tool to make sure portfolios with similar mandates are consistently managed and perform against each other as they should.

Instead, avoidance of loss and downside risk are substantial elements of risk management, as is the Sharpe ratio. We use such information ratios to evaluate portfolios, and our portfolio managers run reports every week to see how a portfolio is performing in terms of risk budgeting and risk tolerance. 

All the risk management in the world will not work without a process designed to slow down investment decisions and deconstruct it among many people. A chief risk officer works with the portfolio construction and management teams to ensure the cohesiveness of our process and that it has been thoroughly vetted. With more than one person making decisions, it translates to performance that is predictable, scalable, reliable, and explainable day in and day out—that is at the heart of risk mitigation in our organization.