Q: Would you give us an overview of the fund and the company?
The fund was launched on September 30, 2011 with the objective to compete in the unconstrained bond space using our existing team’s fixed-income expertise, which dates back twenty years.
Our fixed income strategies are both top-down and bottom up, though we generally limit the macroeconomic positioning and take less interest risk and currency risk than many of our peers. We adhere to a discipline that budgets risk and allocates to fixed-income sectors based on the economic cycle. Our active management focuses on rotating among sectors to find undervalued issues, using bottom-up credit research in the markets of corporate, securitized and emerging markets debt.
One reason this fund was launched is that during periods of significant market volatility, returns for traditional bond strategies are poor, and Unconstrained funds have the flexibility to protect returns in rising interest rate and/or widening credit spread environments. Likewise, there are times when Unconstrained funds can take advantage of dislocations in the credit markets and position the fund for high absolute returns. We believe the fund has demonstrated its ability to alter the exposure of the portfolio to both protect investors in difficult markets and achieve very attractive returns in more benign market environments. Our objective over a full credit cycle is to produce a return of LIBOR plus 4%.
TCW was founded in 1971, and the firm acquired Metropolitan West Asset Management in 2009. Today, MetWest exists as a TCW mutual fund family that includes this fund and the MetWest Total Return Bond Fund, our flagship core-plus bond investment strategy.
Q: How do you define your investment philosophy?
We believe in the strong mean-reverting tendency of fixed income over the course of a business cycle. Although rates, the shape of the yield curve, and sector spreads move around, they migrate to an average level over the cycle. This is due to strong self-correcting mechanisms between the economy and the credit markets with respect to fixed income.
From a macro standpoint, we hold that inefficiencies in fixed income do not exist over short time periods. However, at the security level, there are persistent inefficiencies due to the complexity and over-the-counter nature of fixed-income markets. Our team is dedicated to exploiting these.
Q: What is your investment strategy and process?
To position for mean reversion as dictated by our philosophy, we take a long-term view. When spreads are wide, the portfolio is positioned for tighter spreads in the future. When spreads are tight, the opposite holds true: the portfolio is positioned for wider spreads in the future.
Another way of stating this is we have a value discipline. The portfolio invests in areas of the market that have been penalized, where the prices are low and the spreads or yields are high. Because of mean reversion, we believe that value management within fixed income generally leads to strong returns.
Most fixed-income strategies have a defined benchmark and limited latitude to move a fund’s risk parameters around its index. In contrast, unconstrained funds do not manage to a benchmark and have significantly greater flexibility.
Because of the way we express this flexibility through duration, currency exposure, sector exposure, and quality exposure, our fund looks quite different from its peers and has a five-year history of constraining the macro elements of fixed income.
Our current strategy on interest rates is to keep exposure low because the risk/return proposition is poor.
Central banks around the globe are pursuing aggressive policies to try to cure structural issues in developed market economies. But these issues are not solvable with monetary policy. When economies have aging demographics, poor productivity, or excesses of debt, it does not matter if interest rates are 2% or zero.
We try to produce good returns for investors by keeping the interest rate sensitivities low and our allocations away from the U.S. government sector. Currently, duration is at 1.4 years and we are not investing in the U.S. or other sovereign bond sectors – we own zero Treasuries, zero German bunds, and zero Japanese government bonds.
Instead, we are looking for the high-quality spread that comes from the securitized market: commercial mortgage-backed securities, non-agency mortgage securities, asset-backed securities, and quality corporate bonds. Our belief is that this will cushion the portfolio in an environment of rising rates.
Although the fund does not have a standard benchmark, we manage it versus the LIBOR, which is effectively a cash-like benchmark that has neither duration nor sector exposure.
Q: What is your research process?
Our process is split to cover two broad areas of portfolio management: generalist functions and specialist functions.
Four senior members make up the generalist team. We have oversight of the entire portfolio, and set targets for macro characteristics, including duration, yield curve, and sectors. Because we do not trade, we can remain objective arbiters of value through the cycle.
An additional 60 people specialize in the bottom-up part of the process: analytics, trading, and decision-making related to individual securities in specific sectors. These teams of sector specialists are responsible for finding the best risk/return opportunities within their areas and continually optimizing sector exposure within the existing risk budgets set by the generalist portfolio managers.
Not only are these sector teams best in class in their areas, we have built proprietary analytics systems which are used along with state-of-the-art, third-party tools.
Each sector team – whether corporates, agency mortgages, non-agency mortgages, or emerging market debt – has lead portfolio managers, traders who identify and execute opportunities, and analysts who perform the fundamental work on individual securities and sectors.
Over time, consultation between the generalists and the specialists will alter the sector exposure targets based upon changing valuation in the marketplace, changing economic conditions, and where in the business cycle we are. Based on this, the generalists modify the objectives and the risk budget for the sector teams.
Q: How do you look for opportunities?
To illustrate how our exposures change based on the ongoing conversation between specialists and generalists, we can look at the period following the 2008-2009 financial crisis.
At that time, we had a significant overweight to the corporate bond sector, both investment grade and high yield. Specifically, the portfolio was overweight the financial industry, including banks, broker dealers, REITs, and insurance companies.
Our belief was that these entities were in the process of de-risking and de-levering, effectively becoming safer and more creditworthy. So we were wide to other sectors in the fixed-income market through 2013-2014.
Through 2012-2014, however, the corporate bond team continually came to the generalist portfolio managers with the idea that risk/return was getting less and less favorable in their sector. Spreads were tightening and leverage was building, particularly in the industrial area.
Over a period of about 18 months, this led us to go from an overweight to a fairly significant underweight in the corporate bond and high-yield sectors.
Coincidentally, the same thing happened with our emerging markets debt exposure. We saw tight spreads, a significant increase in debt, and a decline in the quality of debt that was being issued, both in U.S. corporates and in emerging markets.
As a result, we continued to reduce our exposure. By the middle of 2015, the fund’s high yield exposure was taken from over 10% down to 2.5% and emerging market debt exposure from just over 20% to 2%.
In late 2015, there was significant turmoil in the market caused by a slowing of emerging markets, a 70% decline in the price of oil, as well as drops in other industrial commodities. This put pressure on many areas of the credit market, and we saw the opportunity to increase our exposure to both high yield and emerging markets debt. Our value discipline led us to increase high-yield exposure from 3% to 6% and take emerging markets up modestly from 2% to 3%.
In 2016, as spreads have tightened once again, we have become a bit more defensive and have taken high-yield exposure from 6% down to 5%.
Q: What is your portfolio construction process?
It is standard for unconstrained bond funds like ours to have wide duration parameters, typically between negative three years and positive eight years. Even given such latitude, our practice is to be very constrained and keep duration within a one- to four-year range.
Similarly, unconstrained bond funds often use up to 40% to 50% of foreign currency. Though our fund again has a wide range – non-U.S. dollar exposure can be zero to 40% – our experience has been to keep exposure to foreign currencies at a maximum of 2%.
However, we do make use of our significant flexibility in exposures to the various sectors in the fixed-income market. For example, our exposures to emerging markets debt and high yield can be between zero and 50%. Our emerging markets exposure has been as high as 24% and as low as 2%, which is approximately where it is today. High yield has been as high as 38% and as low as 8%.
As well, we have the discretion to use up to 10% in preferred stock and up to 5% in common stock, and have used about 1% of that to invest in unique opportunities, specifically in closed-end bond funds that trade as common stock.
In terms of diversification, issue sizes in non-government securities are limited to a 2.5% maximum. Because we believe a well diversified portfolio mitigates idiosyncratic issue-level risk exposures, our average issue size is approximately 60 basis points, or 0.6%.
Annual turnover can be as low as 50% and upward of 200%, though generally it is about 80%. Turnover varies depending on market volatility, opportunities, and how they are changing in time.
Sector allocation decisions blend top-down macro thinking with detailed bottom-up research. The generalist portfolio managers develop the macro view, and determine we are in the business, where we are in the credit cycle, and where spreads are relative to their overall averages. This view shapes our overall risk budget.
Early in the credit cycle, we have large risk allocations to high yield and emerging markets debt – the more volatile areas of the securitized market. As the business cycle ages and ultimately reaches its late stages with recession risks building, where we believe it is today, we reduce our risk budget and lower allocations to more volatile sectors.
We combine our broad macro framework with the comprehensive views offered by specialists who look at the full activity within their sector. They analyze things like underwriting standards, the balance of supply and demand between commercial properties and rents, and the demand for commercial property, as well as the prospects for cash flow in the various sectors.
The specialists determine whether the micro opportunities and fundamentals are attractive for their individual sectors, then meet with generalists to discuss them. We put their opinions in the context of the macro view and ultimately make sector decisions.
Q: How do you perceive and mitigate risk?
We think about risk as losing money on an investment, and it permeates the way we buy securities and analyze research.
To us, the most critical element to risk management is fundamentally understanding downside risk, as opposed to looking at correlations, tracking error, and other backward-looking quantitative elements.
With every security, we want to know the worst-case downside. Can we lose money? What is the likelihood of default? If it defaults, what is the loss on the security? Our fundamental focus remains on protecting principal in any downside scenario.
For example, when we look at corporate bonds, we do a bankruptcy analysis on every credit we look at, as well as a liquidation analysis, assuming bondholders have to go through bankruptcy. We do the same when looking at mortgage securities, assuming the worst – a housing depression – then trying to understand how securities will perform should that happen.
At a more macro level, we are disciplined and make gradual movements in the portfolio. This applies not only to making changes in duration, but also scaling in and out of particular sectors and issues.
Instead of buying 2% of an issue immediately, we scale in over time, using time as a diversifier. This way, we get the traditional diversification through low issuer concentrations, which also helps us minimize idiosyncratic and unforeseen risks.
