Q: What is the focus of the fund?
The fund was launched in 2010 to provide access to individual investors who may be unsure of how to invest in high-yield securities in emerging markets or other complicated sectors. Previously, we offered only small allocations in our strategic bond fund, but this fund offers a much larger allocation, which we can use in a multi-asset portfolio by allocating directly to the sectors.
Our goal is to generate an above-market level of income and return with little or no increased risk. Anything that constitutes high-yielding fixed income is a possible investment, with the core markets being the two biggest, most liquid segments of this market: U.S. dollar-denominated emerging market debt and high yield corporates.
We benchmark against two indices. We are 60% the Bank of America and Merrill Lynch Global High Yield Index, with a U.S. dollar hedge, and 40% the JP Morgan EMBI Global Diversified Total Return Index. That works out to a baseline allocation of roughly 50% emerging market securities, corporate or sovereign, and 50% corporate high-yielding securities.
Q: What is your investment philosophy?
Our core beliefs drive allocation in every portfolio we manage. For example, we believe in being overweight in credit risk, which is why the portfolio typically features greater credit risk than its benchmark. That added credit risk, which we risk manage, pays a premium in excess of the default rate and losses that are incurred on defaults.
Also, we are convinced there is mean reversion in credit spreads, so we hold more credit risk when credit spreads are wider and less credit spread risk when credits are tighter.
In global markets, we believe that high real yield outperforms over time, so we are generally overweight high real-yielding government bonds and underweight low real-yielding government bonds. Regarding this fund, there is general interest rate risk that underlies any bond allocation, but our real yield belief tends to lead to local emerging market debt, as it often generates attractive high real yields relative to developed markets.
In the currency markets, we tend to be overweight undervalued currencies and short overvalued currencies. We think carry wins over time so we lean toward carry, and believe markets tend to trend in currencies, less so in emerging versus developed markets, so we tilt toward trend in our portfolios.
Q: How many managers do you use?
There are currently six managers: DuPont Capital Management Corporation, Lazard Asset Management LLC, Oaktree Capital Management, DDJ Capital Management, LLC, THL Credit Advisors LLC, and Axiom Alternative Investments SARL.
For the emerging markets side of things, we use DuPont and Lazard. DuPont’s primary role is hard currency emerging market debt with an emphasis on the high-yielding portion of the market or that rated below investment grade, while Lazard Asset Management LLC handles local currency emerging market debt.
Oaktree Capital Management is our core global high-yield manager, managing European and U.S. high yield. They are a very stable and consistent manager within the portfolios, capturing almost as much upside as the market, with significantly less downside capture.
DDJ Capital Management, LLC was hired as a U.S. specialist to focus more heavily on the middle market relative to most other liquid high-yield managers. They provide access to a portion of the market few invest in, in the context of a daily liquid fund, a concentration not generally available as a stand-alone vehicle to mutual fund investors.
We use THL Credit Advisors LLC to provide allocation to bank loans, a nice diversifier to clamp down on overall portfolio volatility. They are one of the best in class security selectors within the bank loan market, with a good handle on what is going on in both the collateralized loan obligation space and daily liquid floating-rate funds.
Our newest manager is Axiom Alternative Investments SARL, which focuses solely on the European financial sector. Axiom takes concentrated risks in the high-alpha, complicated European financial debt securities sector.
And our own Russell Investment Management, LLC manages a portion of the portfolio to control some macro risk by tweaking the currency factor, duration, and international interest rate exposures within our portfolios.
Q: How do you go about choosing a manager?
We couple our manager research capabilities with our view on the market to assess both the quality of the managers we seek and the timing of putting such managers into a portfolio.
For example, about 18 months ago, there arose a historic opportunity in high-yielding U.S. dollar-denominated emerging market debt. Spreads became as wide as during the crisis scenarios of the late 1990s, and 2008, making it a potentially fruitful environment for returns.
We asked our manager research analysts which manager would best exploit that environment and chose DuPont. They appeared willing to assume the volatility risk that comes with a deep-value strategy in a high-yielding emerging market. They had a relatively concentrated position in Venezuela at the time, which has paid off in this portfolio—although the situation socially has not improved, the pricing on Venezuelan bonds has been a homerun for portfolios.
Q: How do you decide if and when to change managers?
When our views change, we make adjustments to the portfolios, but the transaction costs associated with changing managers merely to express our own individual views on the markets would be excessive. We prefer to tackle those adjustments efficiently through our positioning strategy or direct investments.
For example, last February we wanted to increase U.S. credit risk very quickly, faster than we could make a manager change, so we accomplished it by doing a CDX (credit default swap index) trade directly within the portfolios. We did the same in December 2015, when we wanted to increase U.S. versus European risk without incurring transaction costs.
We only consider making a manager change if the time horizon is long or if doing so is genuinely an upgrade opportunity, whether because our research staff has downgraded an existing manager or we find a more compelling fit, a value opportunity that matches up with a manager strategy, which we’ll ride out for at least two or three years. We would not change managers based on a view that could alter in less than a year’s time.
Because our manager research team stays on top of the management universe, and we maintain a database of the thousands of meetings the analysts have with managers, we possess substantial institutional knowledge and can typically find managers earlier in a cycle than someone who might need a three- or five-year track record of investment style and consistency.
We look at them first qualitatively, whether or not they are disciplined to their process, how they have performed and whether it matches our expectations, not just in absolute terms, although that is important, but also in terms of when they outperform versus underperform.
Q: What is your research process and how do you look for opportunities?
We evaluate the markets monthly on a cycle, valuation, and sentiment basis. We score the markets and each corresponding sector on a scale of –2 to +2. Our manager research analysts are also responsible for producing macro level sector ratings of –2 to +2, general views on, say, particular currencies, or the overall bond or credit markets. Our fixed income team handles the micro views, which are updated at minimum on a monthly basis, with that analysis on cycle, valuation, and sentiment.
We hold big-picture monthly meetings with our strategists and also a fixed-income-only focused meeting with our strategists and portfolio managers. We have a third meeting that same week with the research analysts to get bottom-up ideas generated by both our analyst and the manager community. We discuss consensus and counter-consensus views. Finally, we have a decision-making or summit meeting at the end of the week to establish three or four actionable items we might institute across portfolios.
There is also a quarterly cycle where we spend several hours evaluating every risk across the portfolios with all of our fixed income portfolio managers and strategists around the globe. We look at everyone’s portfolio: how the risks are positioned, whether they are aligned, what key risks exist in the various market sectors, and whether we should make big-picture, lasting changes—value changes.
If there is a particular holding that two managers feel is compelling, that only serves to strengthen our conviction in the portfolio—it doesn’t compel us to choose one over the other, as we still run relatively diversified portfolios. That said, in the context of global opportunistic credit, there is not much overlap because the mandates and benchmarks of each manager differ.
We monitor the aggregate risk in the portfolios, and if they become outsized to one particular position (usually more of a duration situation than an individual security), that’s all right if we’re comfortable with it, if we have high conviction. If we haven’t got high conviction, then we’ll probably seek to hedge that, at least partially.
In terms of choosing the actual securities, while we do estimate the value of corporate securities using a fundamental investing-based model, we rely primarily on our managers for security selection, including rating a security’s creditworthiness, because it’s they who do the bottom-up research. We determine how much risk should be taken in each bucket, and the right weightings between those buckets, tilting toward value; the managers fill the buckets. We are the architects, and they are the engineers.
Q: How closely do you monitor their performance?
We stay in regular contact with our managers, and meet with them at minimum every quarter by conference call and onsite every year. Our research analysts also continue to meet with competing managers to make sure we have the absolute best managers. We do not wait until we need a manager to start looking around. We may change managers more frequently than those similar to us who also use sub-advisors because we aren’t waiting around to have a problem with an existing manager.
We give our managers customized guidelines and set their rules of engagement, as well as steer them to take risk in the areas we assess they are truly best in class. If they’re only average in a particular way, then we constrain their risk-taking in an effort to secure that space.
Q: What is your portfolio construction process?
We incorporate market sectors that offer compelling diversification opportunities to add yield to a portfolio, and exploit inefficient portions of the market where we feel managers can add value above yield or where a sector of the fixed income market presents good capital appreciation opportunities.
Our baseline is core amounts of high yield and emerging market debt, and we allocate from there. It is very unlikely we would ever be zero weighted in either of those two sectors whereas other sectors can be more transient. We have held anywhere from a low of about 6% in bank loans to upward of 15% to 20%, something not necessarily in the benchmark, while local emerging market debt has ranged from maybe 2% upward to above 20%.
Because the portfolio is designed to be opportunistic, we do not have many hard stringent limits, although we remain aware of the benchmark to ensure we have commensurate risk and return.
Q: How do you define and manage risk?
Risk to us is largely tracking error risk, either against peers or the benchmark, and we try to balance those two. The peers in the benchmark are not identical the way they might be in core bond funds, where generally everyone uses the Bloomberg Barclays U.S. Aggregate Bond Index.
There is no perfect measure of risk. In terms of absolute risk, we take the risk the market gives us. If the markets are volatile, like in 2008, we try to be less volatile, but if we think a return opportunity merits it, we’ll assume volatility risk. It goes up and down with the market. We don’t necessarily try to control the absolute volatility because it’s a given in the market.
Part of the goal is to generate a Sharpe ratio better than our benchmark. We try to manage where our risks come from, and most of the time we attempt to maintain balance between credit, currency, and interest rates, although in this portfolio there will always be more of a bent toward credit, given the meaningful income goals of our investors. At times I want to be very concentrated in credit, while, when credit is tighter, like today, we will have more diversification in credit rates and currency.
I also like to have cash available in our portfolios, but cash with some market exposure. We run relatively high cash balances but overlaid in a variety of ways to generate active returns.
It is critical to have cash on hand to invest when steep drawdowns occur. Bank loans are a good tactical play right now versus high yield, but not as a total allocation, because even if you are right, they are very illiquid and hard to sell in a down market when you want to buy perhaps more aggressive securities.
