Q: What is the history of the fund?
The Fidelity Strategic Income Fund was one of the first funds to have strategic income as an investment objective. In 1994, the year of its inception, this concept was still novel and innovative. The fund offered one-stop shopping for fixed income with exposures to investment-grade and non-investment grade debt securities both in the U.S. and globally.
In the past five to 10 years, it has become far more common for funds to have “strategic income” in their names. Typically, they are not well diversified and many are in the unconstrained bond category, where there is little transparency; a portfolio may change duration or exposures in ways investors cannot expect.
This new breed of portfolios is almost the antithesis of everything we are trying to do in our fund, which is diversified, transparent, and strategic.
We do not view fixed income as the monolithic asset class that others often see. The fund includes a variety of asset classes among many categories to offer investors a different type of fixed-income exposure. However, this exposure remains balanced because any tactical moves we make must fall within defined opportunistic bands.
Though the portfolio has evolved in the past 20 years, our strategic allocation has remained consistent—with one exception—with 40% high yield, 25% U.S. government, 15% emerging market debt, 15% non-U.S. developed debt, and 5% loans.
Q: Have you added any other asset classes to the opportunity mix?
Our allocation to loans is recent. About 18 months ago, we carved it from the U.S. government sleeve, which previously had been 30% of the portfolio, in response to changes in the market as well as within the fund.
In 1994, loans were not as mature an asset class; today, we believe they deserve a slice in the portfolio. Additionally, given the low level of interest rates, we wanted to move into assets with a slightly higher return potential.
Since the fund was launched, its risk profile had also drifted to higher quality. The emerging market sleeve, which was originally all non-investment grade, had become two-thirds investment grade – a tremendous improvement in credit quality. To maintain a more stable risk profile, we had to add risk.
However, because of our belief that a stable bucket of U.S. Treasuries and government securities is important to the liquidity and safety of the portfolio, the reduction to the U.S. government sleeve was fairly modest.
Q: What is your investment philosophy?
By design, the portfolio has a barbell structure which balances safer asset classes with those offering potential for strong yield – there is no middle ground in credit quality. On one end are our highest quality assets like U.S. governments, Treasuries, and high-quality developed market bonds; on the other are higher-octane exposures in emerging markets and high yield.
Having this structure allows us to dampen the downside as best we can. In a fixed-income portfolio, downside typically can come from one of two major headwinds: rising interest rates or credit crises.
Q: How will fund exposure alter when the rate environment changes?
For example, in a rising-rate environment where the economy is going well and there is growth, we would likely do three things. First, our allocation to floating rate loans would increase. Second, we would lean away from sovereign debt, which has only interest rate exposure, and into more credit-sensitive corporate names which do well in this environment. Finally, because there is no longer coordinated monetary policy around the globe, when the interest rate cycle in the U.S. becomes unattractive, we would move exposures outside the country.
Q: What is your investment strategy?
We deliver return to investors in three ways: through beta, security selection, and asset allocation. Because beta is our first driver of total return, the construction of the portfolio and the selection of asset classes for their barbell characteristics are critical to our investment strategy and process.
The second driver of total return is security selection, which is performed by sub-portfolio managers who specialize in each asset class. By leveraging Fidelity’s global research platform, they pick the issues and issuers they believe will beat the benchmark and offer a better-than-average opportunity for rich return. We also do risk/reward profiles on a name-by-name basis.
Asset allocation is the final driver of return. We truly believe it maximizes reward per unit of risk and comes close to the efficient frontier. Because our strategic allocation allows movements of plus or minus 1,000 basis points around different weights, we can take advantage of opportunities when parts of the portfolio look expensive relative to others.
When it comes to data and research, Fidelity has an embarrassment of riches so the true challenge for the fund’s co-manager Ford O’Neil and I is to filter it and reconcile opposing inputs. By necessity, this requires the well-defined process we have put in place.
Q: What does your investment process entail?
Our investment process starts with a global macro view that determines where we are in the business cycle, as this has obvious implications for whether we want the portfolio to be risk on or risk off. This macro view is provided by an asset allocation research team headed by our head of asset allocation research.
For us, “business cycle” refers to a specific period within the larger economic cycle, which is broken down into three time horizons including a tactical short term and a 20-year projection of growth and inflation rates, and by default, interest rates. In the middle of these is the business cycle which runs from about one year to 10 years.
In the next step of our process, quantitative analysts help us see whether asset classes tend to outperform or underperform during the phases of the business cycle. Importantly, my co-manager and I can disagree with any part of this analysis.
Then we build both bull and bear cases for each asset class using data including views on its macro, fundamentals, valuation, and sentiment. A preponderance of evidence determines where we overweight and underweight asset classes.
A good example of how we decide weighting can be found by examining the portfolio during the global financial crisis. We had no doubt a crisis was coming and it would make for an extremely ugly economic environment, ultimately leading to recession.
In the summer of 2007, the portfolio was as high-quality as it had ever been. We were quite overweight in cash, U.S. governments, and Treasuries and significantly underweight in credit exposures. The overall macro environment drove our view; during those types of circumstances, we want high quality in the portfolio.
A more recent example illustrates an opportunity we found when the business cycle was still going, where valuations were cheap, fundamentals not terribly weak, and sentiment was dour.
Earlier this year, there was a tremendous amount of volatility in high yield, with much of it coming from the energy sector. Though there was some spillover into other sectors, the fundamentals of the high-yield space were okay.
Moreover, the business cycle was not nearing its end; in fact, we believed it was mid-cycle, meaning there was still an opportunity for risk assets to outperform. Additionally, valuations were attractive in the high-yield space. We saw spreads go to 1,000 basis points and that usually makes for an attractive trade in high yield.
The combination of these factors led us to be overweight high yield this year; it has been a good trade because the business cycle has indeed remained on the positive end.
The final stage of our investment process is its gradual implementation. We do not tactically trade the portfolio; instead, our aim is to identify themes that will play out over at least three months to potentially years.
Q: How would you describe your portfolio construction process?
In asset allocation, the guardrails for the portfolio are that plus or minus 1,000 basis points around the strategic allocation. Individual securities are typically constrained to 5% or less of a particular name outside of things like U.S. governments or Treasuries.
Unlike their equity counterparts, bond portfolios tend to have many issues and issuers – we are quite diverse and have several hundred holdings.
The fund’s benchmark is not generic but an amalgamation of the benchmarks of our individual sub-portfolios. This composite benchmark, as we call it, is then given the same weight as the strategic allocations. By composing a benchmark in this fashion, we have ensured it is tightly aligned with our overall strategy and the missions of all the sub-portfolios, giving their managers a clear direction on what they need to beat and how to do so.
Our sell discipline can be driven by several factors. Because our process starts with a macro view, a material change in the business cycle would be the first. For instance, if we thought we were moving toward a recession, that would trigger us to sell out of asset classes with higher beta to get more into quality. Similarly, a change in our valuation perspective can also trigger a sell discipline; when an asset class becomes too expensive for us, we move out of it.
Q: How do you define and manage risk?
The classic definitions of risk are standard deviation and the total volatility of a portfolio. But fixed income adds a special dimension to risk: downside protection, or the risk the portfolio falls below zero percent.
This is a serious concern for many of our fixed-income investors. It is a serious concern for equities as well, but it is well understood that equities have more volatility and at times may have negative returns.
Our investors view bond portfolios as a “sleep at night” asset; the expectation of fixed income is that it will provide upside potential without the worst of the downside. Our philosophy advocates this on behalf of our shareholders, delivering an attractive risk/reward profile that focuses as much on return of capital as it does return on capital.
