Q: What is the history of the fund?

The fund was originally started in 1991 by our firm, EARNEST Partners LLC, an Atlanta-based investment advisor. Twenty years later, in 2011, we began sub-advising Touchstone, combining our management of this fixed-income fund with Touchstone’s extensive marketing expertise. 

Although we use the Barclays Aggregate Bond Index as our benchmark, we’re distinct in how we approach the bond market. Our mission is to provide investors with a fund that consistently beats the Barclays Aggregate Bond Index on an absolute and risk-adjusted basis while being a solid diversifier for a broad portfolio. 

The fund has about $200 million in assets, but the strategy is applied to a little over $2 billion of EARNEST Partners’ over $20 billion in overall assets under management. 

Q: How would you describe your investment philosophy?

Our strategy is to identify the fixed-income market return drivers that generate consistent levels of outperformance on an absolute and risk-adjusted basis, while limiting our exposure to its more inconsistent return drivers. 

Inconsistent return drivers are things like trying to forecast a turn in the macro environment, or predicting commodity prices, or figuring out interest rates in relation to the bond market. We prefer to do bottom-up fundamental work on sectors and securities, and let the income derived from this fundamental research be the primary return driver. 

Q: What is your investment strategy and process?

From an asset class standpoint this is a bond fund, but we limit that scope somewhat, as the fund currently only invests in U.S. dollar-denominated bonds, making us duration-neutral and proximal to the benchmark. We focus on both investment grade and high-yield spectrums, and then across U.S. Treasuries and debts issued by U.S. government agencies, down to single-family and commercial mortgages through to corporate credit, and then, getting into offshore, the emerging market corporate dollar debt, developed corporate markets as well. 

In 2016, with credit spreads on corporate debt widening, we are underweight in that area versus our peers, so the fund is performing well so far this year. 

We are not a thematic portfolio manager basing the portfolio’s construction on market themes. Instead, our goal is to maintain modest allocations to a variety of sectors and securities that can generate returns, as a portfolio that can perform in a variety of scenarios, or credit or rate environments, effectively balances risk. 

Q: What is your research process and how do you look for opportunities?

The bond market is large, so, as a bottom-up manager, we identify peak or outperformance potential by examining sectors using a “gap framework” spanning three primary risk drivers of a bond or sector: duration, credit risk, and prepayment risk. We put these three on equal footing against spread to determine why a certain market sector or industry has a particular spread and whether it is justified. 

The research process, what we call measured underwriting, is our fundamental work. We don’t focus on a security’s yield or how much money we could make—it’s simpler than that. We want to know whether they’re creditworthy, and if we lend our clients’ money to them, how likely are we to get it back.

If it’s a government agency, we want to establish its public purpose, why it exists, will it continue to be funded, what type of guarantees might be involved, and whether they are explicit or implicit. If it’s an industry, we want to know its place in the corporate space—what its purpose is in the industry. Are there high barriers to entry? What is its competitive framework? 

Typically in the bond market, the higher the yield, the more you’re paid for your investment, but that’s a yield trap we prefer to avoid. We will lend to you if we’re confident you can pay it back. In this way, the income we generate from each investment becomes the main return driver. 

Our intent is not to generate capital gains to drive returns. We examine the inherent income stream each investment can make and how, cumulatively, the portfolio’s income drives returns over time. 

From there, we examine the issuers, looking at cash flows or leverage in order to determine how an issuer will pay off the loan. 

If we can lend to somebody with hard collateral for protection beyond their corporate guarantee, that’s preferable in light of a high-grade bond market with asymmetric returns; i.e., you earn only the set yield, with downside risk lying in the investment going bad. 

Q: Can you provide one or two examples?

One example would be Union Pacific Railroad. We believe it’s a great company, and in the portfolio. We have a choice each day. We can lend to them on an unsecured basis, with only their corporate guarantee, or we can lend to them on a secured basis, where on top of that corporate guarantee is hard collateral in the form of locomotives, a rolling stock backing the debt. 

Once we have comfort on the issuer level, we look at what will put us in a preferential position. Using the utility industry to illustrate, in most cases one either lends to the holding company, the parent organization, or lends to the operating subsidiaries. In the latter case, it means lending against a first-mortgage bond and all of the subsidiary’s transmission and generation equipment, which provides the level of additional protection we want. 

Q: Do you single out any particular metrics?

We think about metrics more at the portfolio level than at a sub-industry level. Being duration neutral, we analyze the impact investments have on our overall duration positioning. We focus on the portfolio’s “spread beta,” its spread duration. So, while we might be underweight Treasuries, it’s unnecessary to manage overall spread beta and spread volatility because we manage the portfolio’s spread duration.

The fund’s benchmark is currently about 30% U.S. agency single-family mortgages, 30% corporate credit, 37% U.S. Treasury debt, and maybe 3% commercial mortgage-backed or asset-backed securities. We aim to beat a diverse benchmark, and believe our process complements that benchmark.

Fannie Mae, Freddie Mac, and Ginnie Mae are the three primary U.S. mortgage agencies for single-family home lending, but less represented in multifamily lending, loans made to developers of an apartment building or nursing home serving low to moderate income Americans.

Single-family mortgages in the index, prepayable or not, have negative convexity, but you can also buy something called a Fannie Mae DUS [delegated underwriting and servicing lenders], a multifamily loan with perhaps a 10-year balloon and call protection, so if rates go down and the developer wants to refinance, they must pay the investor, the fund in this case, a premium determined by a spread to Treasuries at the lower rate. 

This enables us to buy something with Fannie Mae’s credit quality but with positive convexity. Considering the option-adjusted spread or the optionality involved, the multifamily security is a better choice than the single-family securities. There are other factors to consider certainly, such as coupons, but the goal is to add positive convexity with comparable credit risk to the U.S. government through Fannie Mae. 

Q: Do macro-economic views influence your process?

While we certainly have opinions on what goes on in the macro or rate environment, it doesn’t insert itself into our portfolio construction. We focus on the return drivers that we believe can deliver consistently for us. 

Most macro economic forecasts are just wrong. I can’t think of anybody who has delivered 25 years of consistent correct macro economic forecasting. It’s guesswork. Whose oil forecast two years ago comes anywhere close to where oil is today? Or international GDP? We prefer to focus on the actual securities and how we combine them to beat the benchmark, regardless of macro events. 

Our composition is still pretty close to what it was in 2008, during the credit crisis, for example. We consistently underweight U.S. Treasury debt, which represents roughly 37% of the index today. Going into the credit crisis, it was perhaps 23% or 24% of the index. But while the duration of the benchmark has changed in the last eight years, we kept our duration proximal to it. You could say we remain more consistent than the benchmark in some respects. 

Our portfolio spans a lot of different sectors: multifamily housing, credit, and the agency space represented by agencies—not Fannie Mae and Freddie Mac debentures, but agencies backed by the full faith and credit of the U.S. government, like the Export-Import Bank, the U.S. Agency for International Development, and the Small Business Administration. 

These are agencies with explicit U.S. government backing, yet they pay a yield comparable to perhaps AA credit. Our diversified grouping of securities drives the overall return of the portfolio; performance doesn’t hinge on just one portfolio theme. 

We want a well-structured portfolio that withstands rates rising or falling, whether the economy continues at roughly 2% or we slip into recession, whether the credit cycle continues down the path it’s been on for the last 18 months, in terms of weaker credit, and whether credit starts to recover. 

Q: What is your portfolio construction process?

We approach portfolio construction as an aggregate of what it looks like, such as bands from a credit standpoint or at an issuer level. We don’t typically want more than 1.5% or 2% in a certain issuer. At a credit level, in terms of broad agency programs, we don’t want to be too levered to one program so that it becomes the overall return driver and skews our diversification and balance. But that balance is also based upon the volatility of the spreads and how they correlate. 

We don’t set hard limits, such as 15% in a certain sector, or two times the index weight. Instead, we gauge the overall risk factors as they pertain to the index. All of our risk management is geared toward the index, so as the index changes over time, the shape of the portfolio may change as well. 

Q: How would you define your sell discipline?

We don’t set parameters, like if it hits a certain target or the spread tightens to a particular level—every portfolio security is available for sale at any given moment if the price is right. We look at the whole marketplace. You could say our sell discipline lies in keeping the duration intact with the benchmark and balancing the portfolio risk. 

If a well-performing credit throws off the overall balance of our risk management comfort zone, it becomes a sell candidate. It’s not just about performance. However, given our measured underwriting, the steps that we take, and the way we think about credit, such an event has rarely occurred in the portfolio. 

Bonds are an asset class that self-liquidates. Every day, throughout the month, we receive mortgage payments, coupon payments, maturities, sinking-fund payments. The most efficient means to sell a bond is to let it pay off, because there is no spread to Treasuries and no illiquidity. The money just shows up in the account. 

The beauty of fixed income is the regular, monthly inflow of cash. 

Q: How do you define and manage risk?

We think about risk in terms of underperforming our benchmark over a rolling three-year period, the risks involved in consistently generating a level of performance that beats the benchmark over time. 

This attracts two kinds of investors. The first is someone who allocates a small portion of their portfolio to fixed income, so if the stock market falls 10%, they can rebalance. We want to perform like a bond manager, beat the benchmark, yet be there for the investor who needs those funds to rebalance or take advantage of something. 

Alternatively, if someone needs more fixed income, perhaps money every month over a three-year period, we can help them meet those cash needs. 

Because we underweight Treasuries, we have greater spread duration, so there exists some volatility versus the benchmark. BBB-rated bonds have much greater spread volatility than AAA-rated bonds, so portfolio composition is important. If two managers underweight Treasuries, but one buys AA-rated debt of corporates while the other buys BBB-rated debts of corporations, that may work out well until spreads widen to reveal the BBB buy involved more risk. 

Historically, we believe our lower turnover has been attractive from a tax perspective for investors, and in terms of trading costs. 

Q: Did the 2008 credit crisis affect performance?

This fund has weathered a great many economic disasters in addition to the credit crisis. Think back to the S&L crisis of 1994, which was then termed the worst bond market in history. In 1998, Long-Term Capital Management dissolved after the Asian contagion and the Russian meltdown, followed three years later by 9/11, and then Enron, Global Crossing, and Worldcom. Then came 2002, which was bad for capital markets. 

The 2008 credit crisis was more a flight to Treasuries and our underweighting Treasuries contributed to our 2008 performance. And in 2009, we didn’t hold any subprime mortgages, so there were no liquidations at 50 cents on the dollar. There may be distress periods where spreads widen, but with good assets, we believe spreads should eventually narrow. 

We had a pretty good 2011, despite its difficulties. The U.S. government was downgraded that summer and the best-performing sector was Treasuries for the year. Companies like Bank of America were trading for less than $5 a share. 

Crises will continue. Down the road we might see something on the back of this year’s oil at $25 a barrel. We just don’t know. Our focus is on good bonds in a duration-neutral portfolio, comparable in quality to the benchmark, and building in as much structure and protection as we can.