Q: What is the history of the company and the fund? 

Howard Nixon and I co-founded IRON Financial in 1994. Previously we were members of the Chicago Board of Trade and I was also a member of the Chicago Mercantile Exchange. We started the fund with the ultimate goal to offer alternative fixed income investments.

The strategy itself was run as a Separately Managed Account until 2006. It really started with the same philosophy that we have always had, which is that if you are going to just get beta, then you are better off going into a low cost, high quality index of whatever type makes you comfortable. But if you are actually trying to produce alpha, then it needs to fit into the portfolio and make sense. From that our perspective and ultimate goal has always been to be a non-correlative fixed income-type investment to the Barclays Capital Aggregate Bond Index.

The fund has approximately $340 million under management. We have strived to offer a fund that is not correlated to the bond index and for the life of the fund the correlation to the Barclays Capital Aggregate Bond Index is approximately 0.18. 

We do not operate the strategy in the SMA partly because this is one of the rare times where operating a fund is cheaper for the end investor than an SMA. The reason is that this is an absolute return, credit-focused, liquid alternative strategy with short positions. 

If you were in a Separately Managed Account you would have to have a securities account, a short account, a margin account and a swap account. It is too costly and expensive to make sense. A Separately Managed Account would cost you more to run than managing through one fund account. 

Once we launched the fund, when the markets became liquid enough on the credit derivative side, we rolled all of these Separately Managed Accounts into the fund structure. The fund structure is the only way we manage the strategy.

Q: What is your investment philosophy? 

Our philosophy is that your returns are going to come based on your asset allocation. Your two biggest components in the average person’s portfolio are going to be stocks and bonds. For you to make a difference in that allocation as opposed to being more or less in stocks, you have to add something else to the portfolio that does not correlate to one of those broad categories. Our expertise is on the bond side.

The goal is to reduce the volatility and to add more consistency to your portfolio. The reason we do this is it gives you more consistency over time, especially when you get into periods like rising interest rates or credit volatility, or 2008, when the market and the whole system melted down. Most investors, especially retirement-focused investors or investors that are trying to mitigate risk in their portfolio, they are not going to be able to afford the volatility or draw down in a standard buy and hold portfolio. 

If you are a couple of years from retirement, or you are in retirement right now, and you happen to go into a protracted bear market or bull market, whether it is with stocks and or bonds, those periods can last a long time and you may not be able to handle that risk financially or emotionally.

In order to affect the asset allocation of the portfolio you need to have something that does not correlate. In order to get something different, you have do something different – you cannot just do the same thing and expect a different result. We believe that adjusting exposure through time in different credit markets, using different hedging techniques, and focusing on the long-term return of non-correlated returns to one of the major classes in your portfolio, in this case bonds, gives you an easier track through your investing life or through retirement. By going into a static portfolio, you are going to be affected by volatility at some point in time.

For example, look at what happened in the equity markets from 2000 to 2010: in that decade you had two time periods where the stock market was down over 50%. If you look over 25 or 30 years it doesn’t look so bad, but when you’re in it, and it is 2008 and that’s the year you’re retiring, you might not be able to afford that same type of risk. With risk in mind, to affect your asset allocation, you have to have multiple asset classes that do not correlate.

Q: What factors does your investment process focus on? 

The first thing we are focused on is looking at the macroeconomic picture. We are going to assess the broad macro environment. We have created an econometric model that helps us gauge what type of environment we are in. The model includes many different components, essentially we looking at stress points in the marketplace. We are trying to gauge what the backdrop is. 

If you have a highly levered system and cash dries up in the system itself, you go into a period like 2008. If you are unlevered, and the Fed opens the floodgates in terms of capital, you are going to get a period like 2009 and 2010.

The first thing that we want to do is look at the macroeconomic environment and gauge whether it is positive, negative or neutral. We typically look at it in a binary fashion. We are not trying to predict long term GDP and economic growth; we just want to know if the environment is positive, expanding for credit, or negative, contracting for credit. That helps us then initially gauge what the backdrop is and then we make certain adjustments to the portfolio based on that.

Once we gauge the macro-environment we look at what we call a credit market model, which we developed. We are trying to be a little more specific on the credit markets and look at things like liquidity factors, spread changes, spread relationships, pricing relationships. As the risks rise in the marketplace spreads change, not only spread between high yield and treasuries, but also spreads between the bid and ask will change. 

As those spreads change, that’s the risk going up and down, and as risk starts to change we will adjust the portfolio. We may put more or less hedging on the portfolio, and adjust what the underlying portfolio is in.. That is how you make enough changes that will actually affect the portfolio in terms of your correlation to a broad fixed income index.

As risk changes in the fixed income markets, we are going to change exposure in the fund. The more risk that is in the environment that spreads are going to widen, or you are going to get some sell off in credit, we would take certain hedging or credit protections that would help mitigate risk inside the portfolio.

The last metric we look at is the volatility environment. This is an empirical model that we came up with that allows us to gauge volatility in credit markets. There is no stock market volatility index like VIX, so in credit markets we have created our own. We monitor volatility in price and yield which is similar but slightly different. That allows us to gauge underlying risk in the marketplace. As those risks change the portfolio construction and hedging needs to adjust. 

We also like to look for opportunities within the portfolio. We like convertibles. We never have more than 10% in convertibles. The reason we like convertible securities is because we think there is an opportunity with the structure of those types of securities. 

We look for specific types of structures in the convertible market because that market is part bond; it is a bond with a stock call option. If that changes we either think something is overvalued or undervalued and many times in the convertible market securities are not even rated, but they may be investment-grade quality. It is a smaller market but it is also a market we think there are opportunities in. We are going to look at it from the long side but we are going to try to find a security that looks very much like a bond with potential equity upside of what it can be converted into.

We also take positions in the movements of the yield curve itself. That is going to be a long and short position so we might be long the 5 year Treasury, and we might be short to 10-year Treasury It really depends on the marketplace. We calculate a fair value where the securities should be trading. As that fair value changes we are going to look for a security that is overvalued and a security that is overvalued to take long and short positions. Then, it doesn’t really matter what direction per se that interest rates are moving in. We do not think predicting the direction of interest rates is fruitful. What we are trying to take advantage with this type of a strategy is the volatility of the yield curve. Economic forecasts on the direction of interest rates are almost always wrong, we think there is an opportunity to take advantage of those incorrect forecasts through yield curve positions.

The opportunity we look to profit from in the fund is called relative value. There are about 1,600 ETFs now that trade in the marketplace, a lot of those being credit ETFs. We have seen many opportunities that we can take advantage of in long or short positions. If it’s an ETF to a credit derivative then you might get a security that is supposed to be a high-yield ETF that trades for a premium or a discount and then on the opposite side the credit derivative trades for a premium or a discount. What that does is allow us to take advantage of the volatility in the uncertainty as opposed to betting on sector and duration.

Really what we have done is build a model to time weight the beta to give us our alpha on the credit side and then on the yield curve and relative value side, developed models to take advantage of the mispricing of securities.

Most alternative or unconstrained bond funds are not really doing that. They are going to look at sectors and they are simply going to look at spreads to treasuries and determine which is cheaper and which is expensive, and that is how they are going to overweight. 

When it comes to interest rate risk, we have 2 ways we like to position the fund. First, our models are constantly looking for opportunities to be long and short at different parts of the yield curve. Second, we would adjust the duration of the overall portfolio as interest rate risks change. 

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

For the research process we are going to look at top down first. We look at our desired net credit exposures. It is going to be a macro process. The top down process encompasses three different models: macro, credit, and volatility environments. 

Once we figure out what net credit exposure we want the fund to be at, we will then look from a bottom’s up process to decide which area of the bond market we want to be in. Then, we will go down further and populate that from a relative value basis. If we want to be in convertibles, we will look for a structure that gives us a bond-like structure with an equity-type upside and then we are going to put a portfolio together that is sector and credit neutral to the convertible index.

As a security moves in price and starts getting out of line with what we think its value is, we will make adjustments to the portfolio to bring it back in line. The reason we are very focused on credit and sector neutral is because we are doing a lot of hedging in the portfolio at the broad index level. If we like the below investment grade universe and we are long, and we believe risks are rising and we need to hedge a piece of the portfolio, we are typically going to use credit index derivatives in order to hedge the portfolio, which is similar to buying puts on the S&P500 in order to hedge a broad stock portfolio.

We want to make sure that the correlation of the hedge to the underlying part of the portfolio is as close as possible. The way to do that is to be sector and credit neutral to the index. We believe that the biggest value that you can have in an alternative fund is adjusting your exposure through time as opposed to just being long all the time and saying you have a fundamental process for holding 400 securities in your portfolio. 

The problem with that is, and the big difference is, when the market goes down you are going to correlate 100% to whatever your underlying exposure is.

In our case we want to be invested until the risk changes, and as that risk changes we have different ways we will adjust the portfolio. One of them is hedging. With hedging we want to make sure the hedge is as correlated to the underlying portfolio as possible. All in all, we use our Macro, Credit, and Volatility models to figure out current market risks and what our desired net credit exposures to that risk should be. 

Q: What is your portfolio construction process? 

The way we construct the portfolio is going to be from a bottoms up process. Because we are an alternative fund we are going to be focused on liquidity and relative value. We then look at each fixed income sector and evaluate them for risk and potential return. Once we figure out which fixed income sectors we want to be in, we then look at different types of securities in that sector to see which type of exposure gives us the best blend of liquidity and relative value. The types of securities we would invest in include bonds, mutual funds, ETFs, cash, and of course derivatives. 

2008 is a good example of how we put our liquidity and relative value process in place. There were periods where we took the portfolio down to where we were pretty much neutral. We did not have many longs at all. We had a lot of hedges on the portfolio and that changes over time, but specifically in 2008 and 2009, you had to be very nimble We were up over 30% in 2009, but in order to capture that return, the portfolio pre-2008 had to be constructed in a way that would allow for change. Because of our liquidity and relative value process, we were able to adjust the portfolio in order to capture the big up move in 2009.

Q: What are your buy and sell disciplines? 

Our buy discipline is going to be a function of liquidity and relative value. If we like a certain space we will be credit and sector neutral to that space. We have analytics that we have created of which securities to pick and we can essentially pick from the universe of bonds, ETFs and funds and look at a certain point on the credit quality curve and it will show us all the bonds trading in that area, where the price is and so we would look at applying liquidity and value screens to that.

Our sell discipline is going to be opposite to that. Once something gets way over-valued or out of whack we will adjust the position on an individual basis. If there is a convertible that we own that runs up in price significantly we might take that convertible off the portfolio and then look for something else in the area that makes a lot more sense. From a broad perspective we will change the exposure of the fund itself. If we were in high yield and we see risks rising based on our modeling, we might lower the risk of the portfolio by either going to cash, loan securities, or using a credit derivative to hedge the portfolio.

We like the credit derivatives a lot because they are very cheap to use, they are very liquid and they are very easy to trade whereas bonds can be a bit dicey depending on the day.

When it comes to turnover our goal is to try to make as few adjustments as possible to the underlying.

Q: How tax efficient is your fund? 

You can look at that when it comes to capital gains distributions. The last few years we have issued very little, in some years no capital gains distributions, even with positive yield return. In 2013 we had a 6.22% return. The Barclays Capital Aggregate Bond Index was down 2% and we issued zero capital gains. In 2014, we issued $0.10 in capital gains. A way to keep that low is to try to take longer-term positions in the underlying portfolio. And adjust the portfolio’s broad risk with derivatives.

Q: How do you define and manage risk? 

On a security level basis, every security that we put into the portfolio we will have an expectation for it in that it fits into a certain piece of the portfolio. The example I gave you of a convertible bond, the company did real well so the convertible went up significantly. The profile of that convertible changes to where it looks almost like the underlying equity because the price is so high. 

In that case at a security level the risk reward profile of that security changed, so we make a change by selling the security. 

In the case of a bond, if the credit quality changes, if we are looking for a security that looks like it is investment grade rated and it starts falling to a junk level, or we think it is going to fall, then we would also exit that security and look to replace it.

At a portfolio level we are looking to have a certain type of exposure based on our modeling We monitor the portfolio for exposures on a day-to-day basis and if those exposures get too far out of whack we will make adjustments to those portfolios.

We also might want to have a certain beta to a broad index. Lets say it is high yield, we might only want to have 50% exposure to high yield at the time so we also have measures to monitor to make sure that we are in those areas of exposures. 

We have different levels of risk management depending on whether it is a security, the sector we are in or the portfolio itself. My quant team has put together a way to do a lot of regressions on different indicators and economic information that comes out. We are primarily trying to gauge whether credit is expanding, contracting, or staying the same. There are over 50 pieces of data inside our Macro model and it is really focused on trying to gauge risk in the system.

We look at a combination of things – different money flows, supply and demand of credits, sovereign debt, currency movements, as well as leading economic indicators and other spreads and things that are potential risk factors.

What we have seen is that it is a lot of the shorter-term rates that you can monitor on a day-to-day basis to judge stress. As the banking system starts getting choked you start seeing certain rates in areas become stressed. You cannot predict exactly when the straw is going to break the camel’s back but it will lead into potential problems down the road. If the banks are getting choked then the way they lend will change and you have this waterfall event.

We focus a lot on the shorter-term spreads and risk-types of tools that monitor money flows on a shorter-term basis. We think it is more valuable than trying to predict where the 10-year treasury is going or the 30-year bond or something like that. We find most predictions by market experts are wrong over time. So we do not try to predict. We simply build models to monitor risks. As risk changes over time, we change the portfolio. Our overall goal is to give the best risk adjusted return an investor can hope for in the fixed income space through time.