Q: What is the history of the fund?
Back in 2005, a client in our traditional multi-sector products asked whether we would run that strategy versus cash or LIBOR-plus instead of a traditional benchmark. After several years of doing so, I pondered whether it would be a good strategy to launch to the public. We did, in December 2010.
Our fund is generally referred to as one with a non-traditional fixed-income strategy. It is designed to diversify away from the significant term structure risk embedded in traditional fixed-income strategies.
Traditional strategies tend to be tightly and relatively managed against a benchmark like the Barclays Capital U.S. Aggregate Bond Index, with a high degree of correlation to interest rate risk. The role of these traditional strategies has been income, liquidity, and ballast during turbulent times for equities. For several decades, it has been an easy choice to plug a fixed income allocation with a core fund. The income was there, and principal risk was not a concern because interest rates were declining on a secular basis. Today it’s not such an easy choice with interest rates close to the zero bound. Simply put, core funds can no longer be counted on to be your portfolio’s main source of yield and ballast.
Our strategy offers investors a means of diversifying away from term structure risk while staying firmly planted in the fixed income world. The portfolio’s returns are measured versus cash rather than a traditional fixed income benchmark. We expand our opportunity set beyond just U.S. term structure risk to exploit a more diversified set of risk premiums, including corporate credit, currency, global yield curves, convertible bonds, and so on. We seek to manage the portfolio’s risk profile comparable to that of typical core strategies, and we’ve guided investors to expect a standard deviation of 4%-6% over the cycle. Our targeted Sharpe ratio is 0.5 to 1.0. That works out to be about LIBOR plus 2% to 4% target.
We have about $4.5 billion assets under management, split about 50/50 between fund vehicles and institutional investors.
Q: How would you describe your investment philosophy?
Loomis Sayles has a long track record in the multi-sector space where guidelines are relaxed and investments in other risk factors are allowed while staying within the fixed income market.
Typically, in the generally known investment vehicles governed by the Investment Act of 1940, one is limited on the long side to cash and derivatives, but can only short through the derivative side. We can be 100% long and 100% short, so technically 200% gross.
We directionally tilt toward where we want to take risk, which tends to be long. In other words, we are not market-neutral like many hedge funds claim to be. While many of our competitors are new to running multi-sector portfolios, having come from relative return strategies, we have always done so.
When risk is low, with fewer opportunities, we pull back, whereas when volatility increases, we add to risk, because that’s generally when the best opportunities exist. We limit drawdown from a number of levels and try to be true to an alternative-to-core style—investors need assurances that drawdown will be in line with the expectations we’ve set.
Q: What are the tenets underlying this philosophy?
There are three philosophical tenets to our strategy.
First, we want to harvest and protect the risk premiums available in terms of our 3 Cs: credit, curve, and currency risk factors. Our analysis shows that the risk premiums associated with these factors behave in familiar, similar ways cyclically.
Risk premium varies through the cycle. Much of our macro process involves identifying which phase of the cycle exists at the moment. At attractive points in the cycle, we will be long beta when the expected return is better than one to one relative to the expected drawdown. In other words, we are seeking out return patterns that are skewed to the positive side.
At other points in the cycle when the return distribution has a negative skew where our downside is greater than our base case returns, we back away from the market, by either going short or staying neutral.
Second, the market does a poor job pricing specific risks, with securities in some cases trading far higher or lower than intrinsic value. Loomis is well known for its fundamental research, a core tenet of our bond-picking capability. We calculate how much a security is undervalued, how the return profile looks, seeking positive skew in returns with the most upside and least downside.
Third, because we run a core alternative strategy, our risk management process focuses on drawdown. Investors care less about volatility than negative drawdown. We seek to limit drawdowns on several levels. First, we set our standard deviation guidance to 4% to 6%. We also seek to minimize drawdown through careful risk analytics that calibrate the portfolio for the type of cycle we’re currently in. We look for returns offering a better than one-for-one payoff relative to drawdown expectations.
Q: What is your investment strategy and process?
Fundamental research permeates our investment process, both from a top-down and bottom-up security selection perspective. We start with the top-down view. We take a deep dive via research from our macro strategist, updated quarterly, to determine the most likely scenarios for the economy, rates, and so on. We create base case, upside, and downside scenarios and project expected forward returns for various sectors under each scenario.
We plot these expected returns versus drawdowns on a for numerous risk factors like currency , term structure , or credit risk, and we draw a 45-degree-angle line through them to represent the one-to-one trade-off between base case returns versus expected drawdown. What falls above that line and to the left, in that upper left-hand quadrant, should provide the best return versus drawdown.
We then allocate to our different buckets based on our assessment of those returns relative to drawdown. The limitation on how much we add at different risk factors will be the amount of overall volatility we want in the fund to stay within our maximum 4% to 6% deviation guidance.
On the bottom-up side, we work with our key strategists who are responsible for separate parts of the portfolio. We have specialists in convertible bonds, emerging markets, rates, currencies, and more.
Q: Can you provide one or two examples?
If we decided that bank loans looked attractive from a top-down perspective, I would give our strategist parameters to accumulate those broadly diversified bank loans the bank loan sector team thinks are attractive. Rather than seeking alpha, we would target small, individual positions within banks loans, maybe 0.25% each, to get up to our allocation, which in 2014 was about 10% or 15%. This is a pure top-down allocation focused on harvesting attractive beta.
Alternatively, we might identify idiosyncratic ideas that are pure alpha, and start allocating to those, even if we do not like the sector. If we like a particular credit on the investment grade or high yield side, we can go long and then short the beta out of it, to neutralize it, by buying protection in the credit derivatives index market. This fine-tunes our capability to isolate alpha even if we do not like the individual beta associated with it.
Everything, whether a bottom-up or top-down idea, is based on how to achieve positive return skew, where the payoff is better than one to one relative to the expected drawdown.
Q: How do you look for opportunities as part of your research process?
We have centralized research, with 60-plus analysts on fixed income and equities, and about 100 industry experts overall. The person who covers, say, the steel sector covers it globally, from investment to non-investment grade. It’s deep, intensive work, and they assign their own ratings via our proprietary rating system, so we do not have to rely on external research.
While we tilt toward U.S. investments because our investors are dollar-based, and those are the biggest markets in the world, we can, and do, invest globally.
We have a sector duration component between -2 and 5 years, enabling us to go short term structure risk, although we have not utilized this yet because conditions have not been right. We also can position the portfolio to benefit from shifts in global yield curves. Right now we have some curve “steepeners” in the short end of the curve through the swap market in the U.K., the U.S., and one other market.
Every fixed income credit sector is available to us. We currently have about 30% of our book invested in securitized right now, including non-agency residential mortgage-backed securities, plain-vanilla auto and credit card receivables, and some esoteric types of asset-backed securities, like time-share properties, credit mortgage-backed securities, etc.
Those ideas are driven by our securitized research group, four top-notch securitized people covering their sectors for decades. Other sectors include investment-grade corporate, high-yield corporate, emerging markets, debt, and convertible bonds, and we have a 5% bucket for common stock.
We have a dedicated trading desk here in Boston that has three to four analysts on almost every desk, from Treasuries to emerging markets.
Q: Would you give an example to illustrate your portfolio construction process?
Recently, the collapse in oil represented a great opportunity. We assessed opportunities in the fixed income corporate debt market stemming from the shale boom. We looked first at where oil and natural gas were heading, cyclical sectors driven by supply and demand. While demand is growing, there was just too much supply, but not to where the imbalance would take a decade to come back into balance. We felt oil prices, from the time we started investing, would rebound above $60 a barrel within a reasonable time frame.
Shifting to a bottom-up perspective, we went to our industry analysts in the oil service, pipelines, and production company areas looking for names that could survive a two-year oil-price drought, the ones featuring low-cost production and financial flexibility. We accumulated a position of oil-related names, willing to take some level of drawdown to do that. As a value investor, one buys some names and then drops the bid. We did that through the first quarter of this year, building our position to 10% within the energy sector, consisting of bank loans and investment-grade and high-yield securities in a range of well-diversified issuers. Those investments are paying off now and are driving returns.
It helps that we’re not benchmark-driven. When a manager has a benchmark, they rarely deviate from it significantly because they risk underperformance. Having a benchmark implicitly states you will have some degree of beta exposure through the cycle. Our neutrality is basically cash. Sometimes cash is the best place to be. There have been times where we have run cash as high as 25% to 35% reserves, anchoring it closely to LIBOR-plus.
Interestingly, LIBOR has crept up to 75 basis points, so we can buy instruments tied to LIBOR that lock that in that return and then seek to invest around that. Whenever we make an investment, we don’t think about risk relative to the benchmark but risk relative to a neutral point of cash, which is basically zero. We aim to add absolute return relative to absolute drawdown potential.
Q: How do you define and manage risk?
Risk management is embedded in our investment process. We work closely with the firm’s Quantitative Risk and Research Analysis group. Together we have built proprietary systems that help manage risk within complex portfolios bearing various risk factors that can be difficult to separate and identify. Our risk management philosophy differs somewhat from our peers because opportunities are judged not by return relative to volatility but return relative to drawdown, and wanting to have at least a one-to-one payoff to that expected drawdown.
We also provide guidance on the risk we take, which is unusual among multi-sector portfolios. Investors rarely know how much risk these portfolios take unless it is specified.
We approach understanding drawdown from multiple levels. One is our analytical regime tool that loads the portfolio and assesses how it would perform over historical cycles: downturn vs. credit repair vs. recovery vs. expansion cycles. We identify what regime we are in now and can see how the portfolio would have behaved historically in that same regime.
During the credit repair phase, the portfolio can do exceptionally well by tilting to the credit sectors. Returns tend to be the most positively skewed at this stage because dollar prices are low and yields are high to start. Stylistically, that is when we tend to maximize our credit exposure. As we move later into the cycle, we tend to reduce credit until we are neutral or even net short.
We find that calibrating the portfolio upfront is the best way to handle drawdowns. Will we get paid better than one to one for the risk we’re taking, or not? If not, we dial down risk to an appropriate level.
Hedges and shorting capability are great to manage beta and such, but we don’t view these as risk management solutions by themselves. A lot of hedging can churn the portfolio and drive up costs, so it’s treading water without making much money. We might think the portfolio can return, say, 4%, but we would therefore not want to expose it to a drawdown of more than 4%. Properly calibrating the risk-to-drawdown profile up front is the most important step to the risk management process.
Our risk tool isolates risk factors, looks at them independently, measuring the portfolio’s term structure, different credit spread sectors, and currency allocations, both in isolation and together to measure the co-variances and diversification benefits.
We want to understand the shifts in correlation and analyze what would happen if and when we enter a new regime—how the portfolio would likely behave.
