Q: How is your fund different from its peers?
In 1996, when we started the Delaware Wealth Builder Fund, all the other balanced funds were 60% S&P 500 Index and 40% investment-grade bonds.
We wanted to create a fund that acted like a convertible, designed to capture about 67% to 75% of the S&P 500’s upside, without being too interest-rate sensitive when rates rose, and just half the downside. And that is what we have achieved, capturing about 75% of the upside with about 52% of the downside.
We have accomplished that because of how we manage asset allocation and also due to the sector allocations and security selection of the managers who oversee each of the fund’s sleeves.
The fund invests in income-generating securities and provides a yield that is competitive with fixed income, but with more upside, while providing a premium yield to equities with better downside protection. Overall, the portfolio yields about 3.2% on a gross basis.
Q: What is your investment philosophy?
We maintain a macroeconomic overview with an absolute value approach to sector and security selection.
Our sector and security selection provide four key benefits. The first is responsible income, because we invest in income-generating securities up and down the capital structure and across geographies. It’s important to note that we don’t necessarily pursue the highest levels of income; we prefer to look for responsible levels of income.
The second benefit is diversification, in that the fund invests in different types of income-generating securities across different locales and regions.
The third benefit is low volatility. The fund has experienced only 70% of the volatility of the S&P 500 Index over the last 20 years.
The last benefit is the potential for upside appreciation. That is why the fund is named “Wealth Builder.” In today’s environment, many have forgotten that returns are achieved through two components, yield and price, which together equal total return. Many investors are chasing dividend yield. Instead of bonds, we opt for equities that are bond-like or bond surrogates, across sectors that include utilities, REITs, MLPs, and consumer staples.
We have weathered multiple economic, equity, and credit cycles without deviating from our balance between income and price appreciation. That consistency has provided steady, strong performance through cycles, through the tech boom and bust, the housing boom and bust, and the credit boom and bust.
Many of our fund’s peers, which have emerged over the last seven or eight years, promise high yields. But it’s important to point out that those yields limit each fund’s investment universe and makes each fund more interest-rate sensitive. In contrast, we try to diversify those risks and provide a vehicle that is better balanced and designed to build wealth over time.
Q: How do you transform this philosophy into an investment process?
There are seven portfolio managers and 28 analysts who work on this fund. Between the two lead portfolio managers is 46 years of experience managing income-generating securities. The two of us determine asset allocation and monitor income generation.
We begin with a dashboard that tracks global economic trends and, notably, how they affect income-generating securities up and down the capital structure and across regions.
We look at historic trends—global monetary policy, commodities, currencies, interest rate swap spreads, credit default swaps, corporate bond spreads, valuation and earnings, global inflation breakeven spreads, lending conditions, fund flows, and more.
Asset class diversification is just one step in risk control, and it is a blunt instrument, especially when you have the entire world engaged in a monetary-easing policy. Regardless of environment, income-generating securities have certain credit risks that can completely nullify one’s asset allocation. If you focus solely on yield, you fail to pay attention to credit.
We study the effective movements in credit to all of our income-generating securities. Whatever they might be, we want to know the effect movements and credit spreads will have on them.
Q: How do you determine asset allocation?
We begin by assessing the financial system—what the central banks are doing and what’s happening in the interbank lending systems. We measure global funding spread through sovereign debt spreads, swap spreads, forward rate agreements, dealer inventories, money growth, and so forth.
Once we establish where we are in the credit environment, we can appropriately weight equities, convertibles, debt, and alternatives within the portfolio. Then we sit down with each manager on a bi-weekly basis and work through the valuation framework, fundamental research, and attribution. We assess our exposures and adjust accordingly.
We buy mostly liquid securities, not growth stocks like Facebook. They correlate because they’re all income-generating securities and are affected by credit spreads. Since the financial crisis, we hedge more, such as CDX hedges in the high-yield sector. We’ve done some shorting, some pairings of long and shorter stocks, and some shorting of the E-mini S&P 500 futures. We have expanded the toolbox not just for the sake of generating income, but to preserve capital when valuations appear stretched.
Q: What role does diversification play in your allocation strategy?
This is a diversified portfolio, with a minimum of 50% in equity or equity-linked securities. We can be zero equities and 50% in convertibles. We have no more than 45% in high-yield bonds, up to 35% in non-U.S. securities (both debt and equity), no more than 25% in any one industry, and no more than 5% in one particular name.
The weightings today are 44% large-cap value, 13.3% high-yield bonds, 3.7% international equity, 9.4% convertibles, and 0.8% international fixed income. We have an opportunistic sleeve that is about 4%. REITs are 6.3%, investment grade bonds are 2.9%, and municipal bonds are 1.1%. Cash has been high. We’re trying to lower that, but we are a bit more defensive given today’s market valuation.
Q: What is the opportunistic sleeve?
In 2008, despite outperforming the S&P 500, we felt we could perform better. There were asset classes not represented in the fund, so we created an opportunistic sleeve where we could buy any income-generating security: small-cap, mid-cap, large-cap, international, U.S., and non-U.S. We own stocks that are not a part of the other sleeve. We own Microsoft Corporation, Qualcomm Inc., we own gold, closed-end funds, and an ETF, an exchange-traded fund.
More recently, we did something new that not many mutual funds do. We can invest up to 10% illiquid by prospectus, so we bought a 440-unit apartment building in Manchester, New Hampshire, which made sense for this portfolio over the long term, 7–10 years.
We went in with about an 8% preferred return, and our internal rate of return, based on our underwriting exceptions, is projected to be 17% to 18% over that 7–10 year period. The beauty of being in an illiquid private investment is that it yields more information than a public investment, and it’s in an area where institutional capital does not go, a secondary market, no supply, and 98% occupancy.
Q: What is your research process?
Each sleeve manager has its own process, its own models, but each manager’s goal is to find outperforming risk-adjusted income-generating securities.
We have two asset allocators who sit down on a bi-weekly basis with each team and review the valuation framework. Using large-cap value as an example, they review price to earnings, price to cash flow, price-to book, EBITDA, and yield versus growth. They also look at earnings stability, leverage levels, cost and availability of capital for each company, along with its current sector exposure.
Last year we did well in large-cap value. Because even though the sleeve was overweight energy, it was underweight industrials and materials. We also asked the convertible and high-yield teams to lower their weights in the energy space. We did well relative to peers last year because we understood our energy exposures.
From a top-down basis, after I review the attribution, security, and sector selections, I look at our exposures from developed to developing countries to determine whether we are more cyclically or defensively oriented within each sleeve and examine the beta and whether it’s changed.
Once we have all that, we optimize based on valuations, fundamentals, dividend yield, and exposures to asset class, country, and sector. It’s a dynamic process. We are not tactical asset allocators. We are fairly strategic and we have conviction.
Our sell discipline is based on valuation, fundamentals, and what has outperformed or underperformed. We constantly monitor these conditions through sector and security attribution analysis at the sleeve level.
Q: Can you provide any specific historical examples?
Back in early 2009, we had 51% of the portfolio in convertible and high-yield bonds. Today that is down to about 23%. We were getting equity-like returns without buying equities. At the end of 2013, in the taper tantrum, we bought municipal bonds at 6%. Tax adjusted, it was a 9% equity-like return, which is nirvana for us.
Much of what drives our allocation decisions is credit. Fixed income is driven by credit; convertibles are driven by credit spreads; high-yield equities are driven by credit (mainly because most high-yield equities have slower growth, higher leverage, are more cyclical, and if they have slower growth, they pay out dividends). Growth is how you offset credit spread widening or inflation, and why we seek a responsible level of income instead of aiming for the highest.
The most important price in capitalism is the U.S. money market interest rate. It drives stocks, bonds, currencies, and derivatives. Right now that is 25 or 30 basis points. After taxes and inflation it is basically zero. That zero cost of funding is the reason for current valuations in the income-generating world of REITs, utilities, consumer staples, and high-yield bonds.
We had the opposite last year when they were hawkish and credit spreads widened—these stocks were volatile and underperformed.
Credit investors look for return of their capital. Equity investors look for return on their capital. If credit investors are nervous, then equity investors should be frightened.
When rates are low, the economy lags, and we have too much debt, which then causes rates to stay low and inhibits growth. I believe rates will stay low, but at some point investors will lose confidence in central banks and we will see a correction.
Certain things can be challenges: the percentage of banks that are tightening has gone up, as have LIBOR rates and swap spreads. In Australia, for example, the RBA (Reserve Bank of Australia) just lowered rates with the four big banks, and two of those raised their deposit rates. Somebody is nervous about doing Australian interbank lending. Why? Because housing is expensive.
At some point, a trigger will appear. I don’t think central banks can raise rates that much because there is just too much debt. All these programs—QE (quantitative easing), NIRP (negative interest rate policy), ZIRP (zero interest rate policy)—have gotten us nowhere.
The Bank of England, in the second day of its QE program, could not find bonds to buy because insurance companies said, “No, thank you. I’m not relinquishing 3.5% GILTs to reinvest at 1%. I can’t meet my obligations.”
All we can do is monitor what is happening and when it appears this is no longer sustainable, we’ll adjust the portfolio.
Q: How do you define and manage risk?
Every asset class has volatility. Even safe asset classes have volatility. I define risk instead as potential loss. We manage potential downside by diversifying asset classes by geography, managing the duration risk in the fixed income, and understanding valuation framework within each asset class.
I perform a portfolio stress test, uploading it into a quantitative model, which is the only quantitative analysis I do. I stress it based on movements in the yield curve of maybe 50–100 basis points either way and examine what happens when volatility increases 10%, 15%, or 20% (or if it goes down), if oil loses a certain percentage, if the market is up 20 or down 20, and so on. I want to identify the portfolio’s sensitivities. I do not manage to beta or tracking error.
Responsible income combined with price appreciation is what helps build wealth over time.
