Q: Would you provide an overview of the fund?
Since the portfolio team started working on this strategy in 2007, the investment process has remained consistently the same.
Although global fixed-income presents a vast opportunity set, we distill the drivers of bond returns into four basic risk factors: interest rate risk, credit risk, currency risk, and inflation risk. We then assess these risks and target diversified sources of return across all sectors and global markets, seeking income in all environments.
Q: How does the fund differ from its peers?
We designed our fund to have full flexibility to meaningfully change its risk profile over a full market cycle and thereby solve for two distinct client needs: generate income and navigate interest rate volatility. We have found that the universe of multi-sector funds generally delivers one or the other of those needs—traditional multi-sector funds generate income but tend to be more constrained from a duration standpoint, and non-traditional funds often forgo income in exchange for low volatility and less sensitivity to rates. Our goal is to bridge that gap and deliver what we call “tactical bond market beta”. By tapping multiple bond market risk factors, we can deliver the diversification benefits of bonds as well as a competitive income stream to our investors.
Many peers rely on a committee framework with specialists from every corner of the market, be they in corporate bonds, mortgage-backed bonds, or international securities. Such concentration on one particular thing is not necessarily bad. In practice, however, these peers tend to succeed or fail at predictable or explainable times, whether due to manager comfort, experience in a certain sector, or a specific type of risk.
Our approach is different. It has always valued having an independent multi-sector team that can make unemotional decisions about opportunities. Backed by an experienced management team and deep research capabilities, we will shift allocations based on market conditions.
There have been fluctuations in interest rates, credit, and currency during the six years I have been manager, and the fund has navigated these in a way that creates a different return profile that balances well for our clients.
We also think the size of our fund is an important differentiator as it allows us to generate performance through individual security selection and reduces reliance on getting a single outsized bet right. We want the fund to benefit from our extensive team of credit research analysts, who have been investing in their sectors and industries for 15 years on average. By investing in cash bonds as opposed to broad market derivatives, the fund is able to avoid problem areas of the market. Last year is a good example. In 2015, bonds in the energy, metals and mining sectors wreaked havoc on the high yield bond market. Because we were able to selectively participate in those commodity-related issuers where we had high conviction we generated a positive total return from our high yield allocation.
Q: What is your investment philosophy?
Our philosophy is that a risk-balanced fixed-income portfolio can outperform through a cycle.
Furthermore, because every risk factor has a slightly different cycle, we have done significant research to see how each performs in different market environments. Putting them together creates a diversification benefit, which historically has given the fund an opportunity to make money regardless of the environment.
Q: How do you transform this philosophy into your investment strategy and process?
We use our risk-balance framework to segregate, understand, and analyze the attractiveness of each risk throughout the cycle, and ultimately inform portfolio construction and allocation.
However, the word “cycle” is itself tricky. People think about business cycles and recessions, but we have found that, with broad risk factors, sometimes the cycles are aligned and sometimes they are not. Our process pulls apart these factors and analyzes them independently, giving us a view of their attractiveness and direction.
For example, when examining the attractiveness and direction in global interest rates, we look at how and where they are diverging. With credit risk, we look for areas of credit that are performing differently and try to determine what they are telling us. Within currencies, we examine the dynamic of global currencies, how this dynamic informs policy decisions, and how those decisions impact the market. In inflation, we analyze how its evolution will feed into and affect the other risks.
At the moment, we are taking a deep look within the credit risk factor and its cycles. The corporate credit cycle begins as companies are recovering from a tough period, then progresses as they repair their balance sheets, increase their profit margins, start to borrow again, lever themselves, and finally become the riskier entities seen late in the cycle.
We are nine years into the current cycle – it is actually quite advanced. But our analysis goes deeper and asks whether the cycle is true across all areas. Energy-related companies, for instance, may already be through the worst of it, but in other sectors things may be worsening.
Our investment universe is all things bonds in the global marketplace. We can invest in the U.S. and elsewhere, in developed markets and emerging markets. The fund is multi-sector, so it includes sovereign bonds, government mortgage-backed bonds, corporate bonds, etc., but not equities. Although we have the ability to buy general convertible securities, we have never done so.
We also invest in bank loans. Some would argue that these are not bonds, they are floating rate loans. We see them as an important allocation within the credit risk factor and look at them closely, particularly as a peer to the high-yield corporate market.
Our firm gets separate perspectives from its large, dedicated teams in high-yield bank loans and high-yield corporate bonds.
The bank loan team provides an outlook on the performance of the collateralized loan obligation (CLO) market and how CLO issuance is transpiring. Our high-yield corporate team, which has a global institutional business as well as a large mutual fund business, furnishes credit research. Additionally, we gain the team’s invaluable perspective on the appetite of global investors for those asset classes.
Q: How do you find opportunities through your research process?
Our research process assesses the attractiveness of risks independently and then blends them in different proportions over time, allowing us to create expected outcomes and then allocate the portfolio accordingly, in a way that might be quite different today than it was a year ago.
Though the portfolio management team is independent in its management and accountability, it is not independent of idea generation and execution, so our research process is both bottom-up and top-down. Getting bonds in the portfolio results from the efforts of many people at the firm and their analysis, which includes top-down valuations, fundamentals, and technicals.
Each risk factor – interest rate, credit, currency, and inflation – has its own research process and committee to evaluate its attractiveness every week, with daily updates.
For example, our global interest rate committee and research process focus on the attractiveness of interest rates, helping us understand where returns are on an absolute basis, on a currency-hedged basis, and on a risk- or volatility-adjusted basis. More importantly, we learn what is driving policy assumptions and how they are evolving in relation to movements in government bond yield.
These processes view risks at a high level. But their output is something we hold ourselves more accountable for, so we also look at how attractive each risk is on a fundamental basis. We analyze the fundamental drivers of cash flow or policy that could change the dynamics of an investment, and how attractive its valuation is – what are we being paid, what is the yield, or what is the spread that we are compensated for these risks?
Our bottom-up process takes place simultaneously and is continuously going on within each sector team. We bring them in to learn what is going on at the underlying sector level and to discuss their relative value within the context of a multi-sector portfolio.
From this, we are able to provide feedback loops, perhaps telling the corporate team about trends we are hearing from the mortgage team regarding demographics that are affecting housing choices, which will loop to what is going on in the construction sector within the corporate bond market.
We also look at investments on a technical level, looking at the amount of asset flow coming into an asset class to see whether a central bank is buying it or whether investors are showing a strong preference in favor or against it. Technicals can be leading; often they are only temporary. However, they can also be quite strong, as they are right now particularly in credit-based asset classes driven by technical flows coming from overseas.
Putting together valuations, fundamentals, and technicals leads us to an overall attractiveness of duration risk across countries, of credit risk across sectors, of currency risk and inflation risk across regions and countries. We set basis targets for asset allocation in each of these, and the sector teams put the dollars to work on our behalf.
Q: What is your portfolio construction process?
The process is one of deciding on the risk target, creating a market value target, and then working with the team to understand specifically where we should focus that target.
Putting together valuations, fundamentals, and technicals leads us to an overall attractiveness score of duration risk across countries, of credit risk across sectors, of currency risk and inflation risk across regions and countries.
Everything is rated from one through four, with one meaning low risk and high relative value. Ideally, we want to be close to one, to avoid high uncertainty and focus on areas where we have a stronger fundamental basis and can capture an attractive risk premium.
Take emerging markets, for example. We might tell its sector team we want 8% of the portfolio in emerging market sovereign debt. Working with them, we use a process to evaluate all the regions and countries, and have an expectation for excess return in that market. Our process might lead us to an area like Mexico as opposed to Venezuela or Columbia.
The global benchmark is approximately 60% outside the U.S. Historically, we tend to be more domestically invested, with about two-thirds in the U.S. This is true in part because of the income focus of our product, which is important to our shareholders.
Frankly, it is important to the way we think about prospective total return. In constructing a return expectation for a bond-like security, income should be a significant piece, and more of the income share is in the U.S. – many bonds outside the country are extraordinarily low in yield.
The asset-class concentration of the portfolio can dramatically vary over time. In high yield, we have been as high as 50%; that is down below 30% now. In corporate securities, we have been as high as 75%, though currently we are significantly lower at about 40%. Our research process is leading us to a more cautious view on the corporate side, but an increasing view on the consumer-related side, therefore our structured asset position has increased to about a third of the portfolio from less than 20% a year ago.
As a global multi-sector portfolio, we fight against over-diversification. Diversification is critical to the way we think about portfolio construction and how much of each of these risks we want to put together in it.
The reason our research process moves from the top down is not so that we can take large frequent tactical swings in the risks in the portfolio. It is actually the opposite, so that we can take high-conviction positions but not feel like we have to move them all the time.
Flexibility should not be measured in trading velocity. Instead, it should be measured by the ability to change the complexion of risk in a portfolio over time, and not necessarily to look like a particular benchmark. With liquidity as poor as it is, making trading costs as expensive as they are, I think high-frequency trading is a losing proposition.
Q: How do you define and manage risk?
Risk can be measured in many ways and we get it through a few lenses. Although we target tracking error of around 5% versus our benchmark, which is the Bloomberg Barclays U.S. Aggregate Bond Index, ultimately we view risk as a scenario in which we fail to meet our investment objective.
On a practical basis, we want to know where most risk models would say our bets are concentrated, and want to be certain we are concentrating risk in the areas with the highest conviction.
Our daily risk budget allows us to choose which risk factor to focus on, and how much. This is fundamentally different from most fixed-income investment products or indices which by their nature and construction tend to be concentrated in one factor all the time.
In the Bloomberg Barclays Aggregate Index, 98% of the returns are explained by the movement of U.S. interest rates. That does not change. If you were to buy a global bond fund or look at a global index, about two-thirds of the return are explained by movements in currencies, all the time, over time, with little variation. The same thing is true for a credit index. If you use a high-yield corporate fund, 90%-plus of the returns are explained by credit risk all the time.
We are not right 100% of the time, and sometimes careful risk analysis reveals that our conviction should have been lower, that we need to reassess and scale our exposures to our collective conviction. During our monthly portfolio review process, we ask things like how much value did we think we had at risk? What did the market do? Did the portfolio perform in line with our expectations?
Because we look to the basis point every day, these reviews do not produce huge surprises. We do gain insight into whether a certain sector is behaving unexpectedly, perhaps in a way that challenges our thesis.
An example of currency risk will illustrate this. A year to 18 months ago we had quite a defensive position on foreign currencies, which was beneficial to the product as the dollar appreciated in value.
Midway through last year, as the appreciation of the dollar fed into commodities and then into monetary policy, our conviction in the subsequent direction of currencies became much lower. Rather than take an opposite bet, or buy a random or benchmark basket of currencies, we looked at the risk budget and decided to simply take risk to a de minimis level. That was our highest comfort level for our shareholder dollar.
