Running to Stand Still?", Insto

Swiss S, "Running to Stand Still?", Insto. April 2002, pp 10-21. Running to Stand Still? Swiss (April, 2002) !n Januafy 2002 Mercer Investment Consuiting (Mercer) dropped a bombshell in the domestic fixed income market, arsnoundng its conclusion that traditional Austraiian active managers who derive their excess returns from duration and yield curve management - weren't adding sufficient value. The asset consultant stated: "We conclude that there is no reason to suggest that active managers, in general, will improve their modest excess returns in the absence of any new structural theme such as substantial changes in bond yields and credit spread. As a result, Mercer said it is ceasing the research of conventional active Australian fixed income strategies and instead focusing on oiher fixed income products such as enhanced passive fixed income strategies which, according to Mercer, deliver better va!ue, "Hiis announcement, and the basis of Mercer's research, has created a furore in the domestic active fixed income fund management industry. Nobody disputes the facts on which the Mercer opinion was based - it is true that excess returns from active managers over the last five years have deteriorated from their highs in the 1980s snd up to 1997 (see chart on page 12), But active managers claim that structurai changes in the domestic and internationa! fixed income markets have heralded in a new era of active management, They argue slrorsgly that the shift in the investment landscape requires diversified sources of excess return. The crux of their defence is that the traditional ways for active managers to add value ~ duration and yield curve management, relative value and arbitrage - have been greatly enhanced by the addition of credit - including the use of boih sector rotation and stock selection. At the same time, the potential to exploit the added depth and diversification of the global fixed income markets has galvanlsed the active approach, they say. The Mercer argument Since releasing the damning report in January, Mercer has had time to expand on its argument BY SAMAHIHA SWiSS Simon Romijn, consultant at Mercer and author of the report, comments: "What we are saying is In January 2002 a report by Mercer Investment Consulting that over the last five years, so-called (Mercer) sparked a fierce debate En the Australian domestic convenfionst! fixed income products which fixed income market. Brandishing tive years of performance looked to add value pnncipally through duration data, Mercer concluded that traditional domestic active fixed and yield cun/e management have not added income managers are not adding sufficient value to justify enough value to justily investor interest We\ie their fees. The consultant concluded further that enhanced looked at this Irom a number of angles and passive domestic fixed income products in particular are a decided that these products don't represent better value proposition. While nobody argues with the value for money for our clients." Romijn adds; data Mercer used to substantiate ils claims, not all asset °We decjdeci to c^J a spade a spade and make consultants take such a radical view and many fixed income the call that, instead of going out there and managers have leapt to the defence of their qctive investment continuing to research 20-odd products that we style. They argue that there is still value to be had from are not actively recommending io clients duration and yield curve management, and more importantly, anyway, we would concentrate ouf resources that the key to successful active management in the future is where we may sti!! be abie to add some value accessing diversified sources of excess return - including in fixed income. One such area is domestic both credit and global fixed income markets. passive enhanced products' continued on page 12 10 fNSTOAPR!L2002 Page 1 Swiss (April, 2002) Running to Stand StEil? Rolling Five-year Excess Returns significant to the overaii portfoiio performance. • of Conventional Australian Fixed Income Managers Stephen Nash, senior portfolio manager in fixed income at State Street Global Advisors (SSgA), agrees. He comments: It comes down to the fact that there is asymmetric.risk in fixed income. So if you.want to go for the big bets and unlimited upside, you don't go to the bond markets, you go to the equity mafket" But the active fixed income fund managers I "" find this argument a little defeatist As Glenn S. 1,0 Feben, head of fixed income'at Perenniai r^^~~. investment Partners (Perennial), says: \A ^ •' ' ^ "Generally around a quarter of a balanced ^£ portfolio is invested in the fixed income sector. in Ac")t!A lose Jim Occ Am Dec /jAA>fccAi E»cî\3ei^T(lii. Dec ;wZ.[^T/Jlun ESec Ai oEcSiefec' if this is actively managed rather than simply fW t«0:tiW 1991 IWl 1932 19S3 t»« 19W ie9<< 1995 \9W 199G MSe tS9?~TW7 TOSS \3Ss 1199 1999 MOO SSOO EiB! 2(XH indexed, the additional active return will, over a , period of time, make a very significant impact on the overall performance of a fund.The key is - 25th Percentiie — Median - - • 75th Percentila to identify managers who can deliver excess returns consistently. Such fund managers Source: Mercer Performance Analytics, Maich 2002 definitely do exist and it is the job of the asset consuitante to identify them. The-'risk budget' Central to Romijn's pro-passive enhanced looking for simplicity in fixed income producis. argument is very shaiiow. The amount of 'risk argument is the information ratio of fund Ail they want is safe, reliable results," budget used up by a qualify active fixed income managers (see box on page 14) - a risk- This comment of Romijns ieads to an issue at manager is very small - and our information adjusted excess return figure obtained by the heart of any fixed income strategy ~ asset ratio is high ~ compared with that of equities. dividing the excess return by the tracking error. allocation at the overall portfolio levei and the He comments: "It became dear to me that one basic reason for including an allocation to fixed "The alpha Aussle of the reasons good enhanced passive income. In making this asset allocation decision bond managers managers moved down the risk spectrum was for superannuation funds, trustees and their add is so they can improve their information ratios. In consultants are faced with the question of uncorrelated with exploiting a more limited range of opportunities whether to allocate most of their risk budget the alpha Aossie by taking advantage of market inefficiencies, into the equity market where they may expect equity managers, enhanced passive managers can produce a higher returns ~ in the region of 200 to 300 add. So as you more reliable excess return, with information basis points per year, as opposed to a diversify across ratios of between 1.5 and 2.0, Têy are able to maximum of 100 basis points for top quartile a series of asset' generate a modest but consistent level of fixed income fund managers. As Denis Carrofl, classes you can return after fees. By comparison, better chief executive officer of AvSuper, says: If you increase your conventional active managers produce iook at historical performance over the last 200 alpha potential respectable information ratios of between 0.6 years, cash returns around 3,847 times, fixed without paying and 1.0 but once you take into consideration income returns around 9,950 times and shares out any additional their fees this information ratio is only of return 9,856,849 times. What that tells you is risk at a total academic interesL" that there is a compelling argument to weight portfolio level." Romijn condudes; "Our research led to the your portfoHo in the longer term towards Symon Parish conclusion that it is better to reap the sure shares." nickel than the uncertain dollar. Our clients are However, compelling as the data may be, that In addition, say acSve managers, because the argument fails to consider the impact of 'fixed income markets are largely uncorrelaied Our research led to volatility. All market participants agree that fixed with the equity market, looking for return from the conclusion that income is a necessary diversifier, in an overall fixed income doesnt cost anything at the It fs better to reap portfolio sense, to act as a foil against equity overai! portfolio level. For Symon Parish, the sure nickel than market voiatihty, A general rule of thumb for portfolio manager at Frank Russell, diversity the uncertain dollar, Australian balanced funds is around 70 percent across a series of active asset classes offers Our clients are allocated to equity and other growth assets and active managers a powerful outcome. He says; looking for the remaining 30 percent to fixed income, Tîe The alpha Aussie bond managers add is simplicity in fixed question then becomes what do clients expect uncorrefated with the alpha Aussie equity income products. in terms of risk and return from iheir fixed managers add. As a consequence, as you AH they want is income ailocafion? diversify across a series of asset classes you safe, reliable According to Romijn, because there is no can increase your aipha potential without results" consistency of return in active domestic fixed actually giving away or paying out an/ additional ^Simon Romijn income fund management, it may be better for risk at a totai portfolio level, The additional superannuation funds to put their fixed income return doesn t cost you anything, so why not funds to work with passive enhanced managers take W where there is a small but consistent return, Al John Stratton, director in fixed income at the same lime, the risk budget of Alliance Capital Management (Alliance), agrees: superannuation funds should be put to use in "If you take away active risk from lixed income the equity market, where there is promise of you do not free up the same amount of rist< for higher returns and results that are more equities.

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