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»c^i\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, T^ey 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, T^ie 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. Tlie broader you diversify the less risk continued on page 16

12 INSiO APRIL 200?

Pages Running to Stand Still? Swiss (April, 2002)

Romijn uses the sharp difference in excess returns of top quartiie managers over 12 monihs and five years to support his argument Part of the Mercer Investment Consutting A new development that some fund that superior performance has not been . (Mercer) argument that traditional active fixed managers and consultants Ihink may grow in consistently maintained. He argues that this income fund management is no longer valid for the future is Macquarie Investment means it is difficult to continue to support-active superannuation funds revolves apoursd the fees Management's strategy of offering clients the management because even superior managers active managers charge for the excess returns return on the composite bond index for no fee based on Mercer research were not capable of they produce... at all. Says Philljp Dolan, head of investment consistently outperforming the benchmark. Howei/eft determining the fees charged by research: This is a pure performance fee Active managers counter that data from the active, enhanced passive and passive fixed where we keep any outperformance, but make last two years and indeed the fast 15 months is income fcncf managers in the Australian market up any underperformance. This is offered to the a more accurate measurement of their is no easy task. Fund managers are wholesale market and suits ciients who do not performance ~ rather than the last five years - understandably cagey about giving concrete want any manager risk at all, but y^ho also want because it rejects the changing nature of the information On fees, but from tntervisws with the lowest possible - in this case zero - fee. index. 17 of Australia's top active and enhanced . Our view is that there is a spectrum of risk passive "Fund mainagersr it is possible to get a appetites among clients and we need to offer "Returns have come down in generai idea- Until recently, fees for acyve the full range - from exact indek tofradttionaS the last i'fve years. However, managers hwe ranged between 26 fo 30 active" tradung error ha? also basis points per year. How6ver,.with a decline Simon Romijn, invesbnent consultanl at decreased, meaning thatths in exte$s returns, these fees are now coming Mercer, says. ^ li)s March 2002 report The Sure qusttty of oytperformance down to between 15 and 20 ba?is points per Niclfel Versus the Uncertain Dollan ffTl)e median provided by active fund year. Fees forpurety pas6^@ fund rnanagement manager of conventional Austraiiw Uesd managers has come in at arpuncj eight basis poirts and for interest products &jded 0.20 percent of excess been maintained.", enhanced passive fees come !n at around 10 return relathfetofie UBS Warburg Composite John Stratton basis points. ;. * f3ond Index in 20Q1. Over the last fiveyearSi !n terms of return for fees, active fund th? median manager generated on)/. 0,12 fnanagete.-say 9. general ryle of thumb is to percent per annum of excess return before expect a return of three times their fee. This fees, An/ lingering excitement should be means that for the higher end of active fund crushed after taking into account that manager fe?$ - 30 basis points - the return wholesale management fees for such products Would have to-be 90 basis points arid above to are between 0,18 percent and 0.20 percent per justify the fees, However, exp^ctetions of excess annym" Later in ttlfe same report Romijn return have declined due to the structurai comments on excess returns from top qLfartile changes in the fixed income markets, Most active managers, He says; Top qtiartife active managers say they are aiming for managers generated between 0,6 percent and between 7£1 and 80 basis points of excess 1.5 percent of excess return irt $001. Top return for clients. Enhanced passive managers, quartfie managers based on the Iqst five years on the other hand, are aiming for excess bf performance generated between 0.3 percent returns of around 20 basis p&lrtt? per year, and 0.6 percent per year of excess return" Acth/e manager? glso say Mercer fogic is flawed because ijie. consultant hss !eS out a Median Information Ratio in Australian Fixed Income (all funds) discussion of th? information ratio when June 1988 to Feb 2002 reviewing the performance of fund managers. Median versus UBS Composite Bond Index (before tax and before fees) As John Stratton, director in fixed income at Aiiiance Capital Managemeni, says; "Returns 1.4 T have come down !n the !ast five y6ars, as evidenced by Mercer's data However, backing error has also decreased, meaning that the 1.0-i- quality of outperform an ce provided by active kind managers has been maintained, as indicated by the consistently high information ratio achieved by top quartile managers" The information ratio - excess return divided by tacking error - is the preemlnent measure of o.a.j- manager skill, and is therefore a vllaf Ingredient when assessing active fund managers' 1 /rV)V ^L/.: performance, In active fixed income fund -o.a-i- v ^W/w %'f^'l management, a good information ratio is around 0,5, white anything above one is considered doing really well, The chart betow shows Mercer data on information ratios from June 1998 to

Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun Jun June 2001. The first table opposite shows 19BB 13B3 1990 1991 1992 19931384 1995 1986 1997 1998 1999 2000 2001 mercer data for Australian fixed income

— 3-Year Rolling information Ratio •—••• Upper Quartiia Lower Quartile specialist funds - nsk versus return for the three years to January 31 2002 (calculated monthly), Source: Mercer Investment Conauiting, March 2002 The second table shows the same information for Australian passive enhanced funds.

14 iNSTO APRIL 300?

Page 3 Swiss (April, 2002) Running to Stand StiSI?

Australian Fixed Income - Specialist Funds. Risk vs Return for Three Years to January 31 2002 (calculated monthly)

Annuallsed | Standard Reward to \ Excess! Tracking Information return ! deviation risk ratio:, I return I error ratio

Advance Asset Mat > . ,: na;......

AMP Indl^Portfolio-Servfoes.

B^-daYS,Qjob^,!nvje'stors;/;;;:i ^t^^

iN&jnve^entMaftassmfipt:

3:31' < (21)

^ •iuta5'Sya(i?.B^.c| Infe.resltLRf^s :^^[<7) 3^''^(4). 1.5:...(1^..:;;-..0^,,:;..,.a6___^^.,,_q^_,<12i,_.0.8^_,^ ll-M^yy^liv^SIISS^^ j^^^^^^^i^^^^^^^^ ^^^^i^^^^^^^^

|;^g^g^^^gc^^m'"^g|37iTm"M^^|T^^J^(i^i^

|:.Westpac[nv^ftentMgt; ' ..iI&4^(1CJ) a&.::;:^4) 1.S. (123i^ 0.<2 0,3 (16) '0.7 (11)' ,:.1>2

l.\ u^a!^|^^7^"[Z7Z^^'I|:^MZ^

LowerQuariile :;-••' • •:^&S:;, a4 1.5.-.:, 0.1 03 0.2 ' '. 0,2

^^l!^>£^t^^^^.^^^^l^^M.^.^M^^L.^

Vftrere an 'na' is giron, ihere is effiifer not enough data (or UjspSfiod chosen orfhedatahasnotbeenpro'ridedoflamonlhf/basis. The index used ((> caicutate excess rehjm find assodateti statistics was ftie UBS Vto^vng Ccmposite Bond fndffic. All tates of (etum aie bflfoie tax and bafore managemeh^tees in A?. Rales of risk arid tsfcm aie annualised tor periods eKrteding one year.

Source: Mercer investment Consulting, March SOOS

Passive Australian Fixed income'- Enhanced Index Funds Risk vs Return for Three Years to January 31 2002 (calculated monthfy)

lanager/Fund Annuatised | Standard Reward to | Excess | Tracking Information return ! deviation risk ratio I return I error ratio (%pa)rank\(%pa)rank^yalyeran^^^ ^^^ii?^^sitBi^^a^t^^^^^^^!%^ Fixed Interest 5.3 (2) 3,5 (1) 1.5 ,(1) 0,2 0.1 (2) ,,2.4 (3) 3.9 ^;q^^^^:F^s^^lli^i--(®^'-^-:=;:C1)';-">"-1^ ^'3.4- '(I):-' 6fi NCI-MlCAust Enhanced Fixed interest 5.4 (1) 3S (1) 15 (1) 02 02 (1) 1,0 (4) 1.7

Source: Mercer Investment Consulting, Match 2002

1NSTD APR! L 2003 15

Page 4 Running to Stand Still? Swiss (April, 2002)

you are taking at the overa!! portfolio level And "Fund managers declining. !n addition, the commonwealth and because the Australian market is a reasonably have to be semi-government bond markets were relatively low tracking error environment there is not an realistic and look uncorreiated, creating market inefficiencies awful amount of risk. As a result, active fixed at investing io with wide semi-government bond spreads that income is really a free option" terms of making could bs readily exploited by active fund a lot of small managers prepared to play the spread. As The defence: diversified sources of bets, some of James Crawford, principal at Towers Pemn, excess return which pay off says: "With these structural dynamics st was Active fund managers and some asset and some don't." almost a free lunch for active managers during consultants argue that even within fixed Income Nick Griffiths that time. Particularly as only part of the market portfolios, using diversified sources of excess was out there actively managing their fixed return can improve risk-adjusted alpha. For income portfolios - banks and insurance firms, them, this is the new era of active management, for example, were just holding bonds for other where duration and yield cur/e management reasons such as reguiatory requirements, are only two of a number of ways to add value, duration matching or risk management They Even Mercer agrees with this proposition, weren't trying to predict the direction of interest Proponents of this view say this has become rates to the same extent as active iund possible due to the changing structure of the managers. As a result, many active managers fixed income markets, with the development of were able to correctly predict the direction of credit in particular as an extra arrow for their interest rates over the medium term and add diversification bow. Says Peter Sumner, portfolio Central to this argument of aflowing fund value by taking relative!/ big duration positions. manager at MLC Investment Management: managers to use multiple opporitifijty sets to Since then, however, interest rates have "Fixed income is a diversifying asset for us - it add vaSue is the overriding belief that the bottomed out and become more stable from a is about income generation and capita! consultants and their clients should make the medium-term perspective, so medium-term preservation. Using diversified sources of broad asset aiiocation decisions for a portfoiio volaiiliiy in interest fates has declined. Says excess return we can boost expected returns and then leave the rest up to the fund Eleanor Debelle, asset consuliant at Towers without significantly increasing risk" He adds: manager, Says Kumar Pafghat, head of Perrin: °1 doubt vefy much that nowadays or in "in a lot of cases it comes down to how you portfolio management, fixed income at PIMCO the near future we will see inflation scares like construct your portfolio and how good you are Australia; Trustees are {he ones who know the we did in the 1980s. Cenlrai banks such as at taking sensible risks. I fikea it to playing Siabjiity and profile of their members. At the the Reserve Bank of Australia are explicitly craps - if you sit there and just bet on one overarching portfolio level, they should targeting inflation," number - like the aid duration and yie!d curve determine the mix of fixed income, equity and These macroeconomic changes in the cash and then decide on Ole benchmarks market, the slow pace of active managers in "Fixed income is a against which the investments will be judged" responding to them and the subsequent diversifying asset - it is He argues that once trustees give the fund decline in performance figures that led Mercer about income generation manager Ihe risk profile they are comfortabSe to conclude that duration and yield curve and capital preservation. with as well as other constraints such as how management are no longer viable sources of Using diversified sources much they can allocate to high yield debt, added value for fixed income fund ot excess return we can emerging msrket debt, global debt and so on, management Says a Mercer report published boost expected the trustees and their consultants shouSd allow in March 2002; "Our research indicated that returns without the managers to decide how they want to add the high levels of excess return generated by significantly value. conventional managers in the late 1980s and increasing risk" Shaun Mays, managing director at Westpac early 1990s resulted from the successful Peter Sumner Financial Services (Westpac), agrees. He exploitation of generally declining bond yields comments: "When the portfolio is built at the and stale government spreads. This decline, in client level, the issue is how much aggregate turn, has been attributed to the reduction in risk trustees are prepared to take in their inflation and a much improved fiscal position of portfolio. Ttiat's their decision and ttien they both commonwealth and state governments. should hanci that out to fund managers in The lack of meaningful excess returns since manageable bites. They need to give managers this structural market trend was piayed out in a very precise mandate by which to p!ay their the mid-1990s suggests that managers game so they are keeping within the risk struggle to generate meaningful excess returns parameters. Once this is done, it should be up in the absence of a marked structural trend" managers ~ you have far fewer chances of to the managers to add value° winning than if you take multiple positions to Duration managers fight back maximise your likely payoff" The duration game But not all fund managers and asset Nick Griffiths, investment consultant and Why have performance figures from active fund consultants agree with the Mercer logic, Some actuary at Aon Investment Consulting (Aon), managers decreased so dramatically in the last claim that there is still a macroeconomic cycle agrees. He comments; 'Fund managers have five years? Most agree that the main reason is which managers can fake advantage of with to be realistic and look at investing these days that the big duration calls of the 1980s and duration management Says Darren Spencer, in terms of making a iot of small bets, some eariy 1990s are no longer possible. investment consultant at Aon: "You can add of which pay off and 5ome don't But with !n the 1980s and up until the mid-1990s the va!ue by duration, even though it's difficult to do numerous bets, the net effect is yoLfre fraking mainstay of active fund managers' excess so consistently. The fact remains that Australia money more consistently and certainly rather returns was duration management This was a has been one of the most volatile bond than with just a few big duration calls period of high volatility in interest rates and also markets in the world and if that remains the each year? a period in which interest rates were steadily case, there will be opportunities to add value

16 IMS1Q APRIL 2003

Pages Swiss (April, 2002) Running 60 Stand Stiil?

"The fact remains that Performance of Average Active Australian Fixed Income Managers vs Australia has been Benchmark (Jan 1990 to Dec 2001) one of the most volatile bond 2,0 markets in the world Tota! Vaiye Added (% pa) 0,39 and if that remains Tracking Error (% pa) 0,50 the case, there will Information Ratio (% pa) 0.78 be opportunities to add value througt duration management" Darren Spencer

-1.0

-1.5

^ Jan 90 Jan 91 Jan 92 Jan 93 Jan 34 Jan 95 Jan 96 Jan 97 Jan 98 Jan 39 Jan 00 Jan 01 through duration management" Debdle at Towers Perrin agrees: 'Interest rate volatility has Monthly Value Added RoNfnS 12-Month Value Added dedined in Australia, particularly over the !ast five years, and therefore it is more difficult to Sowce: Towers Pemn. March 2002 corssistently add value through duration management However, we still research active management theory revolves around taking "We are looking for bond managers as some top quartiie active smaller but more frequent duration bets, rather managers who manage managers have managed to outperform the than the previous method of making one or two across the whole index over the last three years. big duration calls a year, Says Philip Dolan, spectrum of active Warren Bird, head of fixed income and foreign head of investment research at Macquarie management." exchange at Colonial First State Investments, Investment Management; "In certain market Dennis Sams adds: "The name of the duration game has conditions it is possible to add quite a bit of definitely changed. But there is sti!l a cycle and value with a relatively small number of positions I think that provided we structure our product in that oniy change very infrequently, We haven't a way that is priced realisticaliy for what we can seen those types of conditions in recent years deliver there is sti!l value for money in active and as a result managers have had to adapt duration management Ifs just that we didnt thesr processes so as to continue to be able to have to look too hard 10 years ago because add value." duration was a fairly easy game to piay" Feben at Perennial says fund managers today "We still research better understand the macroeconomic active bond environment they are operating in, are more managers as certain about the way cenlfal banks adjust some top been a consistent drop in interest rates which monetaty policy, and as such are better quartile active directly corresponds to a rise in bond prices. positioned to predict the trend of interest rates managers have The next 10 years will experience a compieteiy necessary for dLfcation caiis. He says fund managed to different environment If you invest in the index managers have iived through a. period of low outperform the only and rates rise, for example, you will incur a irrfiation and can be confident that inflation will index over the capital loss," be much lower and more stable than in the last three years." Dennis Sams, head of investment research at past As a result, they should have more Eleanor Debefie InTech Financial Sen&es (InTech), concurs, and confidence that whiie bond markets wil says !nTech will continue to support adive continue to display volatility, the interest rate management He comments: "We are looking cyde will be shallower and in some respects for msnagers who manage across the whole more predictable than in the past He spectrum of active management However, we comments: "This puts you in a better position to wouldn't rule out a style choice it fund exploit the volatility using duration," managers said they wanted to be reiaiively Some fund managers say the way to take passive on duration or yield curre management advantage of volatility in the present market is Ironically, Mercer may have given up on - it Is up to the individual managers to make to change the way duration is managed. Says duration management just at \be time when that decision." Sams cautions, however, that Stratton at Alliance: "What we're finding now is duration plays may be starting to add more aithough it has become more difficult to get that the markets are range trading, which is a value. Says Westpac's Mays: "We made 30 active returns from duration management as very different style of duration management basis points of return in one week in mid-March directional bets have declined, the danger of There is a lot more technical analysis involving through taking a duration position," The giving up on duration management will become more consideration of liquidity and sentiment managers caution that saying Vr\e duration apparent if the market went into a steadily indicators in both Australia and offshore. Now game is over based on backward-fooking data rising interest rate phase. "In that situation," he we are a relative value trade within the dollar may be throwing the baby out with the bath comments, "managers could come back and bloc whereas a decade ago we were treated water. Some asset consultants agree, Says pick up returns from being long Or short like an emerging market" The new duration Aons Spencer: "In Ihe last 10 years there has duration,

IMSTO APRIL 30)2 17

page 6 Running to Stand Still? Swiss (April, 2002)

Lance F'upelis, head of fixed interest at period of time can pick the direction of interest yield cun/e, tive percent from sector rotation, Rirtfolio Partners, says banking sector flows rates. So ?s all well and good saying that five percent from relative value and arbitrage are inexfricabiy linked \o declining returns for duration management is a source of alpha ~ it trading and 20 percent from credit Now the fund managers from duration management He probably is if you can pick it - but th& evidence mix is more like 40 percent from duration, 10 comments; "In the last few years, banking suggests that you cannot accurately pick the percent from yieid cufve, 1 0 percent from sector flows have become far more important in direction of interest rates." sector rotation, five percent fromlrading, and the marketpiace, This has meant that if the However, other passive enhanced managers 35 percent and heading north from credit economy slows, as it has done, the banking agree thai duration management may be an Because of the changing fixed income market sector flows immediately experience a decline extra source of added value that should not be dynamics and the opporiunit/ now for active in lending. Banks might then put their surplus ignored. Traditionaiiyi these investors deliver a tixed income fund managers to use more ihw) funds to work in the fixed income markets. As a low-fisk form of active managemsnt by actively just the directionai bets of duration and yield resuil, the bond market starts to rally and fund managing the credit portion of their portfolios curve management to provide excess returnSi managers may have been a little slow to and tracking the index for government and some argue that the Mercer report has come at understand what is driving that upswing" semi-government securities while remaining the wrong time, particulariy because it is SimiSafiyi adds Rjpeiis, it the economy gathers duration neulra). However, both Barclays Globa! backward looking. Says Frank Russell's momentum and the banking sector starts Investors (BG!) and SSgA say they are moving Sneddon: "We feel that some peopie are lending again, banks pu!l their money from the towards including duration management in their throwing in the towel on active fixed income fixed income markets and put them to work in value-adding armouries, Says SSgAs Nash: At right at the time when the evolution of the the "real econom/, So important is ihis trend, the moment we are using relative value trading Australian non-govemment market is offering says Pupelis, that Portfoiio Partners has been and credit to get a return of around 10 basis greater opportunities than ever, Having researching its impact since mid-2001 and ihe points over the index. Our enhanced strategy observed the opportunities presented by simi!ar performance results from initial analysis are includes a duration trading model to increase developments in other single country bond very encouraging. He adds; "However, the proof the sources of alpha, so as \o achieve a total of markets, Frank Russell is more committed than of the cake will be in the eating and we havent around 30 basis points. Our enhanced model ever to active Australian fixed income. had enough time yet to validate this point" therefore includes all three sources of adding value to fixed income ~ duration, relative value "We believe that a more Excluding duration a riskier and credit - all contributing around the same meaningful assessment option? amount to total outperfofmance" of the merits of active The second argument for not giving up on Michaei McCorry, head of research at BGI, management needs to duration management revoives around altowing adds: "We take active duration positions, recognise the changing fund managers the maximum amount of although we have very tight risk contro! bands nature of the composition opporturstties to add value. Tlie theory goes that in place so that we are not more than a quarter of the Australian fixed being forced to eliminate one of the potential of a year long or.short duraiion relative to the income market in sources of value-add cuts down on options for index. Were not looking for duration to make or recent years" diversification and is therefore a more risky way break the strategy" McCorry says SGi's Greg Michel to operate. Says Andrew Sneddon, associate approach to investing is to manage the three portfolio manager at Frank Russell: The more dimensions of performance - return, risk and sources of active risk you have the better, The transaction cost He comments: "While way we've built fixed income portfolios is to traditional active managers focused almost take active bets across both directiona! and exclusively on total return without managing risk non-directional strategies and that's the way the and cost veiy well and passive managers are best fixed income fund managers in the US good at managing risk and cost but with no and the UK operate. active return considerations, we bring all three Alliance s Stratton agrees; "The answer going elements together with scientific investing to forward is to have equally weighted use the best of active and passive opportursities to add value, You have to be able management" As the index structure has changed, there is to add as much value from duration as you do an argument that Romijn and Mercer shou!d from yie!d cun/e> sector rotation and stock Credit to the rescue have used data from the last two or three years selection. Every time you take one of these In the three years to March 2002 {he corporate for researching the value of active fund eiemenis out you are reducing the ability to add component of the U8S Warburg Composite management, rathsr than the last five years. value. You cant just whip out duration and leave Bond index (the index) increased from eight Many managers have noted the substantial the rest behind because by adding in duration percent to 28 percent The growing credit chstnges to the composition of the bond market you are increasing the opportunities to add market has started to provide another very over this period. Comments Greg Miche!, value. Because each of those different bets are significant way to add value through active director and head of fixed income portfolio not perfectly correlated, it reduces the overall management For active managers, this fact management at Deutsche Asset Management standard deviation of return and tracking error. atone represents one of their major defences (DAM): 'For the first three of the iast five years !f you remove duration you will actuatiy increase against the Mercer paper ~ and one about the corporate bond component of the index tracking error without the corresponding which Romijn says he wiil keep an open mind, averaged wel! under 10 percent Far the !ast opporiunsty \o add value." Kevin Taibot, director in fixed interest and two years it has averaged over 24 percent and But not everyone buys this logic. Mathew currency at AMP Henderson Global Investors by the end of March 2002 at represented McCrum, manager fixed interest at Vanguard (AMP Henderson), puts the importance of almost 30 percent of the index. We believe, Group, comments: "It is an interesting argument credit in active fixed income strategies in therefore, that a more meaningful assessment but you have to look at the facts. Around 90 context He comments: "A decade ago 90 of the merits of active management needs to percent of the return of a bond comes from its percent of our returns came imm duration recognise the changing nature of the interest rate characteristics, but there ss no management Two years ago this mix changed composition of the Australian fixed income evidence to suggest that managers over a long to 60 percent from duration, 10 percent from market in recent years' Mlchel adds that continued on page 20

18 !MSTOAPRtL2003

Page? Swiss (April, 2002) Running to Stand Stiil?

"Why pay 20 to 25 basis points when defensive but we re also trying to at least seek investment community to encourage the use of you can pick up an enhanced passive out ways for our clients to add value within that a broader index has led to a 5ituation which has fixed income portfolio for 10 basis conterf, and the corporate bond market offers inhibited the development of the BBS and sub- . points and it's likely to generate that opportunity'1 investment grade markets in Australia. "If we returns above the management fees had moved earlier En lobbying for a wider index , and for much less risk?" Index a problem we would have had a deeper credit market James Crawfcrd Fund managers say they cannot take full earlier and there would be a lot more • advantage of credit as a value enhancer unless opportunities for issuers and investors alike to the index changes to allow them to invest in add value. Instead, many Australian companies Soaking at the upper qoartile excess returns - securities rated lower than the A- cut off point have either gone offshore or used the bank excluding passive managers as Ihese suppress Says Tafcot at AMP Henderson: "We have to be market for their funding," survey returns - the value added for the last able to use a broader index than just the UBS Taibot says using a wider index would allow five years is 30 basis points per year. Over the Warburg Composite Bond index, We need an domestic fund managers to more closeiy past two years, however, which he says is more index that goes down to BBB- and one which replicate the Lehman Globa! Aggregate index, representative of the current and prospective includes more fixed rate soft bullet asset- which in turn will allow them the opportunity to fixed income environment, excess returns have backed securities, like the UBS Warburg Fixed produce returns similar to those being produced been a healthy 50 basis points per year (see Interest Index. He says the reluctance of the by offshore managers who use Ihe Lehman chart). However, these results have to be taken with a pinch of salt as ft is generally accepted Excess Returns of Active Managers that a rellabie isme frame for judging over Two, Three and Five Years performance is three years and above. One way to cater for the increased credit pflanager/Fund | IWo-year | Three-year | Five-year component of the index while keeping fees ^- Lvalye rank Lvalue rank I. value rank down is the enhanced passive strategy that places more emphasis on sector rotation and JOOF/Perennia! 0,85 (2) 0.82 (3) 0.74 (2) security sefection rather than dufation management Says Towers Perrin's Crawford; 0.34 (10) 0.40 (4) "Why pay 20 to 2B basis points when you can pick up an enhanced passive fixed income 0.62_. .(6). . 0.36 (9) 0.36 (6) portfolio for 10 basis points and ifs likeiy to generate returns above the management fees Rothschild Australia 0,11 (18) 0.85 (2) 0.34 (8) and for much less risk?" Another argument relates to asset allocation. NC!,,,.,,,,.,.,,, 0,33 ,(12) ,,0.20 (13) 0.29 (10) As the corporate bond market increases the ^a^Na,tf(^^^ii^^^^ii^^m^iht^: fixed income market is becoming more Credit Suisse A. Mgt -0,13 (23),, . 0,12 (18) 0.18 (12) correlated with the equity market, thus ^^^^iK^^^^^i^^i^^^^W- '•': substantially changing the risk profile of the Westpac!nY.M(]t^ ...... ^•l^.(.1.9 ...... P..1.?. ..<1.4), fixed income component of a tota! portfolio, ^8ii^^iN^^ii^ia?^^ ^^ww^' Says Stephen Knight, general manager treasufy (\Q) 0,08 (20) 0,13 (16) and deputy chief- executive officer at New ^Na^^a^lS^^li^QM4l^^^^^»»^^ South Wales Treasury Corporation: "!f a trustee INVESCO 0.25(14) 0,22(12) 0.00(18) has 30 percent of a balanced portfolio m??M^U!?i^^RaN®^g|,^^^(^,^^^ aflocated to fixed incomei they general!/ work ING.!n.Y-M9L...... ;053J.26L...... P.Q? (2.1).. -0.03 (20) on the basis that that 30 percent is risk free as HS^^^M8^^:^NII^»t^^^^^^M^^il"^ fixed income is a defensive asset class and is MLC 0.48.(7) 0,28 (11) -0.13 ^2) largely uncorrelated with the returns on equities. ^^^^^^^^W^^^^^v^-^^^^ That is fine when the bond index you are TOWER Asset Mgt -0.19 ,(25;> -0,12 J28) -0.16 (24) managing against is essentially government Ztjn^SCudder ^:^;0;^,TO^R. -W^^-Q^.^^ risk. But if ifs nearly 30 percent corporate risk Nonwlch Union Life -0.53(29) -0,25(29) -0.23 C26) and possibly moving towards 50 percent JBV^tW^^^.^r -(^($6jt^;.: ^-057' (27^r- corporate risk ~ you now have a ver/ different MerrillLynchinv.Mgrs0.27 (13;) -0,01 (24) risk profile, I don't think either the consultants or S?rt)derJ^Mgt;^^'-(XOl'::(%1);':':I^CiLC©;-&3)]i; / ^. . . the trustees have thought about this eriough," Towers Perrin's Debelle agrees that corporate Punds :-;s;^-!'-:.;.;^.29J30i:-%i;:.;-7;^aOO .:^:^! ^ <^TOO^';1-;;';-1': bonds are more highly correlated with equities Average 0.22 0,26 0,16 than government bonds, which could detract Asset^Velghted*^; ;052;:.'w:-^;'^^,2^',.-.i;;;;^ ^"CM^::^;;^ from the essentially defensive nature of fixed Upper Quartile 0.47 0,42 0.34 income as part of an overall portfolio strategy, Median '•• 054 .'" '0.19 •• ," ai5^':i1..:' However, she adds: 'Our research on overseas Lower Quartile -0.04 0.06 -0.07 credit markets has shown that the benefits you obtain from the diversity offered by corporate U8S Comp 0+ 0,00 0.00 0,00 bonds far outweigh the potential negative that can occur during times of crisis when the Produced with Die fnTedi OeskTpp Consullant Returns are expressed gross of lax and ongoing fees correlation between corporate bonds and Excess Return is measmed fdabva ta U8S Waibuig Composite Bond Indi equities increases quite dramatically, We're Aii Maturities mindfu! that we need to keep fixed income Source: InTech, April 2003

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Pages Running to Stand Still? Swiss (April, 2002)

"Without doubt, high yield debt, AvSuper's Carroll comments: 'Wlhin "We have to be emerging market debt and asset- Australian fixed income, ifs probably a line bail able to use a backed securities have higher risk decision whether you would bother.paying broader index premiums but they also hold the active fees or whether you would passively than lust the UBS promise of higher returns" benchmafk the portfolio, What that ignores is Warburg Denis Can-oi! the wider debate of the kinds of securities Composite Bond available in the debt markets. Without doubt, Index. We need an high yield debt, emerging market debt and index that goes asset-backed securities have higher risk down to BBB- premiums but they also hold the promise of which includes index as their benchmark, He comments: 'We higher returns" more fixed rate have a corporate bond fimd that is run along Carro!! says constructing a portfolio with these soft bullet the same lines as the Lehman Globa! kinds of securities purely within the Australian asset-backed Aggregate Index so is more diversified than the context is impossibie. For this reason AvSuper securities" domestic index, Over the last three years to decided some years ago that as fixed income is Kevin Talbot February 2002 it has produced the same a global product and Australia represents less results as the gSobal index. By introducing than one percent of the global bond market, the greater diversification and reducing the risk only place for fixed income in AvSuper's through diversification, the performance of this portfolio was in a properly stfuctured giobal fund has been 6.6 with a risk of 3.2 compared bond portfolio, He condudes: "We have been ailocaling a reasonable portion of the fixed with a performance of 5.9 and a risk of 3.3 for very happy with our decision. Since July 1998, income risk budget to Uie offshore debt the UBS Warburg Composite Bond index. Our in gross terms Loomis Sayles ~ which manages markets under a diversified debt strategy information ratio has been 1.9 over the last these funds - has returned 10,42 percent approach. MLC views debt as one sector, says three years' against a benchmark of 7,03 percent' Sumner, incorporating both offshore and Fund managers say the A- limit to the index Romijri says Mercer had internal discussions domestic components, He adds that looking prevents most Australian corporations from at the end of March about the appropriate forward MLC could have up to 60 percent of using the debt capital markets as a source of global strategy for its dients. The asset debt exposures invested offshore. funds, because even if they all obtained a credit consultant has devised a broad framework that rating, the majority would be in the BBB rating in deciding the allocation to domestic or global The jury is still out band, As George Boubouras, investment fixed income, clients should put the domestic It is still too ear!y to tell how the domestic manager at HSBC Investment Management, allocation towards the lower end of what they debate on active and passive f\wd income says; "There is merit to expanding the domestic feel comfortabis with, and think about allocating fufids management wili pan out. The Mercer index as there is a large concentration of more offshore. paper addresses only one sector of investors corporate credit around the 8BB level." Towers Perrin s Debelle says a client's active allocating a part of their portfolios to fixed However, Romijn counters that if trustees fixed income risk budget may be better spent in income - Austraiian supefannuation trustees were looking for genuine 8BB credit risk or the non-government debt market. She and kind executives using fixed income as a even sub-lnve stone nt grade credit, Mercer comments: "We believe that the iiquidity, defensive investment as a foil for their more would recommend a global credit mandate. He diversity and depth of the offshore credit volatile equity investments, Romijn recognises comments; ^/Ve believe that locaJ credit - market offers the most potential and the best that there are numerous categories of investors, especially once you get below A- ~ has too opportunities for deriving the highest return for each with their own risk appetite and says his many conslraints in terms of liquidrty, a given levei of risk." She adds that the way to theor/ on active management does not apply to diversification and spread. This makes a purely dampen risk from a credit market is through those investors seeking absolute returns from Australian approach to BBS and sub- industry and stock diversificalion, "In Australia, fixed income investing, He adds that Mercer is investment grade credit a poor choice relative the banks and other finandals dominate more leaving the door open to acth/e management if to a more global approach" than half the corporate index industry managers can prove in the future that they are Fund managers disagree. Says Andrew weightings" she comments. As a resuit, says adding sufficient excess returns for the fees Moylan, former senior marsager fixed income Towers Perrin's Crawford, while five years ago they charge. credit at ING Investment Management: "Ttiis the asset consultant wasn't recommending any "The active managers who have expressed logic is clearly wrong. In the first place, 42 overseas fixed income exposure, today it is their views in this feature a!so recognise that percent of the composite bond index is sourced recommending that 50 percent of a ciienfs there are different clients wild differing risk- from internatjonai issuers, so the domestic fixed income allocation goes offshore. return profiles and as a consequence they offer index may be Australian dollar denominated but Griffiths at Aon says the asset consultant is a whole spectrum of active risk outcomes, it is not a pureiy Austrsiian index. firmly in the active fixed income management including passive and, increasingiy, passive camp. However, he adds that because Aon enhanced strategies. Global investment may dwarf agrees that it hss been difficult for Australian What is certain, then, is that the debate has domestic opportunities active fixed income managers to add value moved from the rather ssmptistic dstermination There is no getting away from the fact that right consistently from the domestic martet, this is of the merits of active, passive or passive now, the global markets offer depth and an opportunity to move mone/ offshore, enhanced investing to the more complex issue dfvereificatson way beyond the limitations of the "especially given the relative sizes of bond of how fixed income fund managers can add domestic fixed income market As a result, markets and the thin corporate bond markel we value within specified mandate constraints, asset consultants and trustees are focusing on have in Australia". He says Aon's rule of thumb whatever their strategy. an increased allocation to global fixed income for domestic and offshore aiiocation of fixed in the search for diversification and excess income investments is 25 percent domestic and returns, Most corssuitants are now 75 percent international, recommending an allocation of up to 60 Sumner says MLC has maintained the view percent of fixed income assets offshore. that there are significant benefits from

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