Right Strategy, Right Manager, Right Environment Navigating Success Within The Unconstrained Bond & Multi-Sector Credit Fund Universe

CHRISTOPHER SMAILES | Managing Director, Asset Management

A SHEFFIELD HAWORTH PUBLICATION Navigating Success Within The Unconstrained Bond & Multi-Sector Credit Fund Universe

This document is meant to provide a brief overview of the current landscape for unconstrained bond or multi-sector bond funds and the challenges facing asset owners and investment consultants in the selection of capable portfolio managers. The document is not a comprehensive manual for the institutional investor market, but instead features some observations and insights gained by the Sheffield Haworth Asset Management practice as we’ve helped asset managers evaluate, select and build their fund teams in the recent months and years. This document does not seek to provide any legal or investment advice. While we do highlight some notable funds that are of interest, their inclusion and mention in this document is by no means an endorsement of their offerings.

EXECUTIVE SUMMARY

Market volatility has forced asset owners to Strategic partnerships with asset owners veer away from specialist managers (e.g. high are growing in this category, particularly as yield, investment grade; leveraged loans, customization allows asset owners to “cherry structured products, distressed, private credit; pick” separate accounts with better economics emerging market debt, etc.) and shift allocations and fees—and the potential for longer-term to managers with the ability to customize, locked-up capital and follow-on allocations. allocate and flex across securities and asset classes. Debate continues regarding “liquidity” of these assets within ‘40 ACT funds. Some managers The best, most successful managers integrate have struggled to strike daily liquidity based on and pivot across these asset classes, despite the relative illiquidity of underlying investments. having previously worked within more traditional Many illiquid managers, uncomfortable with teams and incentives structures. daily liquidity requirements, have chosen to focus on separate accounts. Asset owners and investment consultants are still in the early days of shifting to skilled Distribution and fund vehicles continue to play multi-asset/unconstrained allocation strategies, a significant role in product positioning, AUM recognizing that specialist managers no longer flows and adoption. have the time, skill or expertise to transition in an environment of significant volatility.

Strategies have been difficult to scale for many managers due to the low interest rate environment —and ensuing fee compression. To build scale, successful managers have shifted from “alternative 1 & 20” structures to base points or flat fee structures.

sheffieldhaworth.com 2 Introduction

The financial crisis of 2007-2008 and the global economic recession with years of sluggish growth POTENTIAL BENEFITS that followed prompted unprecedented quantitative of unconstrained or multi-sector fund easing by central banks in the US, the UK, the strategies include: Eurozone, Japan and others. As a result, investors have been on the hunt for much-needed yield while Low correlation to avoiding the risks associated with interest rate hikes. core fixed income. Attractive risk- In response, many have increased exposure to more adjusted returns. volatile and less liquid sectors of the bond market, veering from traditional fixed income benchmarks Actively managed downside risk in favour of total returns that include contributions mitigation. from alternatives like distressed credit and currencies. With this move has come the rise in popularity and prevalence of unconstrained bond and multi-sector credit strategies (also commonly referred to as “Strategic Income” or “Diversified Fixed Income”).

These mandates allow managers to run dynamic portfolios with flexible duration levels and greater exposure to noncore investments such as high yield, bank loans, emerging market debt and currencies— without being anchored to traditional benchmarks. In the case of unconstrained bond funds, it is not uncommon to see allocations of as much as 25% of the fund in equities, real estate and other asset classes.

sheffieldhaworth.com 3 Navigating Success Within The Unconstrained Bond & Multi-Sector Credit Fund Universe Huge Growth Following The Crisis For years now, asset owners have been shifting more capital toward capable portfolio managers with the ability to customize, allocate and flex across all securities with the best risk-adjusted returns. According to Seeking Alpha, as of November 2015, there were 122 open-ended mutual funds with total assets under management (AUM) of USD 140 billion, up from just 19 funds with AUM of USD 9 billion at the end of 2008.

Growth of Unconstrained Bond Funds 180 140

160 120 140 100 120

100 80

80

AUM (USDAUM Billions) 60 Funds of Number 60 40 40 20 20

2008 2009 2010 2011 2012 2013 2014 2015

Total AUM Number of Funds

Source: Morningstar, S&P Dow Jones Indices LLC. Datas as of November 2015. Chart is provided for Illustrative purposes.

Originally created by Seeking Alpha

Managers in traditional strategies employ tools such as yield-curve management, credit-curve analysis, empirical credit behavior, roll-down strategies, and other fundamental and technical inputs into the decision- making process. It is not uncommon to see PM teams with complementary skill sets, such as a portfolio manager focused on credit-sensitive segments of the market paired with another that’s focused on rates and FX expertise. When managers are able to apply these tools and tactically shift allocations within an expanded opportunity set, the ability to add value has the potential to expand for a given level of risk.

sheffieldhaworth.com 4 Navigating Success Within The Unconstrained Bond & Multi-Sector Credit Fund Universe Constrained Our View: A By Low Special Formula Interest Rates For Success Theoretically, unconstrained or multi-sector funds While traditional bond funds can fall back on the should be able to navigate virtually any market broader success of an investment strategy and environment, but their popularity stems primarily benchmarks, the success of an unconstrained from being hedges against rising interest rates. fund rests squarely in the hands of its portfolio However, the climb in interest rates has been manager and team—and the opportunity cost slow to materialize, and unconstrained funds can be huge when a portfolio manager makes the have lagged behind traditional fare in recent years. wrong call. As Daniel Ivascyn, chief investment officer at Asset owners and investment consultants are Pimco, told Barron’s recently, unconstrained bond still struggling to overcome the traditional, knee- strategies may have been “too focused on pro- jerk approach of hiring specialty managers (for tecting against rising rates.” With this mentality, which there will always be a need, of course). they’ve actually become constrained and are being Now, more than ever, success lies not so much in treated solely as instruments to avoid rate risk. a fund’s strategy but in the fund manager’s ability to easily and comfortably pivot across asset Transparency is also a concern for investors, as classes in a volatile market. managers can make trade-offs between a variety of risks, and investors may not know which risk This may make the right manager sound more they’re exposed to at any given time. like a unicorn than a person; however, to date the most successful ones have all come from prior The Wall Street Journal reported that funds in roles in siloed teams and with traditional incentives Morningstar Inc.’s nontraditional-bond category structures. The ability of these managers to beat core intermediate-term bond funds in 2012 think and act as top-down asset allocators across and 2013 on average, but trailed in 2014, 2015 the firm’s underlying fundamental experts is and through the first of half of 2016. As such, important experience for success in this space. according to the WSJ, some $80 billion has However, it’s not so much about the individual’s flowed out of these funds in the last two years. experience but about the environment and structure in which they operate as well. As a result, managers utilizing a flexible investment approach across fixed income sectors without constraints on maturity, sector, quality or geography are the aim. These strategies strive to provide returns of roughly 400-600 base points (bps) in excess of cash with volatility of roughly 300-400bps. From our observations, the most successful managers have been supported with and benefited from world-class distribution.

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able to deliver over and above returns, typically in Structures the top decile or quartile. From our experience, separate account fees tend to be approximately 60bps (with $250-$300 million That Work minimum); commingled vehicle fees tend to be To build scale, we’ve seen many successful 55bps ($5 million minimum) and mutual funds managers shift from “alternative 2 & 20” structures at 65bps ($2 million minimum for institutional to BPS, flat fee structures or lower their traditional shares). Other fee structures for commingled fee structure. Those managers that have not chosen funds range from 70bps to 80 bps on all assets to reduce fees have seen their ability to build up to $200 million on the high end of the spectrum scale negatively affected. Given the heightened with the mid-range at 55bps and 37bps to 40bps scrutiny on fees from regulators and asset allocators, at the lower end of the fee spectrum. this comes as no surprise. To maintain high fees, investment managers must have an impeccable track record, within a desirable asset class that is continued on next page

DISTRIBUTION V. PERFORMANCE What drives growth in AUM? Good performance or good distribution? Valid arguments exist for each, but we thought we’d look at the performance and results of some notable unconstrained bond and multi- sector credit funds since the beginning of 2013 (through July 2016). Take a look:

FUND 3Y TOTAL RETURN AUM TODAY Est. AUM CHANGE Fidelity Strategic Income (FSICX) 11.43% $7.4 billion -34.92% Apollo Tactical Income Fund (AIF) 10.77% $238 million -0.42% Osterweis Strategic Income Fund (OSTIX) 8.73% $4.9 billion -18.33% Ares Dynamic Credit 7.88% $554.9 million 58.52% Allocation Fund, Inc. (ARDC) BlackRock Strategic 7.73% $28.6 billion 302.82% Income Opportunities Portfolio Institutional Shares (BSIIX) Goldman Sachs Strategic Income Fund -0.21% $11.1 billion 38.75% Institutional Shares (GSZIX)

As you can see, the three top performing funds in this example – Fidelity, Apollo and Osterweis, respectively – all experienced negative AUM change, whilst the others saw big rises. In the cases of BlackRock and Goldman Sachs, the gains have been very significant despite their performance relative to their peer group; likely the result of strong relationship management and marketing/brand. Especially when asset managers are playing defense, you can see the value in having teams adept at client support and communicating performance lag. Marketing and brand also go a long way in appeasing investors. One could argue that BlackRock and Goldman are two of the best firms in the industry when it comes to distribution (selling a product) and relationship management/brand (which impacts retaining assets). It clearly shows.

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Strategic partnerships with asset owners are platform in place. In other words, these managers growing in this category, particularly as customization already have established selling agreements allows asset owners to “cherry pick” separate and relationships in place with the largest wires, accounts that reflect “the best of” across private banks and broker/dealers (e.g., Merrill, Morgan equity, distressed, direct lending and liquid Stanley, Wells Fargo, Raymond James, Baird, credit – take Apollo Management Group and The UBS, RBC, etc.) providing access to countless Blackstone Group via its GSO entity (highlighted financial advisors. The ability to provide multiple below), for example – with better economics and investment vehicles is more of a hallmark of fees. This also provides the potential for longer- unconstrained bond funds and less common in term locked up capital and potential follow-on multi-sector credit funds which tend to have far asset allocations. more illiquid and distressed components not suitable for 40ACT vehicles. Managers with successful 40ACT funds in this arena are successful primarily due to an already established financial or intermediary distribution

sheffieldhaworth.com 7 A SELECTION OF NOTABLE FUNDS & THEIR STRUCTURES These funds are interesting to us, not simply because of their returns—which, on the whole, are relatively impressive in comparison to traditional categories—but more so because of how they’re structured and run. We believe that they are good representations of a “good plan put into thoughtful action.”

Multi-sector Funds Of Note FUND MANAGEMENT NOTES & ANALYSIS Apollo Tactical BRET LEAS A non-diversified closed-end management investment company. Its Income Fund Global Co-Head, primary objective is to seek current income with a secondary objective Corporate Structured Credit of preservation of capital. They seek to achieve their investment Ticker: AIF objectives primarily by allocating assets among different types of Inception: 2/2013 JOSEPH MORONEY credit instruments based on absolute and relative value consider- AUM: $370 million Global Co-Head, ations and their analysis of the credit markets. They invest in credit Performing Credit instruments including senior loans, subordinated loans, high-yield corporate bonds, notes, bills, debentures, distressed securities, JAMES VANEK mezzanine securities, structured products, bank loans, corporate Portfolio Manager, loans, convertible and preferred securities, government and municipal Performing Credit obligations, mortgage-backed securities, repurchase agreements, and other fixed-income instruments of a similar nature that may be represented by derivatives.

Ares Dynamic Credit KEITH ASHTON A closed-end management investment company. The investment Allocation Fund Portfolio Manager objective is to provide an attractive level of total return, primarily through current income and secondarily, through capital appreciation. Ticker: ARDC SETH BRUFSKY The Fund invests primarily in a broad, dynamically managed portfolio Inception: 11/2012 Portfolio Manager of senior secured loans made primarily to companies whose debt is AUM: $538.2 million rated below investment grade; corporate bonds that are primarily high JOHN LEUPP yield issues rated below the investment grade; other fixed-income Portfolio Manager instruments of a similar nature that may be represented by derivatives; and securities of collateralized loan obligations.

Avenue Capital Group’s JEFFREY J. (JEFF) GARY The Adviser (Avenue Capital Management II, L.P.) provides day-to-day Credit Strategies Fund Senior Portfolio investment management services to the Fund and is part of Avenue Manager, CLO and Public Capital Group, which comprises 5 registered investment advisers that Ticker: ACSAX Fund Strategies have extensive experience investing in stressed and distressed Inception: 6/2012 obligations throughout the world. Portfolio Manager Jeff Gary has AUM: $821.2 million access to the investment teams within Avenue Capital Group, including the distressed credit teams.

The investment objective is to seek total return, primarily from capital appreciation, fees, and interest income. It focused on high yield bonds, senior secured bank loans, and distressed debt.

Blackstone/GSO ROBERT ZABLE The Fund is a diversified, closed-end management investment company. Strategic Credit Fund Lead Portfolio Manager Its primary investment objective is to seek high current income, with a secondary objective to seek preservation of capital, consistent with its Ticker: BGB GORDON MCKEMIE primary goal of high current income. It invests primarily in a diversified Inception: 9/2012 Portfolio Manager portfolio of loans and other fixed income instruments of predominantly AUM: $715.3 million US corporate issuers, including first- and second-lien secured loans and high yield corporate bonds of varying maturities. The Fund’s adviser uses a research-driven credit analysis approach designed to identify companies that offer attractive risk/return characteristics. The adviser (GSO) maintains a rigorous investment process based on thorough due diligence and judgment. A seasoned team of researchers that cover 900+ borrowers, representing a broad range of industry sectors, supports the Fund’s portfolio managers.

sheffieldhaworth.com 8 Unconstrained Bond Funds Of Note FUND MANAGEMENT NOTES & ANALYSIS BlackRock Strategic RICK RIEDER The investment process consists of three steps: identification of Income Opportunities Managing Director & CIO, investment regime, asset allocation, and security selection, with Inst Fundamental Fixed Income Rider and Miller taking the lead on the first two. Investment regime & Co-Head of Americas identification involves examination of level and trajectory of global Ticker: BSIIX Fixed Income economic growth, inflation, and implications on economic policy to Inception: 2/2008 form macro views. Once the investment regime has been determined, AUM: $28.9 billion BOB MILLER the portfolio managers identify which asset classes perform well Managing Director, in the context of current valuations. Finally, the portfolio managers Fundamental Fixed Income outsource the bottom-up security selection to fill the asset allocation and Portfolio Manager for targets to sector specialists who implement trades. The investable Core Bond, Total Return universe for the strategy consists of global fixed income instruments & Strategic Income and derivatives, including all sectors of Barclays Aggregate Index as Opportunities Funds well as high yield, emerging markets debt and non-USD investments. The team also has discretion to invest outside of fixed income, including investments in common equities. The portfolio does not employ any formal sector constraints, however, equities are targeted to make up less than 25% of the overall risk contribution. The strategy has a formal duration band ranging from -2 to +7 years; the typical duration range for the portfolio is 1-5 years.

Fidelity Strategic JOANNA BEWICK The Fund invests primarily in debt securities, including lower-quality Income Fund Portfolio Manager, Global debt securities. It allocates the Fund’s assets among four general Asset Allocation Group investment categories – high yield securities, US government and Ticker: FSICX investment-grade securities, emerging market securities, and foreign Inception: 5/1998 FORD E. O’NEIL developed market securities. Principal risks include prepayment (call), AUM: $7.4 billion Portfolio Manager foreign securities, loss of money, not FDIC-insured, issuer, interest rate, market/market volatility, and equity securities. MARK J. NOTKIN Portfolio Manager

JONATHAN M. KELLY Portfolio Manager, International Fixed Income and FX Analyst

DAVID SIMNER Portfolio Manager

WILLIAM (BILL) IRVING Portfolio Manager & Quantitative Analyst

FRANCO CASTAGLIUOLO Portfolio Manager & Research Associate

GS Strategic JONATHAN BEINNER The Team seeks attractive return opportunities across the global Income Fund CIO, Co-Head of Global bond spectrum and invests in sectors that are overlooked or not Fixed Income and Liquidity easily accessible. The team can potentially shift sector, security, Ticker: GSZIX Management duration and currency allocations as the team uncovers opportunities Inception: 6/2010 throughout the economic cycle. Its expert strategy teams can help AUM: $11.7 billion MICHAEL SWELL their investors implement positions and uncover unique opportunities Co-Head of Global Portfolio as market conditions change. While PIMCO is macro and BlackRock Management, Global Fixed is more quant, Goldman is squarely in between. They have more of a Income Group, Liquidity quant pedigree, but make large macro bets that a model would never Management Team, and tell you to do. They have wide latitude and a broad opportunity set to Portfolio Manager work with.

sheffieldhaworth.com 9 Unconstrained Bond Funds Of Note (continued) FUND MANAGEMENT NOTES & ANALYSIS KKR Income Opportuni- ERIC FALK One of several “opportunistic” credit funds offered by KKR leveraging ties Fund Portfolio Manager and Co- fundamental, integrated industry experts across distressed, mezzanine Head of Leveraged Credit debt, CLOs, structured products, private credit, bankruptcy and high Ticker: KIO yield. This fund is a non-diversified, closed-end management investment Inception: 7/2013 CHRIS SHELDON company managed by KKR Credit Advisors, a subsidiary of KKR. Its AUM: $366.3 million Portfolio Manager and Co- investment teams, which are organized by industry, invest across Head of Leveraged Credit the capital structure with the goal of protecting capital and achieving attractive risk-adjusted returns. JAMIE WEINSTEIN Portfolio Manager and Co- Head of Special Situations Investing

NAT ZILKHA Portfolio Manager and Co- Head of Special Situations Investing

Oak Hill Advisors’ ADAM B. KERTZNER With 22+ years assessing relative value across asset classes and (OHA) Diversified Credit Partner and Portfolio capital structures, Kertzner works closely with credit research and Strategies Fund Manager trading teams on the development and underwriting of investment opportunities. He participates in the Investment Strategy meeting Inception: 1991 and is also a member of the ESG Committee. Fundamental credit AUM: $7.1 billion approach focused on downside protection, maximizing risk-adjusted returns. Wide range of experience across below investment grade corporate credit market (bank loan, high yield, direct lending, stressed & distressed); corporate structured products (CLOs, other) and mortgage strategies (RMBS, whole loans); U.S. and Europe; long and short. Relationship network assists in sourcing and evaluating opportunities (sponsors, intermediaries, other buy side).

Osterweis Strategic CARL P. KAUFMAN Within particular sectors, Osterweis chooses individual securities Income Fund Vice President and Portfolio based on rigorous fundamental and credit analysis. They emphasize Manager a thorough understanding of each company’s balance sheet by deter- Ticker: OSTIX mining the company’s ability to generate recurring free cash flow from Inception: 8/2002 SIMON T. LEE its operations. As a result, they do a significant amount of work to AUM: $4.8 billion Vice President and Assistant determine the company’s business prospects as well as the positive Portfolio Manager and negative levers in its financial model, which influence the company’s ability to generate cash flow. They believe that they find our best BRADLEY M. KANE investments in companies that have great products, a competitive Vice President and Assistant advantage that gives them pricing power in the market, a consistent Portfolio Manager operating history, and management that operate the company as if they own it. Finally, they determine what they believe to be the appreciation potential versus the downside risk to gauge the attractiveness of the security versus other available investment opportunities.

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sheffieldhaworth.com 10 Unconstrained Bond Funds Of Note (continued) FUND MANAGEMENT NOTES & ANALYSIS PIMCO Unconstrained MARC P. SEIDNER The Fund seeks to achieve its investment objective by investing Bond Inst CIO, Non-traditional under normal circumstances at least 80% of its assets in a diversified Strategies; MD & Portfolio portfolio of Fixed Income instruments of varying maturities, which Ticker: PFIUX Manager may be represented by forwards or derivatives such as options, Inception: 6/2008 futures contracts, or swap agreements. It may invest in both invest- AUM: $4.7 billion MOHSEN FAHMI ment-grade and high yield securities subject to a maximum of 40% Managing Director, Portfolio of its total assets in securities. Manager, Fixed Income

DANIEL J. IVASCYN Group CIO Stone Harbor DAVID A. TORCHIA Stone Harbor’s Investment Policy Committee meets monthly to Diversified Global Portfolio Manager, discuss broad economic and financial trends and to set global Credit Multi-Sector Strategies / investment policy. The group is comprised of the firm’s chief global Investment Grade economist, emerging-markets economist and portfolio managers Inception: 12/2013 across all fixed income asset classes. The information shared across AUM: $14.1 million PETER J. WILBY markets helps identify base economic and alternative risk scenarios. (eVestment says it is only Managing Partner, CIO The end result is a global perspective of relative value that helps $3.3 million) create an investment framework and identify areas of specific DAVID J. SCOTT opportunity. Multi-Sector Strategies are comprised of Diversified Portfolio Manager, Global Credit, Multi-Asset Credit, Aggregated/Corporate/MBS & Multi-Sector Strategies / ABS, Multi-Sector Total Return, Global Investment Grade, and Short Investment Grade / Duration/Long Duration. Emerging Market Debt

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Conclusion While market volatility and sluggish growth have Appropriate Fee Structures, vehicles shackled a good bit of the $140 billion in uncon- and distribution capability – More than ever, strained bond/multi-sector credit funds – leading the structure and compensation of an to some heavy outflows for low performers – unconstrained bond or multi-sector credit there are still diamonds among the rough. Finding funds and their respective PM’s is crucial in (or creating) them requires a close, hard look at both attracting the talent necessary for the talent and structure of a fund. As mentioned success and for encouraging strong, consistent here, we’ve seen that winning formulas consist of investor interest. Offering multiple vehicles for the following components: different clients and plugging into the necessary distribution platforms—or forming joint ventures Varied Experience – While finding a portfolio or partnerships with those already leading manager with the total package of multisector strong distribution efforts is and will continue experience (on paper anyway) may be difficult, to be essential for asset managers in this space. you can seek out managers that have a successful record in multiple roles within There is a great deal of confusion in the market traditional and alternative fund offerings or a regarding unconstrained bond funds vs. multi-sector complimentary team of investors that bring credit funds. As a manager trying to determine credit-sensitive expertise and relative value how to approach the development or launch of macro and risk management expertise to these strategies, it is crucial to understand the round out the offering. core native strengths of the investment teams; conduct a gap analysis of missing competencies Strong Research Teams – A seasoned and and then seek to build organically, through outside well-lead underlying fundamental credit team partnerships or through talent acquisition initiatives is a very strong indicator of resources required to fill these gaps and more successfully build to adequately cover and flex across the spectrum market share. There is a place for both types of fixed income and/or credit opportunities, of strategy—understanding how to position, especially when seeking out funds with the execute, market and leverage an asset manager’s flexibility to scale and/or accommodate long- core capabilities are the keys to success. range investments or follow-ons.

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CHRISTOPHER SMAILES Managing Director | Asset Management | NYC

Chris joined Sheffield Haworth in 2014 as Managing Director within the Asset Management practice. Prior to joining Sheffield Haworth, Chris was a Partner and ran the Asset Management practice for a leading search firm for eight years. He began his executive recruiting career in London in 2002 and has worked with Investment management clients in North America, Europe and Asia. He has ex- tensive experience of conducting leadership, investment and distribution searches ABOUT THE AUTHOR within the traditional and alternative Asset Management sectors, as well as providing expert counsel on succession and talent planning. He brings broad international experience to his search work, having previously been based in New York, Hong Kong and London. He is an Honours graduate in English literature.

Email: [email protected] Phone: 646-597-7403

About Sheffield Haworth Sheffield Haworth is a leading global executive search and talent advisory firm. Leveraging its deep industry knowledge, the firm partners with clients all over the world to provide tailored solutions for their business and talent needs at the senior management level. Established in 1993, Sheffield Haworth has 13 offices throughout the Americas, Europe, Middle East and Asia Pacific and serves clients in the Financial Services, Business & Professional Services and Technology industries.

Sheffield Haworth’s global Asset Management practice is one of the largest and most well established in the industry. Many of our consultants have been working together for well over a decade, underscoring our ability to deliver deep industry knowledge, perspective and an unparalleled track record of success on behalf of our clients.

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