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Pension Fund Service

Absolute Return Fixed Income

Aon Hewitt Surrey Pension Fund GAM PGIM UBP Allianz

Stamford Associates NN Investment Partners CQS Lombard Odier Neuflize OBC Investissements

Contact: [email protected]

Chris Southworth – Chief Executive Officer

No.1 Booths Park, Chelford Road, Knutsford. WA16 8GS Tel: 0044 1565 648205

Aon Hewitt

Retirement and Investment

e Form and Function of Absolute Return Bond Strategies

Fixed Income investors are increasingly searching for portions of their portfolios to provide both a unique source of alpha and an uncorrelated complement to their traditional interest rate sensitive fixed income allocations. Absolute Return Bond Strategies (ARBS) may provide an opportunity to capitalize on the unique skillset of select fixed income managers in order to drive positive and uncorrelated alpha within an investor’s portfolio. We believe ARBS have the form and function to potentially meet the disparate needs of fixed income investors in the current market environment.

Let’s start with form

ARBS strategies are available in different forms and structures and are provided by a number of fixed income managers. Over time, the listed universe of ARBS available in research databases has increased to meet the growing demand by investors. Although there are a number of strategies that may be labelled or classified as ARBS, we feel that the quantity that fit our select criteria is fewer in number. Simply stated, many managers classified as ARBS are not absolute return focused. We also draw a clear delineation between those strategies that maintain a long only bias and those that are able to adjust long and short bias over time. We maintain that strategies that are able to shift their directional positioning are the preferred approach for ARBS.
Sectors utilized in ARBS: while sectors will vary by strategy due to manager preference and expertise, many managers utilize a broad array of fixed income sectors to invest in. These include global and emerging market sovereigns, investment grade and high yield corporate bonds, broadly syndicated loans, mortgage-backed securities, other asset backed securities, and currencies. Liquidity is a key metric for ARBS and therefore fixed income sectors tend to be those that can be more easily transacted in. ARBS vehicles typically offer daily or weekly liquidity.

  • Traditional Active Fixed Income
  • ARBS

Benchmark

Physical bonds 0.5 – 2% over benchmark 80% market / 20% skill TE of 1 – 4%
3-month LIBOR 1 – 6% over benchmark 20% market / 80% skill Vol of 3 – 6%

Return Target Drivers of returns Volatility Duration

  • 4 to 8 years
  • -4 to 4 years

Credit Beta

  • 0.8 to1.2
  • -0.6 to 0.6

Investable Universe

Fixed-income instruments, derivatives and currencies
Fixed-income instruments, derivatives and currencies

Source: Aon

Performance (what is expected of ARBS?)

Unlike the majority of traditional bond strategies in the marketplace, ARBS tend to be measured against cash benchmarks such as the London Interbank Offered Rate (LIBOR). Utilizing a cash like benchmark aligns manager returns with manager alpha targets. While benchmarks may be used internally for certain invested sectors, ARBS are expected to employ high conviction purposeful trades that result in a diversified and often complex portfolio structure. Therefore, the approaches lend themselves to matching respective return and volatility targets rather than focusing on outperformance versus traditional fixed income benchmarks.

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Fund A Fund B Fund C Fund D Fund E Fund F
ICE ML US High Yield Index

One of the hallmarks of ARBS strategies is the goal to provide positive returns over time irrespective of performance of the market. This factor drives greater scrutiny on the consistency of performance given the pure alpha targets that are common in the absolute return space. Performance targets can range on the lower end from Libor + 1 – 2% to higher levels of Libor +4 – 6%. Higher return targets may be achieved through different approaches such as constructing a strategy with larger positions, or adding economic leverage to the overall portfolio.

250 200 150 100
50
0

The following chart shows the gross performance of a representative peer group of USD based ARBS managers that Aon monitors, broken down by quartile ranking.

Source: eVestment, Aon, ICE-Merrill Lynch. Data correct as of September 2017 Past performance does not guarantee future results.

ARBS generally focus on shorter term opportunities in order to harvest return, but some do combine longer term focused positions alongside a shorter term trading program to boost expected returns, limit risk and increase diversification. For example, a manager may combine individual bottom up credit selection in an out of favour sector (longer term view) with a short position in an index focused credit default position (short term sector view). The result is a strategy and portfolio that seeks to add incremental return over both the short and long term on a consistent basis.

16% 14% 12% 10%
8% 6% 4% 2% 0% -2% -4%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Coinciding with various performance targets within the absolute return product universe, are stated levels of volatility that the strategies expect to incur. A deep understanding of observed (ex-post) and targeted (ex-ante) risk is imperative to portfolio construction of ARBS. From a research perspective, we expect a solid absolute return manager to deliver a Sharpe ratio approaching 0.5 over the medium to long term.

Source: eVestment, Aon. Data correct as of September 2017 Past performance does not guarantee future results.

Performance drivers can vary by strategy, but are typically globally diversified. This factor is a key element in the ability of strategies to have multiple sources of return in the portfolio, not solely focused on the traditional fixed income sources of return such as credit, carry, and duration positioning. However, there are some specialist ARBS which focus on a single sub-category of the fixed income universe, e.g. credit or developed government bonds.

Use of derivatives and risk management

A key feature of ARBS is the risk management processes, which include the techniques and resources that managers employ to ensure a detailed understanding of the overall risks of the portfolio. Risk measures and analytics utilized in ARBS commonly draw from those factors most often employed in both the traditional fixed income and the alternative or hedge fund space. This suite includes stress testing, scenario analysis, and portfolio measures such as Value at Risk (VaR) and drawdown. Additionally, an understanding of risks external to the portfolio must be analysed and understood. Technical factors, political risks, equity market dynamics and other drivers of the broader global macro environment are key inputs to the understanding
Alongside yield curve positioning and sector and security selection, ARBS also draw upon additional strategies in order to generate alpha. For example, many ARBS utilize long-short credit, relative value and other quantitatively oriented strategies in order to generate returns that are less correlated or uncorrelated with traditional fixed income return streams. The following chart shows the gross performance of ARBS with a 10-year track record versus the return of US High Yield. This displays that while high yield may play a part in ARBS returns other drivers and diversifiers of performance are evident.

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of absolute return portfolio managers and can guide overall level of risk taking within the portfolio. The overarching purpose of risk management is to measure and analyse the intended and unintentional investment risks within ARBS so they are clear and quantifiable and then addressed appropriately by portfolio managers.
Lastly, we advocate for using ARBS within Liability Driven Investment (LDI) strategies where appropriate. Fixed income is at the center of liability hedging pools within LDI frameworks. Historically these collateral pools consisted of government securities or cash to provide the liquidity needed to support liability hedging. With persistent low levels of yields in the current market, ARBS can provide an opportunity to generate increased return over cash and government securities while maintaining the level of liquidity needed for potential cash calls from the hedging portfolio.
Once risks are identified, ARBS then refer to a risk management tool-kit, in order to maintain liquidity and hedge unwanted risk, while investing globally. Portfolio construction and diversification help to alleviate unwanted risks in absolute return portfolios. However, given their opportunistic approach ARBS tend to utilize derivatives as an additional tool in risk management.

Risks

ARBS do not invest without risk and their goal to provide consistent positive returns is not guaranteed to be met. As discussed, ARBS do tend to be complex in structure and investment approach and therefore require a detailed understanding of the process, people, and investment philosophy involved. Additionally, the absolute return label can carry different meanings to investors given the diversity of strategies and managers available to invest with. A summary of potential risks is listed below:
Derivatives can assist in smoothing out the performance profile by protecting the portfolio from extreme drawdowns in performance and to buffer the portfolio from sharp increases in volatility. Instruments used often include options, interest rate swaps, forwards, futures and credit default swaps among others. Rather than being used to purely generate leverage and adding to risk, derivatives are utilized in optimizing and balancing risk in the portfolio and allow the targeting of specific risks that managers want to take on while avoiding those that are unwanted. Also, strategies may use derivatives to access areas of the market on a more efficient basis rather than requiring cash- bond positions.
• LIBOR ≠ Risk Free: Investments in ARBS carry risk of capital loss. In addition, there are trading costs associated with these strategies meaning they should not be treated as cash vehicles.

• Manager alpha capabilities: Assessing alpha

generating capabilities and on-going monitoring requires specialist knowledge and research.

Function — what’s the use?

ARBS derive their characteristics from both traditional fixed income investments and hedge fund approaches, thus leaving many investors with the dilemma of where ARBS fit into a broader portfolio. ARBS are utilized in a number of ways by institutional investors such as providing a relatively stable return stream, as a diversifying asset, or as a portable alpha opportunity. We advise that ARBS are appropriate for these purposes given client’s individualized and customized needs and preferences.

• Diversification and liquidity: The sturcture of ARBS

does not impose any fixed allocation to any given sector of fixed income asset class but instead encorages a construction of portfolios based on best ideas.
• Counterparty risk: ARBS managers make greater use of derivatives than their traditonal fixed income counterparts, therefore clear policies realting to counterparty management must be in place.
• Reporting: ARBS require more detailed and sophisiticated reporting. The manager needs systems that support the process and allow for identification of sources of risk taken and mitigation of unintended risk. Ability to attribute performance to the risk taken in the portfolio is crucial.
Given the current low level of nominal yields in the major bond markets, we feel that ARBS offer an attractive risk/ return balance compared to government, cash, and investment grade corporate bonds. Also, given the low or negative duration profile of many ARBS, they may offer protection in a rising interest rate environment. Many ARBS carry the ability to include directional trades as well as non-directional or short positions within their portfolios and as discussed in the “form” section above, this helps to lower correlation with traditional long only fixed and equity mandates. As a result, ARBS can be utilized as a diversifying asset within a portfolio construct.
• Fees: Fees tend to be higher than those charged for traditional fixed income.

We advise investors to conduct rigorous and detailed manager research and operational due diligence, to address the complexity and potential risks of investing in ARBS.

3

Key characteristics and qualities we focus on for rating ARBS

• Strategies that are not benchmarked against a traditional index but tend to be based off of LIBOR + a rate of return
• A focus on adding value through both directional and relative value strategies and not just by taking on additional market risk
• Strategies that use derivatives to a greater extent for liquidity and for hedging risks
• Ability to attribute performance to the risk taken in the portfolio
• Strategies that tend to have lower return targets than similar focused hedge funds alongside lower fees and greater transparency
• Risk management framework that ensures the positions are sized appropriately for the risk each brings to the portfolio

  • • Track record of key investment professionals in
  • • Systems that support the process and allow

for identification of sources of risk taken along with risk mitigation managing investments in the absolute return framework
• Structure of the product that doesn’t adhere to a strategic allocation to any given sector or fixed income asset class, but rather encourages a construction of portfolios based on best ideas
• Ability to achieve best execution in terms of pricing and volume
• Technology infrastructure that facilitates real-time

  • position monitoring and market pricing
  • • Ability to generate alpha consistently while effectively

managing downside volatility
• Rigorous pre- and post-trade compliance procedures

  • that ensure dealing and settlement quality
  • • Clear process for sourcing ideas from a wide range

of alpha sources and combining them into a diversified portfolio

Contact:

  • Paul Whelan
  • Elijah Reese

Fixed Income Manager Researcher Aon Global Investment Practice +44 (0)20 7086 9256
US Head of Fixed Income Research Aon Global Investment Practice +1 312 381 9961

Disclaimer

This document has been produced by Aon Hewitt’s Global Investment Management (GIM) Research Team, a division of Aon plc, a public company trading on the NYSE, and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and non-proprietary sources deemed by Aon Hewitt to be reliable and are not necessarily all inclusive. Aon Hewitt does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader. This document does not constitute an offer of securities or solicitation of any kind and may not be treated as such, i) in any jurisdiction where such an offer or solicitation is against the law; ii) to anyone to whom it is unlawful to make such an offer or solicitation; or iii) if the person making the offer or solicitation is not qualified to do so. If you are unsure as to whether the investment products and services described within this document are suitable for you, we strongly recommend that you seek professional advice from a financial adviser registered in the jurisdiction in which you reside. We have not considered the suitability and/or appropriateness of any investment you may wish to make with us. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction, including the one in which you reside. In the U.K., Aon Hewitt Limited is authorized and regulated by the Financial Conduct Authority. Registered in England & Wales No. 4396810. When distributed in the US, Aon Hewitt Investment Consulting, Inc. (“AHIC”) is a federally registered investment adviser with the U.S. Securities and Exchange Commission (“SEC”). AHIC is also registered with the Commodity Futures Trade Commission as a commodity pool operator and a commodity trading advisor, and is a member of the National Futures Association (“NFA”). AHIC is a wholly owned, indirect subsidiary of Aon plc. In Canada, Aon Hewitt Inc. and Aon Hewitt Investment Management Inc. (“AHIM”) are indirect subsidiaries of Aon plc.. Investment advice to Canadian investors is provided through AHIM, a portfolio manager, investment fund manager and exempt market dealer registered under applicable Canadian securities laws. Regional distribution and contact information is provided below.

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Registered office The Aon Centre

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Contact your local Aon representative for additional contact and/or registration information relevant to your local country if not included above Copyright © 2017 Aon plc

4

Phil Triggs, finance manager, Surrey County Council Pension Fund

How do the underlying portfolios of absolute return fixed income strategies differ from more traditional fixed income portfolios and how do these strategies differ from equity-based, or multi-asset absolute return vehicles?

We regard bond strategies as having four potential sources of return: duration; curve (timing of duration exposures); credit spread; and illiquidity. For a long-only strategy, the mix will be heavily influenced by the choice of benchmark. A duration of a gilt fund will be over ten years, which will dominate everything else.

The duration component falls and the other components rise as you move from gilts to global sovereigns (duration 8 years), to global aggregate (duration 7 years), to investment grade credit (duration 6 years), to high yield (duration 5 years) to private debt (duration 3 years), to loans (duration less than 1 year).

Total return and absolute return bond strategies in effect take away a lot of duration to let the other return sources matter more. A total return bond fund will usually have a duration in the range 0 - 5 years, with a ‘neutral’ position of 2.5 years. They have positive duration all of the time. Absolute return bond funds look to have a neutral duration of 0 with a range +/- 2 years around that. If they get that right, they can generate positive returns in a rising rate environment, whereas a total return bond fund would find that harder.

These strategies are therefore not comparable with other types of absolute return strategy based on equities or multi-asset, although they may appear to be seeking the same outcome. The key question when selecting any absolute return fund is always, ‘do you have confidence that the manager is good at...?’ - be that bond market timing/credit selection, equity selection or tactical asset allocation depending on the fund type. The second issue is then to invest in a range of different ones to gain manager diversification.

5

GAM INVESTMENTS –

ABSOLUTE RETURN FIXED INCOME

The current environment presents investors with a number of challenges; questionable valuations within the equity market, tight credit spreads and

rising central banks rates. The latter is particularly troublesome for fixed

income investors and has led some to forecast an end to the 40-year bull market for bonds.

  • Introduction to absolute return fixed income
  • Why should pension funds invest in absolute return fixed

income now?

Absolute return fixed income strategies offer a solution, with their typically broad investment parameters creating the potential for positive returns even when asset prices are falling. However, the term “absolute return” is wide-ranging and many of the biases present within more traditional longonly strategies can be found within the absolute return sector. As such, understanding the strengths and weaknesses of a particular absolute return product or fund manager is arguably more important than with more conventional fund investments.
Looking forward there are a number of reasons why pension funds should consider absolute return strategies as an alternative to traditional fixed income portfolios. The most obvious is the return of inflation to developed market economies and the potential for that to drive bond yields higher (and bond prices lower) as US and European central banks begin the process of policy normalisation via interest rate hikes and a tapering of QE programmes.

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    Investor statement on deforestation and forest fires in the Amazon This statement is endorsed by 230 investors representing approximately US $16.2 trillion in assets. It is with deep concern that we follow the escalating crisis of deforestation and forest fires in Brazil and Bolivia. As investors, who have a fiduciary duty to act in the best long-term interests of our beneficiaries, we recognise the crucial role that tropical forests play in tackling climate change, protecting biodiversity and ensuring ecosystem services. The recent reports from the Intergovernmental Panel on Climate Change (IPCC) and Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Service (IPBES) highlight the close links between unsustainable land use and climate change. With CO2 emissions rising and biodiversity declining faster than any time in human history1, these reports highlight the urgency in promoting sustainable land management to halt biodiversity loss, enhance food security and meet the goals of the Paris Agreement2. The Amazon, as the world’s largest rainforest, is a global repository of biological diversity, and provides invaluable ecosystem services which underpin economic activities across the globe. As the largest tract of continuous rainforest in the planet, the Amazon plays a critical role in the Earth’s climate system. Deforestation in the region could potentially bring the entire ecosystem dangerously near to a tipping point, after which the rainforest will not be able to maintain itself, gradually turning into a more Savannah-like system which is much dryer, less biodiverse, and stores significantly less carbon. This would severely disrupt the agricultural sector and other economic activities, by reducing rainfall and increasing temperatures in the longer-term.
  • NN Investment Partners - Emerging and Frontier Market Debt

    NN Investment Partners - Emerging and Frontier Market Debt

    NN Investment Partners - Emerging and Frontier Market Debt Marco Ruijer Portfolio Manager | Marzo 2018 1. EMD Outlook 2018: Driven by Solid Fundamentals 2 EM Fundamentals Growth is expected to pick up further GDP growth rates 10 Emerging Markets Major advanced economies (G7) 8 Growth differential 6 4 2 0 -2 -4 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 Source: IMF World Economic Outlook 2017 (October 2017) Growth differential between Emerging and Developed countries will likely pick up again 3 EM Fundamentals Current Account Balances of Emerging Countries largely have healed GBI-weighted EM current account to GDP ratio EM Current Account Balance (index weighted) 0.50% 0.00% -0.50% -1.00% -1.50% ‘Fragile five’ current accounts looking less fragile -2.00% Source: JP Morgan, Bloomberg, NN IP Imbalances of EM countries have corrected since 2013 reducing the need for higher risk premia 4 EMD & FMD – Yield Advantage EMD HC Euro HY EM Corporate 9.0 UST 10Y Germany 10Y Frontier Debt EMD Local Bonds 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Source: JP Morgan indices yields; TR Eikon, NN IP; Date: Jan-2018Yield pick-up of EM Bonds continues to provide a strong push factor for the asset class 5 Higher Economic Growth in EM & FM 6.0 Average growth over 2018 & 2019 - projections by IMF 5.0 4.90 4.0 3.41 3.41 3.18 3.0 2.12 2.0 1.65 1.0 0.74 0.0 USA Japan MENA Europe Overall EM & FM & EM FM & EM FM & EM Germany Source: IMF; Date: Oct-2017; (the EM countries include frontier SSA FM & EM market countries) Emerging & Frontier Markets continue to have meaningfully higher growth than DM 6 2.
  • 100 Resilient Cities 2° Investing Initiative a Blueprint for Better

    100 Resilient Cities 2° Investing Initiative a Blueprint for Better

    100 Resilient Cities 2° Investing Initiative A Blueprint for Better Business ABN AMRO INVESTMENT SOLUTIONS ABN AMRO Private Banking ABN AMRO/ AAIS Abundance Investment Acadian Asset Management Access Endowment Access Foundation Access to Medecine Foundation Acclimatise Acre Adit Ventures Aegon Asset Management afme Alberta Investment Management Corp Albourne Partners Alecta Allianz Alm. Brand Alpha Leonis Partners Anesvad Foundation Anglo American Aon ap1 AP2 AP3 AP4 AP6 Ario Advisory Arisaig Partners Artemis Investment Management LLP ASI Asset Resolution Athena Capital Advisors LLC ATL Pension Scheme ATP Authentic Investor Aviva Aviva PLC Baillie Gifford Baloise Asset Management Bank J. Safra Sarasin Bank of America Merrill Lynch Bank of Finland Barclays Barclays Private Bank Baringa Partners Baron Capital Basellandschaftliche Kantonalbank Bayerische Versogungskammer (BVK) BBC Pension Trust Bentley Reid (UK) Beshertine Beyond Ratings bfinance BlackRock BLI - Banque de Luxembourg Investments S.A. Bloomberg BlueOrchard Finance Ltd BMO Asset Management BMO Global Asset Management BNP Paribas Asset Management BNP Paribas Wealth Management BNY Mellon Investment Management Border to Coast Pensions Partnership Borg Consulting BP Investment Management Ltd British Airways Pension Investment Management Limited Brummer & Partners Brunel Pension Fund Brunel Pension Partnership BSR Cairn Capital Cambridge Associates Capital Group Companies Carbon Delta Carbon Tracker Cardano Carillion Pension Trustees Castle Hall Diligence CBRE Global Investors Cembra Central Finance Board of the Methodist Church Ceres CFA Institute CFA Society of the UK Chevron Chevron Corporation Children's Investment Fund Foundation Church Commissioners Church Commissioners and Church of England Pensions Board Church Commissioners for England Church of England Church of England Pension Fund Church of England Pensions Board City to Sea ClearBridge Investments Climate Bonds Initiative Close Group Consulting Inc.