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Absolute Return Fixed Income Pension Fund Service December 2017 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 The 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 Sectors utilized in ARBS: while sectors will vary by structures and are provided by a number of fixed strategy due to manager preference and expertise, income managers. Over time, the listed universe of ARBS many managers utilize a broad array of fixed income available in research databases has increased to meet sectors to invest in. These include global and emerging the growing demand by investors. Although there are market sovereigns, investment grade and high a number of strategies that may be labelled or classified yield corporate bonds, broadly syndicated loans, as ARBS, we feel that the quantity that fit our select mortgage-backed securities, other asset backed criteria is fewer in number. Simply stated, many managers securities, and currencies. Liquidity is a key metric classified as ARBS are not absolute return focused. We for ARBS and therefore fixed income sectors tend to also draw a clear delineation between those strategies be those that can be more easily transacted in. ARBS that maintain a long only bias and those that are able vehicles typically offer daily or weekly liquidity. 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. Traditional Active Fixed Income ARBS Benchmark Physical bonds 3-month LIBOR Return Target 0.5 – 2% over benchmark 1 – 6% over benchmark Drivers of returns 80% market / 20% skill 20% market / 80% skill Volatility TE of 1 – 4% Vol of 3 – 6% 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, Fixed-income instruments, derivatives and currencies derivatives and currencies Source: Aon Performance (what is expected of ARBS?) Unlike the majority of traditional bond strategies in the sectors, ARBS are expected to employ high conviction marketplace, ARBS tend to be measured against cash purposeful trades that result in a diversified and often benchmarks such as the London Interbank Offered complex portfolio structure. Therefore, the approaches Rate (LIBOR). Utilizing a cash like benchmark aligns lend themselves to matching respective return and manager returns with manager alpha targets. While volatility targets rather than focusing on outperformance benchmarks may be used internally for certain invested versus traditional fixed income benchmarks. 1 One of the hallmarks of ARBS strategies is the goal Fund A Fund B Fund C Fund D Fund E Fund F ICE ML US High Yield Index to provide positive returns over time irrespective 250 of performance of the market. This factor drives 200 greater scrutiny on the consistency of performance given the pure alpha targets that are common in 150 the absolute return space. Performance targets can range on the lower end from Libor + 1 – 2% to 100 higher levels of Libor +4 – 6%. Higher return targets may be achieved through different approaches such 50 as constructing a strategy with larger positions, or Wealth Inde (September 2007=100) adding economic leverage to the overall portfolio. 0 Sep 17 Sep 11 Sep 13 Sep 12 Sep 15 Sep 14 Sep 16 Sep 07 Sep 10 Sep 09 The following chart shows the gross performance of a Sep 08 representative peer group of USD based ARBS managers Source: eVestment, Aon, ICE-Merrill Lynch. Data correct as of September 2017 that Aon monitors, broken down by quartile ranking. Past performance does not guarantee future results. ARBS generally focus on shorter term opportunities in 16% order to harvest return, but some do combine longer 14% term focused positions alongside a shorter term trading 12% program to boost expected returns, limit risk and 10% increase diversification. For example, a manager may 8% combine individual bottom up credit selection in an 6% 4% out of favour sector (longer term view) with a short Gross Return 2% position in an index focused credit default position 0% (short term sector view). The result is a strategy and -2% portfolio that seeks to add incremental return over -4% both the short and long term on a consistent basis. 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Coinciding with various performance targets within Source: eVestment, Aon. Data correct as of September 2017 Past performance does not guarantee future results. the absolute return product universe, are stated levels of volatility that the strategies expect to incur. A deep Performance drivers can vary by strategy, but are understanding of observed (ex-post) and targeted typically globally diversified. This factor is a key (ex-ante) risk is imperative to portfolio construction element in the ability of strategies to have multiple of ARBS. From a research perspective, we expect a sources of return in the portfolio, not solely focused solid absolute return manager to deliver a Sharpe ratio on the traditional fixed income sources of return such approaching 0.5 over the medium to long term. as credit, carry, and duration positioning. However, there are some specialist ARBS which focus on a Use of derivatives and risk management single sub-category of the fixed income universe, A key feature of ARBS is the risk management processes, e.g. credit or developed government bonds. which include the techniques and resources that managers employ to ensure a detailed understanding Alongside yield curve positioning and sector and security of the overall risks of the portfolio. Risk measures and selection, ARBS also draw upon additional strategies in analytics utilized in ARBS commonly draw from those order to generate alpha. For example, many ARBS utilize factors most often employed in both the traditional long-short credit, relative value and other quantitatively fixed income and the alternative or hedge fund space. oriented strategies in order to generate returns that are This suite includes stress testing, scenario analysis, less correlated or uncorrelated with traditional fixed and portfolio measures such as Value at Risk (VaR) income return streams. The following chart shows the and drawdown. Additionally, an understanding of gross performance of ARBS with a 10-year track record risks external to the portfolio must be analysed and versus the return of US High Yield. This displays that understood. Technical factors, political risks, equity while high yield may play a part in ARBS returns other market dynamics and other drivers of the broader global drivers and diversifiers of performance are evident. macro environment are key inputs to the understanding 2 of absolute return portfolio managers and can guide Lastly, we advocate for using ARBS within Liability overall level of risk taking within the portfolio. The Driven Investment (LDI) strategies where appropriate. overarching purpose of risk management is to measure Fixed income is at the center of liability hedging pools and analyse the intended and unintentional investment within LDI frameworks. Historically these collateral pools risks within ARBS so they are clear and quantifiable and consisted of government securities or cash to provide then addressed appropriately by portfolio managers. the liquidity needed to support liability hedging. With persistent low levels of yields in the current market, ARBS Once risks are identified, ARBS then refer to a risk can provide an opportunity to generate increased return management tool-kit, in order to maintain liquidity over cash and government securities while maintaining and hedge unwanted risk, while investing globally. the level of liquidity needed for potential cash calls from Portfolio construction and diversification help to alleviate the hedging portfolio. unwanted risks in absolute return portfolios. However, given their opportunistic approach ARBS tend to utilize Risks derivatives as an additional tool in risk management. ARBS do not invest without risk and their goal to provide consistent positive returns is not guaranteed to be met. Derivatives can assist in smoothing out the performance As discussed, ARBS do tend to be complex in structure profile by protecting the portfolio from extreme and investment approach and therefore require a detailed drawdowns in performance and to buffer the portfolio understanding of the process, people, and investment from sharp increases in volatility. Instruments used philosophy involved. Additionally, the absolute return often include options, interest rate swaps, forwards, label can carry different meanings to investors given the futures and credit default swaps among others. Rather diversity of strategies and managers available to invest than being used to purely generate leverage and with. A summary of potential risks is listed below: adding to risk, derivatives are utilized in optimizing and balancing risk in the portfolio and allow the targeting • LIBOR ≠ Risk Free: Investments in ARBS carry risk of specific risks that managers want to take on while of capital loss. In addition, there are trading costs avoiding those that are unwanted. Also, strategies may associated with these strategies meaning they should use derivatives to access areas of the market on a more not be treated as cash vehicles.
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