INVESTING FOR WHAT’S NEXT™ Going the extra mile to find reward — an unconstrained approach “Today Ireland is probably one of the most liquid investments out there, but back in 2011 everyone was panicking. We were actively buying.” Michael Hasenstab surveys the scenery near the summit of Everest. Michael Hasenstab Executive vice president and a Master’s degree in economics chief investment officer, of development from the Global Bonds for Franklin Australian National University, Templeton Fixed Income and a B.A. in international Group®; oversees the global relations/political economy fixed income team from Carleton College in the United States Joined Franklin Templeton Investments in July 1995 Accomplished mountaineer who reached the summit of Holds a Ph.D. in economics Mount Everest in 2013 from the Asia Pacific School of Economics and Management at Australian National University, For example, when we started investing in Irish US fixed income portfolios managed to a conventional bonds in 2011, the market was not very liquid. benchmark could be vulnerable as an improving US economy, Today, it is probably one of the most liquid investments out there. coupled with continued tapering of the US Federal Reserve’s Early in 2014, there was more demand for a new (Fed’s) asset purchase program, increases the likelihood of a bond issued in Ireland than for our entire holdings across all of the portfolios we manage. Compare rise in interest rates. Franklin Templeton’s Michael Hasenstab that with 2011 when we were actively buying and the bonds were yielding double digits. Everyone believes unconstrained global fixed income portfolios that was panicking, and selling; Ireland had been have the flexibility to manage duration should be better downgraded several times, and markets were expecting a credit event. positioned for performance. Our objective then was to selectively go in—and With the US Federal Reserve (Fed) continuing to You can’t simply turn a switch to say: “I am we picked this country, which we thought had wind down its asset-purchase program, as of the not looking at tracking error, I am looking at great value, after we had been researching it for third quarter 2014, we expect US interest rates total return.” Instead, it requires a completely months. We accumulated a good-sized position to continue to normalize toward nominal gross different mindset; you have to think about the at distressed levels, and we were ready to hold it domestic product (GDP) growth over the medium risk systems that are involved in managing for until: either the bonds would naturally roll off, term. In this environment, traditional core fixed an unconstrained total return approach—it and we picked a suitable maturity profile to ensure income strategies, often with a duration linked requires significantly more scenario analysis. this, or markets would begin to recognize that the to a benchmark, could wind up being exposed country was in great shape. For trades like this, to interest-rate risk regardless of the health however, it is important to have the risk systems Managing Risk of the economy. and trading systems in place to trade locally and In risk-management terms, our emphasis is on obtain liquidity. It is not easy and can take decades A truly unconstrained strategy has more flexibility the risk of total loss, not the risk of relative loss— to develop the process and resources to exploit to weather and exploit varying market conditions importantly, you have to have the right time frame. these potential opportunities. compared with the typical duration-heavy core It is very hard for a global unconstrained approach portfolio represented by broad, traditional fixed Additionally, if your risk system is based on tight to succeed with a short time horizon, because as income indexes. stop-losses instead of overall portfolio risk of you are expanding your opportunity set and going loss or expected shortfall, you are going to have We have spent decades developing the infrastructure global, many of those opportunities take time a very difficult time exploiting such contrarian both on the investment side, as well as on the risk to materialize and you have to be willing to ride opportunities. To do it right you have to take a management side, to execute this type of strategy. through short-term volatility. long-term approach. Not FDIC Insured | May Lose Value | No Bank Guarantee An editorial from Franklin Templeton Investments | www.franklintempleton.com September 2014 context, not in isolation. For example, what happens OUR UNCONSTRAINED APPROACH IS… in the United States will likely affect emerging markets Hasenstab on: • Not confined to the constituents, sectors or qualities of which, in turn, will influence the global environment. INVESTING FOR WHAT’S NEXT™ a benchmark. The manager has leeway to deviate without If you build a portfolio that is both diversified and very EMERGING MARKETS: Going the extra mile to find reward — an unconstrained approach limit from an index. discerning in terms of which countries you are willing to The global liquidity risks that the market was • Able to invest across a broad spectrum of fixed income invest in, specific emerging markets could be very fertile. so concerned about earlier in 2014 appear to segments in an extensive, global opportunity set. have been a bit overstated, particularly in light Take, for instance, South Korea. Some commentators of Japan’s program of printing money. We fear • Flexible and opportunistic, allowing the manager to quickly and regard the South Korean won as an emerging market that the market is still not fully differentiating strategically adjust positioning in an effort to take advantage currency and see it as unattractively risky. However, between the fundamentals of various emerging of various market environments and business cycles. countries. In fact, we are fairly optimistic when you look at the underlying fundamentals, you see a on a select handful of emerging markets, • Designed to provide a diversified set of uncorrelated risk country that has had 3.5% to 4% GDP growth. It has been especially since we think the fear of a hard exposures, in curve, currency and credit. a capital exporter. It has had positive real interest rates, landing in China is unwarranted. I would not and nominal rates around 3%. South Korea’s government go so far as to say we are bullish on emerging has not been printing money. Its economy has been markets as an asset class, but I would say we Global Depth and Diversification cyclically and positively correlated to a US recovery. are quite bullish on opportunistically selecting certain assets and certain countries within South Korean debt is low—around only 30% of GDP— To take advantage of such opportunities, often found emerging markets, while making sure we purge and it has a current account surplus over 5%, making it in emerging markets, you must have the breadth to be those that we believe have weaker underlying an attractive emerging market currency to us. It is going truly global and not limit yourself to just a handful of fundamentals. to have short-term volatility. But, we think as long as countries. If you are going to go global, it is all or nothing. LIQUIDITY: Mistakes are an intrinsic part of the Our investment time horizon of two to learning process, especially in emerging “ If you are going to go global, three years, or longer, affords us the ability markets given the lack of uniformity. to weather short-term market noise and Expertise is needed, as investing in it is all or nothing. You can’t really volatility and allows us to take advantage of inefficiencies that generally require a longer emerging market currencies carries dabble in it, you need diversification.” holding period to generate alpha. For instance, hidden risks because the variance foreign exchange markets have the potential between individual countries can be very high. You you understand the long-term fundamentals and have to be inefficient in the short term, but can be can’t dabble simply because you need to build the the capacity to model and understand them—and the efficient over longer time horizons. We position diversification, because to do it right, you have to build conviction and long-term horizon—there is opportunity. our portfolios so that we are not forced to a very deep research bench. Establishing operations and In contrast, there are places like Turkey that we believe sell during periods of extreme volatility and have the ability to remain patient for prices to settlement systems, as well as the trading systems, the will likely be fraught with further potential risk. There are move toward what we think is their long-term legal infrastructure and the research foundation, is very places and markets that will come in and out of fashion, fair value. Moreover, we do not use stop-loss expensive and takes many years to refine. It is especially but ultimately, you really have to do the due diligence systems, and this is essential to implementing important to have the risk systems and trading systems to determine if the underlying fundamentals are weak. contrarian views. Recovery values often can in place to trade locally and obtain liquidity. We have You have to construct a truly global portfolio so you be higher than current prices, and some stop- learned this through decades of experience. However, can manage the volatility and the risks. And, if done loss provisions could inhibit investors from receiving the potentially greater value of a emerging markets must also be viewed in a global appropriately, we believe it can work. security. Investment Process INTEREST RATES: Multiple Research Lenses Interest rates are unlikely to fall much further, given a zero lower bound for nominal yields.