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Aug 01

Ramblings about Unconstrained Debt Funds and Portfolio Construction…wonkish and a work in progress

I’ve just returned from a manager research trip in the UK where we visited a variety of strategies from a variety of managers and fortunately for me, with some of the leading thinkers and researchers in the advice industry (hat tip D&G … and I don’t mean Dolce and Gabbana). Several of the managers we visited spoke to their “unconstrained debt” strategies and amongst the research group it was largely agreed that these are flavour of the month, but there was differing opinion about their use in investment portfolios within the advice industry.

Definition

Firstly I think it’s appropriate to define what an unconstrained bond fund is. The key is obviously in the definition of unconstrained…typically, the fund is managed to an absolute return-like objective (e.g. Cash + 3% over rolling 3 years) and therefore independent of traditional bond benchmarks like Barclays Global Aggregate. As a result there is the ability to execute virtually any debt-like strategy or instrument whether it be long or short duration, credit/high yield, government, CDOs, ABS, swaps, etc…hence unconstrained. These basic characteristics don’t suggest they are accepting significant risk, particularly given there is often a secondary objective that is more like a Sharpe ratio (which may be excess return over cash divided by volatility)…so it’s more of a risk-adjusted benchmark which should make the punters happy with respect to risk-based objectives. There may be other characteristics and sometimes certain constraints that are common sense with respect to objectives (e.g. minimum liquidity) but in my opinion these are the core characteristics with the bottom line that managers of these strategies have numerous levers to pull to gain and protect depending on their view of the investment world.

Flavour of the month?

There are several factors that suggest these funds are likely to be very popular amongst investors today with the main ones being…

  • Potential for gain in rising interest rate market…It appears current market consensus is that interest rates around the world can’t stay near these historic lows and therefore can only go one way…up…this means the return expectations for traditional conservative bond funds are very low and investors are looking for an alternative.
  • Flexibility to avoid being caught in another credit crunch…Credit spreads have been tightening since the start of 2009 and the downside risk is also increasing so exposure to a strategy nimble enough to know when to get out of high yield can be quite handy…let’s face it, high yield bond funds had equity-like negative returns during the GFC and no one wants to experience that again so why not give a manager the chance to exercise their discretion?…well, perhaps there’s a few reasons but I digress.
  • Many believe bond benchmarks are flawed and should not be managed to… Rightly or wrongly there is a wide-held belief that debt benchmarks are poorly constructed as they have the highest weights to the most indebted companies and/or governments so benchmark risks are high…managing to an absolute return outcome that is independent of debt benchmarks may be attractive.

Given these unconstrained strategies are not “beta” or market-related strategies, they are very much pure “alpha” strategies and heavily reliant upon the pure security selection and/or market timing skill of the portfolio manager. Their performance has been short term and experienced a tightening of credit spreads combined with declining interest rates so irrespective of the portfolio position many bond funds have a reasonable track record if set up post GFC…and that appears to be the case. This relates to one of the major risks of these unconstrained bond funds and why it may be risky to fall in love with these strategies…they are yet to be truly stress tested by the markets.

Portfolio Construction

In terms of portfolio construction there was a lot of debate around where these funds should be allocated in a portfolio. The agreed options were quite obvious…either the debt (or bond/fixed income) or alternatives allocation.

The debt allocation centred on the fact that the returns come from that particular asset class, whilst the argument for alternatives is pretty much centred on the strategy’s complexity and its non-benchmark investment approach.

My personal belief is that they should sit in the Alternatives allocation but either way, current portfolio construction methodology in advice world is led by the asset allocation decision which is primarily a “beta” (or market-related) decision and these funds with their non-benchmark objectives have the potential of ruining the intentions of any recommended asset allocation. If the beta decision of the asset allocation is less of an issue than the allocation of unconstrained debt strategies is possibly a question of investment philosophy and how these funds are likely to satisfy associated investment beliefs…in other words… irrespective of strategy, a key question to answer is “what is the role of the debt investment in the broader portfolio?”…it is a diversifier to reduce portfolio risk, is it a pure income focus irrespective of correlations with other asset classes, or some combination?

Debt Investment Philosophy

Traditionally, the debt asset class has a defensive role and equities the aggressive/return driving role. The unconstrained debt portfolio may significantly vary between traditional defensive and aggressive assets over time and the return success is therefore highly reliant upon the market timing skills and security selection skills of the manager…which is a risk in itself. This paradox is the first major challenge to assigning unconstrained debt funds to the debt allocation…that is, it potentially compromises the defensive role.

AS already mentioned, there is a widely held belief that interest rates around the world are more likely to increase than decrease in the coming years, and accompanying this is the belief that holding conservative bonds is the risky position. Therefore unconstrained debt strategies may actually reduce risk given an assumed improved return expectation in a rising interest rate market. Unfortunately there is one significant problem with this belief as is it is purely a return driven one and ignores broader portfolio risk. In other words, there is little or no consideration of the correlation with the other asset classes, and we should expect higher correlation to equities will increase portfolio risk significantly more than high correlation to bond indices. Certainly the possibility of low correlation in poor performing equity markets exists, but it requires the unconstrained bond manager to have that position as opposed to being a natural hedge like conservative bonds often are in times of stress.

The GFC was a wonderful exercise in understanding what true diversification was as certain debt investments (i.e. higher yielding) turned out to be highly correlated with equity markets and declined in value at the same time providing little to no diversification whatsoever.

Portfolio Construction Flaw

As mentioned, the current investment approach in retail advice is a two-step process. The first step is to assign an asset allocation based on an investor’s outcome needs and risk tolerances. The second step is to assign investments to the various asset allocations. Model portfolios aside, the flaw in this process in advice world is that these two steps are separate and the asset allocation decision, which is a beta or market-related decision, is often ruined by the investment allocations and using unconstrained debt funds is a case in point unless the asset allocation decision specifically provides for this type of strategy (and if it does then there is bound to be some arbitrary quality to the allocation as opposed to an objective return and risk focus).

For example, if the Strategic or Dynamic or Tactical asset allocation suggests a 30% allocation to debt strategies and the benchmarks for this allocation is the UBS Composite (in the case of Australian debt) and Barclays Global Aggregate (for Global debt), then allocating an Unconstrained debt fund will potentially reduce the required exposure to these asset classes…certainly the strategies we looked at had little to no correlation to these indices hence changing the asset allocation. This is the main reason why allocating to the debt asset class more often than not is inappropriate.

Alternatives Allocation

So what we are left with is the allocation of unconstrained debt strategies to the Alternatives asset class. However, this still creates some problems and the first problem relates to the definition and objective of Alternatives.

For most investors the alternatives asset class is the non-traditional asset class. It comprises anything that has little to no relationship with traditional debt and equity investments. It therefore comprises assets such as hard and soft commodities, illiquid assets like private equity, direct property and direct infrastructure, and complex hedge fund strategies like global macro, arbitrage, short selling, managed futures, and exotic derivatives like structured products. Given their complexity and perceived lack of relationship over time with traditional markets, unconstrained debt strategies appear to sit neatly amongst the complexity of hedge fund strategies.

However, an arbitrary allocation to the Alternatives should never occur…arbitrary allocation will obviously increase unnecessary risks as it is possible to create both a low risk alternatives portfolio and a high risk alternatives portfolio so constructing according to objectives is a must.

The design of the Alternatives portfolio is part of the broader portfolio so should have careful consideration of potential correlations with not just the remaining alternative investments but traditional asset classes too and particularly in times of stress.  Secondly, how will the unconstrained debt strategy likely contribute to the desired return and risk of the alternatives and overall portfolios?

Correcting the Portfolio Construction Flaw

The approach of considering an individual investment at the same time as the broader portfolio’s return and risk objectives should not just occur within the Alternatives Asset Class but at the overall portfolio level as well. Separating the beta decision from the alpha decision is an inefficient approach to portfolio construction and the decisions should be made together with portfolios return and risk objectives top of mind at all times.

This approach removes the two step approach to investing that the advice industry has embraced moving towards an integrated asset class and investment selection approach. The asset class allocation then becomes the output instead of the input.

Of course, all of this is perhaps easier said than done and it may produce other risks unstated and perhaps require tools or skills that are not available…but an integrated asset class and investment approach should increase the alignment with return and risk objectives instead of the current approach in which the investment decision often ruins the recommended asset allocation.

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