Asset management: Investors get smart on asymmetric credit risk


Louise Bowman
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ETFs and swaps drive alternative beta; fixed income braced for negative returns.

Persistently low yields are doing funny things to credit. The increasingly desperate hunt for yield is fuelling increasingly irrational behaviour. “I see unsound practices creeping back into the credit markets,” said Oaktree Capital chairman Howard Marks last month. “People are making investments not because they want to but because they have to – they are handcuffed volunteers.” Low yields are also focusing investors’ minds on what might happen when rates rise. As this magazine explained last month, they would do well to do so. “What has shielded fixed-income investors and lulled them into a false sense of security is the 30-year bull market in government bonds,” says Ross Pamphilon, co-CIO at ECM Asset Management in London.

“It is obvious that with 10-year US treasuries yielding 2.04% the risk-return looks asymmetric. When yields eventually rise your returns are quickly eaten away and you are not adequately protected by carry.” Aside from blind panic, one reaction from both equity and fixed-income investors has been to search for ways to protect themselves. This is driving some of them away from traditional market cap-weighted indices and towards alternatives.

“Over the last six months there has been a confluence of three different strands of debate that have come together under the aegis of alternative beta,” explains Inigo Fraser Jenkins, global head of quantitative strategy for equities at Nomura. “This has been the move from active to passive investing, the rise of ETFs and the increase in multi-asset investing.” Alternative – or smart – beta has been adopted through static approaches such as indices based on corporate fundamentals rather than market capitalization and through more dynamic strategies such as low-volatility, minimum-variance ETFs. The ease with which equity investors can now gain access to macro strategies through ETFs and swaps is fuelling the development.

According to Noel Amenc, director of the Edhec Risk Institute, 40% of equity investors have now adopted alternative weighting schemes. In fixed income the expectation of rising yields and inflation is intensifying the search for new investment strategies. In March, BlackRock identified three key strategies for managing rising rates: sector allocation, yield curve positioning (shifting fixed-income allocations to shorter maturity mandates) and rate hedge overlay (keeping broad fixed-income exposure alongside the purchase of insurance against specific interest rate outcomes).

What is certain is that simply buying a market cap-weighted index isn’t going to cut it any more. “Investors are fully aware that indices represent the broader market, but they don’t always look under the hood,” says Pamphilon. “If you invested in the index in 2002 you were very exposed to TMT. If you invested in 2011 you were very exposed to financials. In a low-yield environment less desirable options to generate returns might be to either add leverage or else increase overall credit risk. However we believe there are other ways to make your fixed-income allocation work harder,” he continues.

“If we can sensibly demonstrate that we can make good beta allocation decisions and unlock value in certain asset classes, we can tap into these sources of beta without disproportionately adding risk.” His solution is to run a multi-asset-class credit (MACC) strategy that focuses on selecting the right credit beta and adding alpha through sector, rating and credit selection. He says that this avoids being anchored to an index and allows more nimble asset allocation. “We are focusing on interest rate duration hedged returns. Our base case for 2013 suggests that an investment-grade bond fund fully hedged for interest rate risk will return between 2% and 2.5% while a MACC strategy could return 4% to 4.5%,” he says.

“In credit you need good stock and sector selection skills to provide alpha together with the ability to avoid defaults. You can probably delegate that through an ETF but you won’t necessarily have the asset allocation skills necessary to make optimal beta decisions.” Anthony Morris, global head of quantitative strategies, fixed income at Nomura in London, argues that an adaptive strategy – such as value, carry or momentum, even in a rudimentary form – is capable of dealing with rising inflation and rising yields and therefore should be adopted in this asset class.

“As long as they are not over-engineered, alternative beta strategies can adapt to big changes in the market environment, while long-only cannot,” he says. “We have seen this over and over. In bonds, long-only has worked as long as yields went down, driving prices up. But it will be problematic if we start getting inflation again. To make matters worse, recent regulation has the effect of pushing many institutions more deeply into government bonds, even if that was not the original intention.

"Given this set of circumstances, there is a real danger of bond market deterioration in the future. Institutions that have the ability and willingness to adapt positioning in a robust, scalable manner have a chance of succeeding. Alternative beta programs can be a tool to achieve this.” However, many investors argue that the low-yield environment can still be tackled using a more traditional approach. Michael Foggin runs the Pyramis Global Credit UCITS fund at Fidelity Investments, a $51 million fund that was established in September last year.

“If you have a long-only bond fund, it may be difficult to make money in this environment, but there are other ways to add value,” he says. “You can add alpha by bottom-up credit selection and understanding which part of the capital structure to be in, and you can hedge tail risks using options and duration. But you need scale. You cannot manage a global credit fund without a huge pool of analysts behind you.”

His fund is measured against the Barclays Global Aggregate Credit Index and will eschew smart-beta-style allocations. “We run a very clean credit fund with limited off-benchmark duration or currency exposure,” he tells Euromoney.

“If an investor buys a global credit fund and they discover two or three years of off-benchmark duration or a large currency bet, then those risks should have been explained to the client before they invested. For example, your client doesn’t want to find that you have gone short when they might have also gone short elsewhere.”

It seems inevitable, however, that the move away from traditional benchmarks will accelerate. “There is likely to be a movement away from traditional benchmark allocations but it will be gradual and in fits and starts,” says Pamphilon. “It will probably be triggered by a large move in interest rates and spread widening. There could be some pretty nasty negative total returns in fixed income due to interest rate duration.”