There are many benefits to taking an unconstrained approach to fixed-income markets, but it requires a disciplined process to avoid “product creep”.
A gathering of 60 of the most influential fixed-income investors in Australia recently heard of the need to remain alert to the complications that can come with investing in unconstrained funds – such as a creep into credit, or concentrated and correlated positions. However, it was also acknowledged that the philosophy behind unconstrained thinking could be applied beneficially to all fixed-income investing.
Kenneth Bowling, head of portfolio management, US fixed income, at Colonial First State Global Asset Management, said that without construction discipline, unconstrained fixed-income funds can create problems, including “product creep” – whereby they can morph into credit funds in disguise.
Another risk is that thematic views can lead to concentrated and correlated positions while filtering out contrarian ideas. In addition, while unconstrained funds have the advantage of a greater breadth of investment opportunities, this requires expanded skill from the manager.
Bowling made his comments at the 2017 Investment Magazine Fixed Income, Cash and Currency Forum in July. Sharing the stage with him was Susan Buckley, managing director, global liquid strategies of QIC, who said investors could apply the thinking behind unconstrained investment processes to benchmarks, betas and other mandates.
“Unconstrained funds have had a less-stellar period since the global financial crisis, but I would caution about extrapolating [from] that, she said. “We advocate an unconstrained-type thinking, even if it is around a traditional benchmark or beta.”
Liberating the manager
For example, Buckley explained, in Australian fixed income, investors could allow managers to hold long/short credit, inflation exposures, active exposures from currency and a full range of derivatives.
“This can be contained within the risk guidelines, but allows them to access the full opportunity set,” she said.
Bowling agreed there was a value proposition for extending the latitude of the investment universe and liberating the manager.
“Arguably, with unconstrained fixed income, there’s an attractive performance target without the leverage and lock-up of hedge funds,” he said. “It also gives managers the broad discretion to take advantage of opportunities away from benchmark and currency.”
Bowling said setting a performance target keeps investors from being dependent on market direction and, therefore, they can be more consistent over time.
“It also means alpha can tactically be extracted when opportunities arise,” he said.
Always an active element
Buckley said at a certain level there is always an active decision in fixed income. Even a passive mandate requires a choice of benchmark, then decisions on rebalancing and hedging, she said.
In fixed income, active investment rewards governments and corporations for strong financial management but passive investment is not incentivised to avoid risk or moral hazard, it simply buys the market, she said.
Mercer figures show that, in the core fixed-income asset classes, upper-quartile managers outperform the benchmark 75-95 per cent of the time, and median managers outperform the benchmark 50-60 per cent of the time.
“You can add 2 per cent if you’re picking the top-quartile managers,” Buckley said.
If investors are interested in unconstrained fixed income, Bowling recommends setting guardrails to avoid product creep and awareness of the use of derivatives in all-weather products.
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