Benchmark Relative. Absolute Return. Total Return? Global unconstrained? Here our global fixed income team demystify some of the common language used to describe approaches to fixed income investing – explaining the differences – and how they can be applied to various objective-based strategies within a broader portfolio. For more download the full investment publication, taming your unconstrained manager.
#1 Benchmark Relative
Benchmark Relative investment management is one of the best known approaches. It has been the bread and butter of active management for many years. Pick an appropriate benchmark to manage to and then place some “bets” around the benchmark to seek some additional outperformance such as going overweight financials or underweight mining. The typical outcomes of such portfolios tend to be correlated to the overall direction of the bond market but to a mildly lesser extent if the active management calls are successful (getting more return from making the right calls). But given that the majority of the exposure of a Benchmark Relative portfolio will remain aligned with the broader market index, performance will ultimately me more aligned than a portfolio which is not aligned to a specific benchmark.
Investing in a Benchmark Relative portfolio makes it a lot easier to compare other managers who are also managing towards that benchmark. Any outperformance comparisons are easily made given the underlying investment universe is ultimately the same. Benchmark Relative investing is also useful for investors who want to gain specific exposure to a subsection of the market e.g. they only want Australian fixed income exposure because they have other portfolios with global fixed income exposure. This allows the investors themselves to make tactical calls on specific sectors e.g. credit versus government, emerging debt or high yield. Of course by choosing this approach the investor has to have faith not only in their ability to choose appropriate tactical allocations but have flexibility in their investment model to react to changes in the market. This is difficult when allocations are in separate portfolios and can result in high transactions costs related to increasing and decreasing allocations to individual portfolios.
Hence many investors are turning towards skilled investment managers who are able to offer a more benchmark-unaware / unconstrained approach to fixed income. In this approach, the manager themselves has the ability to tactically position the portfolio to the current market environment and is also allowed a broader opportunity set to seek additional return.
In the current environment where there is potential for negative returns from bond markets (if interest rates begin to move consistently higher), investors are moving away from a “match the benchmark” approach, seeking instead positive returns over the whole investment cycle. This change of investment objectives has increased interest in Absolute Return and more flexible investing.
#2 Absolute Return
In recent years Absolute Return portfolios have gained popularity both for fixed income and multi-asset investment markets. Absolute Return strategies aim to generate a positive return regardless of underlying market conditions, typically with a pre-specified target (eg. cash + 5%) without the constraints of focusing on a traditional benchmark. These “all-weather” approaches do not necessarily rely on positive capital market performance in order to deliver on the objective.
In fact, Absolute Return strategies – in their purest form – should exhibit low correlations to traditional asset class returns given that they should not have structural biases over time (i.e. market neutral). Furthermore, in falling markets these strategies typically afford the manager sufficient flexibility to profit by implementing short positions. Of course, while the market risk should be low (in theory), the manager risk is high given the reliance on highly active investment strategies. Historically, these strategies have been reserved for the hedge fund universe, which meant they were largely unregulated, utilised leverage, and charged high fees. However, these strategies are increasingly accessible to a wide set of investors, not just sophisticated hedge fund clients.
Certainly Absolute Return strategies sound fantastic on paper – who doesn’t want to earn positive performance in all market conditions? They are also easy to compare manager to manager by simply seeing who has a similar absolute return target and comparing who hit the target and at what levels of risk. However, in reality, delivering an absolute return portfolio to the prescribed mandate can be a lot harder than it sounds. Recent return analysis from Morningstar has shown a number of Absolute Return fixed income portfolios have in fact had a high correlation to the global bond universe (over three and ten year periods). Hence, while promising a low correlation they have in fact remained tied to the performance of the global bond market – probably due to the strong returns on offer during this period. This makes it hard to determine how they would fair in a world of diminishing total returns and potentially negative yields.
#3 Total Return
On the other hand, Total Return strategies tend to incorporate some element of structural market exposure which makes outperformance in down markets more difficult. Traditional Benchmark Relative strategies usually fall into this category since investors either expect passive replication of a market (beta) or market exposure plus excess returns (alpha) in the case of active management. However, if markets are strongly positive, these strategies are more likely to keep up given the structural market beta exposure.
Similarly, Total Return strategies seek to deliver on a pre-specified target above cash, operate a flexible, unrestrained investment strategy, and have little reference to a traditional capital market index. Importantly, these strategies tend to incorporate some element of structural market exposure, thereby increasing the time horizon (typically 3-5 years) and increasing the possibility of a negative return over shorter periods. While these strategies may lag in up markets, the flexibility afforded means that they have the potential to outperform in down markets. The entire aim of Total Return strategies is to make investors’ money and minimise capital losses, so wherever possible they will mitigate market falls using an unconstrained approach (i.e. moving heavily into more defensive or safer asset classes and sectors), derivatives and flexible cash limits. This means that Total Return portfolios may not participate as fully in market rallies as traditional funds. Total Return portfolios are also designed to meet the needs of different investor risk/return profiles. For example, there are riskier Total Return products that target cash plus 5% to 7% per annum. At the other end of the scale, customers requiring consistent smaller positive returns may find a Total Return product that aims for cash plus 2% to 3% more appropriate. A typical feature of Total Return strategy performance is that they will never be as good as the best performing market segment but are not expected to be amongst the worse. Hence a key contributor to the success of the portfolio is the investment manager’s ability in active asset allocation and creating a diversified portfolio. That being said, Total Return strategies tend to deliver over time on their investment objectives given the ability to seek investments delivering return streams aligned with the portfolios objectives. Furthermore, it’s likely they will be more lowly correlated to global bond markets than traditional Benchmark Relative strategies.
Unfortunately, the investment world continues to consistently conflate Absolute Return and Total Return strategies. Throwing in the term Unconstrained has only made things worse. The issue here is that Global Unconstrained products can include elements of all these classifications (e.g. total return product that has a reference benchmark and adds relative value alpha overlay strategies to boost returns) which makes it even more confusing for investors. So, the first order of business is understanding what you are buying and what to expect in different environments. If bond markets are down 10%, would you consider a -5% return a success? If the High Yield market delivers double digit positive results, then would a +3% return from your portfolio be acceptable?
#4 Global Unconstrained
So what is Global Unconstrained Fixed Income? Well really it’s undefined rather than unconstrained! It can be a bit of anything and everything. Though typically there are some common features such as a high outperformance (alpha) target and a broad investment universe and discretion. Products in this space can be difficult to compare as they may have different benchmarks (cash, composite/core index, etc.), be income based, or have very different liquidity profiles. To us, the key to a successful Unconstrained Fixed Income fund is having an unconstrained opportunity set to invest in. If you have true skill to be able to deliver true alpha (more on that later), then you can deliver this in an absolute return framework, against a traditional benchmark, and have the ability to scale up or down the risk/return objectives.
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