RESEARCH | RESOURCES | RESULTS
Multi-Asset Fixed Income Strategy Holds the Key
to Higher Yield and Lower Volatility
by Mark Cernicky,
Managing Director, Senior Product Specialist
Principal Global Fixed Income
Since the 2008 global economic crisis, investors have witnessed a global fixed income
environment in transition. Extraordinarily accommodative monetary policies from the world’s leading
central banks have resulted in historically low interest rates and yields. As a result, asset classes
traditionally considered high risk have been sought out by investors in their quest for yield in areas of
the market that they typically had not invested in before. The end result has been increased correlations
between historically disparate asset classes, an investing world dominated by beta. But now, financial
markets are at a crossroad; the U.S. Federal Reserve has wound down its massive quantitative easing
program and we belive it is only a matter of time before short-term interest rates start heading higher.
We are moving from the easy beta world—of all risk assets rising to a more difficult alpha world—where
we need to generate returns through macro themes, security selection, and duration positioning.
This is putting traditional fixed income strategies under pressure as investors look for ways to generate
yield and still protect themselves from higher rates. As a result, many investors have turned to
unconstrained strategies, which may not afford the kind of protection investors are looking for. In fact,
unconstrained fixed income strategies may have more risk than traditional fixed income strategies
when it comes to protecting a portfolio against market volatility. For these reasons, now is the time
for investors to consider an all-weather multi-asset fixed income strategy, which we believe can cope
effectively with a rising or falling interest rate environment or when volatility is increasing or decreasing.
GENERATING ALPHA
VIA BALANCED
DIVERSIFICATION
Investors often perceive multi-asset fixed income investing as analogous to unconstrained investing
and unconstrained investing as analogous to all-weather investing, but that is not necessarily the
case. Although multi-asset strategies are not tied to one particular asset class, it does not mean
that all are built to withstand an ever-changing market environment. In fact, many unconstrained/
multi-asset strategies have underperformed within the last year because of their concentrated
duration positioning. When looking for an all-weather strategy, you have to have a happy balance
between macro and security risk, or avoid being too concentrated in your macro risk but being too
diversified in your security risk.
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2
MULTI-ASSET FIXED INCOME STRATEGY
CHARACTERISTICS
OF AN ALL-WEATHER
STRATEGY
DIVERSIFYING PORTFOLIO RISK, MORE CONCENTRATED SECURITY POSITIONS
An unconstrained fixed income strategy is not necessarily all-weather because it may take
concentrated risk positions. For higher yielding strategies to be considered all-weather, they need to
diversify the risks within the portfolio. For instance, if an unconstrained strategy is run solely on macro
themes and has only one or two concentrated risks in the portfolio, it is not all-weather. Likewise, if
managers focus solely on security selection without taking the macro environment into consideration,
the strategy is too heavily weighted toward idiosyncratic risks.
A portfolio that is over-diversified in the number of positions may be giving up a source of alpha—security
selection—as the investment world moves into a post-quantitative easing phase with potentially higher
interest rates and increasing sector and security dispersion. On the other hand, if positions are too
concentrated along a few macro themes, such as duration, it dramatically increases portfolio volatility.
Our analysis suggests that a portfolio containing less than 150 positions is the optimal size to retain
a sufficient range of returns to generate alpha from security selection. Accordingly, we believe an
all-weather multi-asset fixed income portfolio that is built upon focused investments spread across
different or multiple macro themes will have better outcomes than fewer concentrated investments.
MULTIPLE LINES OF DEFENSE
How do investors protect their multi-asset, unconstrained portfolios, when they can no longer rely
on the benchmark to bail them out? The answer is to build circuit breakers into your portfolio. First
your portfolio needs to have multiple sources of protection. There is no fail-safe solution other than
hindsight that will protect a portfolio from bouts of systemic risk. As a result, we build in several types
of circuit breakers that are designed to trip under periods of ever-increasing volatility. For example,
we use a tactical circuit breaker such as the CDX index product to hedge an expected short-term
increase in risk. If the risk continues to increase, we use a portfolio stop loss tied to the realised
volatility in the portfolio to reduce risk if volatility exceeds a limit. Finally, we use equity volatility to
hedge tail risk during periods of significantly higher volatility to hedge drawdown risks.
POCKETS OF OPPORTUNITY – THE BENEFITS OF BENCHMARK FREEDOM
In this period of rising interest-rate uncertainty and market volatility, traditional fixed income strategies
may not perform well because they are tied to a benchmark that requires certain sector allocations and
higher durations. As fixed income sectors move in and out of favour, a strategy that can strategically and
tactically adjust allocations will benefit from the ability to move to more favourable parts of the market.
For example, hybrid securities are appealing because they are a low-cost way to enhance yield for incomeoriented investors and have low correlation to other investments.
A benchmark-agnostic approach can also allow a portfolio to shed some interest-rate risk that has
built up in the process of adding duration to gain yield. The way to achieve this is by investing in
sectors that have higher yield but lower duration such as the financial sector and high-yield bonds
that typically have less interest rate risk or duration than investment grade credit.
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3
MULTI-ASSET FIXED INCOME STRATEGY
Additionally, by moving investment selections to a global portfolio, investors can decrease their
interest-rate risk exposure by investing in global yield curves that have less interest rate sensitivity,
such as the European yield curve.
Relative value is one of the biggest challenges facing the fixed income asset class with yields too
low and spreads too tight. We believe the way to achieve higher returns is to actively select credits
in or out of the benchmark that have higher yields and lower duration and volatility that can do
well in a rising or falling interest rate environment. When opportunities present themselves, the
pockets of opportunity, managers must have the flexibility to be quick in order to capitalise on
them. For example, at the end of August 2014, when short-duration bonds and high-yield credits
gapped wider, we were able to take advantage of those dislocations, but now that opportunity no
longer presents itself. Additionally, and more recently, at the beginning of 2015 we were able to
take advantage of the carnage in the energy market by looking for distressed midstream energy
companies. Investors need to find the pockets of opportunity rather than waiting to invest all their
eggs in one trade when it comes along, because it may not in a post QE world.
MULTI-ASSET FIXED
INCOME HOLDS
THE KEY TO FUTURE
RETURNS
Looking ahead, divergence of monetary policy is going to create increased volatility and sector
dispersion, in turn, creating pockets of opportunity for active, multi-asset fixed income managers. Global
yield curves will offer varying points of attraction. The credit cycle has been extended and balance sheets
are strong. The liquidity mismatch and dealer balance sheets will create price advantages.
Placing a greater emphasis on an all-weather multi-asset fixed income strategy brings the
importance of active management into focus. Passive investing will leave investors disappointed.
In the fixed income space, certain types of investors tend to invest in certain sectors of the market.
In turn, this creates dislocation and creates technical opportunities, which active managers can
capitalise on to generate alpha. This is certainly true in the investment grade sector, where in high
yield, active management adds value by seeking out mis-rated companies that are undervalued.
An actively managed all-weather multi-asset fixed income strategy offers the opportunity to benefit
from additional yield and enhanced diversification with lower risk.
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4
MULTI-ASSET FIXED INCOME STRATEGY
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