Investment philosophy plays a significant role at all levels of an investment organization. The philosophy drives product development, asset allocation, hiring decisions at the top to implementing individual trade ideas at the portfolio level. It shapes the path and characteristics of an organization as well as the pattern of investment returns over the long haul.
Some organizations and portfolio managers do not admit to subscribing to a particular investment philosophy. However, upon closer examination of their investment decisions, one can spot their dominant philosophy. Some organizations claim that they diversify among different philosophies but this diversification is an investment philosophy in itself. One way or another, every investment professional and organization subscribes to a style and investment philosophy.
This blog entry presents how we view the process of adding value to our portfolios. The value-add aspect of fixed-income is even more important in this environment of low yields. It is mathematically impossible to replicate the return of the last three decade’s bull markets in fixed-income today. It is our belief that in the low yield environment, the winners would be portfolio managers that can add value with the best risk-return profile (highest Sharpe ratio).
Value-add is the return above and beyond the portfolio benchmark. Advising clients on the appropriate benchmark and benchmark replication (i.e. delivering the benchmark returns) are important aspects of what we as portfolio managers do. But, what differentiates talent in the investment management industry is the return above the benchmark. Adding value consistently in a risk-controlled manner over the long run is difficult in any asset class. It’s especially difficult within fixed-income, which is the deepest and most liquid asset class in public financial markets.
Figure 1 – Drivers of risk and return in fixed-income
Figure 1 shows the sources of risk and return in a bond. This chart is also representative of the fixed-income space as a whole. There is risk and return due to currency, outright duration, positioning on the yield curve, exposure to credit spreads, inflation, and yield volatility. For example, a five year, U.S. dollar, corporate bond will have currency risk (if the currency exposure is not hedged away), duration risk and credit risk for the investor. The size of each slice in Figure 1 is representative of the relative risk of each driver.
Figure 1 also shows the levers that portfolio managers can pull to add value on top of the portfolio benchmark for our clients in the fixed-income space. We can manage any layer of the pyramid in Figure 1 separately. For example, we may deviate from the portfolio benchmark by shortening or lengthening the duration of the portfolio, positioning the portfolio differently along the yield curve or overweight the corporate bonds and sectors that we like.
Figure 2 – Risk, return and Sharpe ratio characteristics of each fixed-income driver
The basket of different drivers in the fixed-income universe leads to the question of which levers have the highest return potential per unit of risk. For adding value, we have to deviate from our benchmark. By definition, this means that adding value introduces risk relative to the benchmark. Since total risk relative to benchmark is not unlimited and is a valuable resource, the portfolio manager has to identify the levers that have the highest return potential per unit of risk. The view on risk vs. return of each fixed-income driver shapes a portfolio manager’s investment style and philosophy. In the long-run, this thought process drives the performance characteristics of a fixed-income portfolio.
Figure 2 shows our current assessment of the environment for value-add opportunities in the fixed-income space. For example, the table in Figure 2 shows that outright duration bets relative to benchmark have a high risk and high return profile but the return per unit of risk (Sharpe ratio) of these trades is generally poor. On the other hand, credit driver which is also a high risk, high return area, generally comes with high return per unit of risk. Curve positions have a Sharpe ratio in the middle of the range.
The intuition behind the low Sharpe ratio in duration bets relative to the high Sharpe ratio in credit lever is as follows. The bond market as a whole is by and large driven by macroeconomic data and central bank actions that are widely available and analyzed as soon as they are released. Government bonds are liquid and auctioned frequently which allows the yield on the bonds to incorporate the new information quickly and efficiently. Making stable, positive risk-adjusted returns by taking outright duration bets, requires the portfolio manager to predict the path of the economic data and central bank policy correctly and consistently over time.
The aspect of liquidity and frequent auctions does not exist to the same extent in the credit world so, at the margin, it opens the door to the potential for outperformance. One explanation for why we get paid in selecting credits is that investing in a corporate credit bond requires the deep dive into the functioning of a corporation, its management style, and future plans, in addition to understanding the macroeconomic environment, the business, and credit cycle. The historical record shows that company analysis for credit selection results in high risk-adjusted returns.
Figure 2 has significant implications for portfolio management, trading, and resource allocation within fixed income. In regards to the two examples given above, three ancillary comments are in order, as follows:
- The investment philosophy in Figure 2 generally holds true through the business cycle and is remarkably stable, but reviewed and discussed periodically.
- Although we generally believe that outright long/short duration bets have poor risk-adjusted return, some curve/structured trades in bonds perform in a rising or a falling rate environment, depending on the type of the structure. We use these structures with a higher Sharpe ratio to express our views on duration.
- The general view on the bond market (duration) implicitly feeds to our outlook for the financial markets including all segments of the fixed-income market. In that sense, the value-add of a duration view manifests itself throughout the investment organization.