The separation of investing into benchmark (beta) and value-add (alpha) is the foundation of institutional portfolio management. The concept of “portable alpha” has been used extensively to help with the efficient portfolio design on different benchmarks that reflect investors’ various long-term goals. This article, on the other hand, will deal with the new concept of “portable beta” for core fixed-income portfolios.
The transfer of private debt to public balance sheets since the Global Financial Crisis (GFC), the issuance of longer term debt in developed and emerging markets, together with low interest rates mean that fixed-income benchmarks have higher duration. As a result, these benchmarks are dominated by interest-rate risk more than ever.
Figure 1. The duration and risk of popular fixed income benchmarks
Higher fixed-income benchmark duration is not necessarily a bad development for balanced portfolios. Most investors’ portfolios are heavily dominated by pro-cyclical equity-type risk. For example, the 60/40 portfolio using the S&P/TSX Composite Index and FTSE/TMX Canadian Universe Bond Index is hardly balanced as it has three times more equity risk than duration risk. Having higher fixed-income duration is a step in the right direction in balancing equity and bond risk.
However, inside the fixed-income investment world, it has long been recognized that the higher duration of benchmarks combined with lower rates means that the risk-return profile of fixed-income asset class has deteriorated. Portfolio managers have responded by chronically underweighting the duration of the portfolio relative to benchmark and overweighting the exposure to credit. Given additional income in select credit spreads, this position can be constructed to be positive carry.
There are two issues with this approach. First, from the asset allocation perspective, the chronic short-duration/long-credit position is identical to having more equity allocation and less fixed income, and this effect can be achieved at the top asset-allocation level by allocating more to equities rather than overweighting credit inside the fixed-income allocation. Second, from the alpha perspective, the portfolio manager effectively has a levered pro-equity position on. Despite having positive expected return overall, however, it fluctuates with a high positive correlation to the equity markets.
Another solution that investors have gravitated towards is allocating to unconstrained bond funds that supplement their core fixed income. The unconstrained category typically holds zero or negative duration and is long credit risk in various forms. The result of adding this type of funds to fixed-income allocation is identical to short-duration and long-credit construct discussed above. Another popular solution in recent years has been allocation to private debt that effectively is another version of long credit with the added flavor of varying compensation (currently low) for the lack of liquidity.
The concept of portable beta
In our opinion, the solution to the skewed duration and diminished risk-reward of standard market benchmarks is portable beta. Portable beta is a portfolio comprising of long exposures to credit, inflation, convexity and duration that is tactically managed. Note that the portable-beta portfolio is not short duration. In contrast to popular short-duration/long-credit constructs, this portfolio is long risk premia across the board in fixed income.
This construct achieves multiple goals. First, it has positive expected return as all levers including duration contribute to returns. Second, it improves the risk-reward of the benchmark as it introduces an uncorrelated and diversified collection of risk premia. Third, this construct does not correlate positively to the equity markets.
Figure 2. The composition of portable beta in fixed income
Figure 2 shows a typical composition of the portable beta that we employ across various strategies. Regardless of our portfolio benchmarks (FTSE/TMX Canadian Universe, Short and Long Bond indices, J.P. Morgan Global Aggregate Bond Index, J.P. Morgan Emerging Markets Bond Index Plus and Bloomberg Barclays US Aggregate Bond Index), portfolios benefit from this collection of beta exposures as essential diversifiers. The allocations inside our portable beta exposures are managed tactically. This applies to credit, inflation and convexity exposures. Duration is then adjusted to counter-balance the other risk factors. We believe this is a superior solution to the poor risk-reward of current fixed-income benchmarks. Figure 3 shows how this all comes together to create a modern fixed-income portfolio.
Figure 3. Modern fixed-income design with benchmark replication, portable beta and portable alpha
Figure 4. Signature Tactical Bond Pool performance attribution as of October 5, 2017 (internal estimate)
Figure 5. Signature duration-sensitive fixed income product suite
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise indicated, the indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. First Asset Investment Management Inc., manager of First Asset Long Duration Fixed Income ETF, is an affiliate of CI Investments Inc.