Fund managers that take a flexible approach to credit investing have the ability to shift capital between regions, sectors and instruments on the basis that fluctuating macroeconomic cycles and interest-rate environments create opportunities in different places at different times. But while the ability to respond to fast-moving market developments is desirable, style drift is not. Like all investment strategies, flexible-credit funds must also stay true to their mandate.
Style drift happens when an active manager starts to move away from their stated investment strategy. In a siloed product - an emerging-market high-yield fund, for example - it is fairly obvious when this happens. But it isn't always so clear for a flexible-credit strategy designed to move across the fixed-income spectrum. Because of this, it is particularly important for managers of flexible funds to communicate to clients exactly what their current strategy and risk parameters are. At the international business of Federated Hermes, we have an open dialogue with clients to ensure they know exactly what our mandate is across our range of flexible-credit funds.
Avoiding danger areas - flexibly
The unanticipated shift in strategy - and subsequent implosion - of several high-profile funds in recent years means that style drift is high on the watchlist of many investors. But what is often overlooked is the fact that a rigid approach to maintaining style at all costs can be just as dangerous.
The issue becomes more pressing in a low-rate environment when investors are thirsty for income. This is because targeting yield often involves going down in credit quality by investing in more sub-investment-grade instruments, allocating capital to highly leveraged issuers or targeting illiquid assets that may offer the potential for higher returns - but with much more risk.
We believe that a flexible approach is beneficial because it enables managers to avoid the trap of blindly targeting riskier assets. The fixed-income universe has changed beyond recognition over the last two decades and allocating across the entire credit spectrum allows investors to access new types of instruments that have the potential to deliver income in a low-yield environment.
Flexibility does not mean that fund managers inevitably stray from their mandate. Instead, a more diverse toolkit means that they can tackle risk and uncertainty in more ways, taking advantage of new sectors and instruments and using options to protect against the downside.
Staying vigilant: risk analysis
Staying true to mandate also involves assessing risk. First, our Credit team monitors this by looking at the default risk of issuers and portfolio duration. The team then considers risk in a variety of different ways at the weekly barometer meetings, where bespoke, cross-sectional analysis is used to create heat maps which illustrate geography, sector and ratings exposure.
The team also discusses its responsibilities to investors on a regular basis. Rather than taking the chance that a fund manager may not immediately spot that they are deviating from their mandate, discussions within the team and at weekly meetings with sales representatives ensure that clients' needs and risk appetites are always considered.
In addition, our Investment Office continually monitors the funds' positioning to see how far they are deviating from their benchmarks in terms of style and risk. The Investment Risk team also sits down with the Multi Asset Credit Committee on a fortnightly basis to clarify whether proposed trades lie within a strategy's mandate.
And twice a year, fund managers are invited to the Portfolio Review Committee to provide an update on issues like the evolution of risk, style and factor analysis, liquidity and the structure of the team. These processes all mean that the Credit team works in tandem with our internal oversight bodies to ensure our portfolio managers stay true to mandate (see figure 1).
Figure 1. How we say true to our mandate
Source: Federated Hermes, as at January 2020.
Green shoots: integrating ESG
We believe that staying true to our mandate goes beyond just looking at credit quality. As the investment industry increasingly recognises what we have long championed - that environmental, social and governance (ESG) integration is important in credit analysis - there is a risk that not all strategies will live up to their green credentials.
At the international business of Federated Hermes, ESG analysis is integrated into the bottom-up research of all our investment teams and our credit analysts use quantitative ESG scores to consider whether investors are fairly compensated for the risks they are taking on. Central to the Credit team's belief is the understanding that poor ESG behaviours can lead to weakness in operating and financial strength, which can increase credit risk.
But we don't just claim to include ESG factors in all of our investment decisions: we have a Responsibility Office that ensures we do and supports our efforts to further develop this work. The team monitors ESG integration across all asset classes and strategies and discusses controversial names, recent newsflow or changes in company ESG scores with credit fund managers.
The additional oversight of the Responsibility Office is essential to making sure we stay true to our mandate - which is to guarantee that ESG risks are consistently considered throughout the investment process.
Living up to our responsibilities
A central aspect of the compact between fund manager and investor is the pledge to avoid style drift. We firmly believe that our flexible approach to credit investing does not give us a licence to veer away from our mandate. Instead, our regular dialogues with clients mean they are fully aware of any changes in strategy or positioning, while our internal oversight bodies ensure we stay true to our pledge to invest with conviction in liquid instruments, to integrate ESG into all of our investment decisions, and to always have investors' interests at the forefront of our minds.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
For professional investors only. This is a marketing communication. The views and opinions contained herein are those of the Credit Team at the international business of Federated Hermes, and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.
Author profile:
Andrew Jackson, Head of Fixed Income
Andrew joined the international business of Federated Hermes in April 2017 as Head of Fixed Income. He is responsible for leading the strategic development of the Credit and Direct Lending investment teams, and developing a multi-asset credit offering capable of accessing all areas of the global credit markets for pension funds and other long-term institutional investors.
Andrew joined from Cairn Capital, where he was Chief Investment Officer. In this role, Andrew was responsible for the development of the asset management business, which included designing new products and managing the investment teams, including strategy, portfolio management and research. He has managed assets across the spectrum of global credit and fixed income. He was previously vice president within the European credit structuring team at Bank of America and has held roles with Fitch Ratings and PricewaterhouseCoopers. Andrew holds a BSc degree in Mathematics & Theoretical Physics from Kings College London.
