Stuart Lingard, director of global fixed income product management at Franklin Templeton Investments, challenges the perception that active, less constrained fixed income means more risk.
For global bond investors, a benchmark tracking-based strategy can be an important part of a portfolio but focusing on benchmarks alone does give rise to certain problems: low yields, less diversification than might be expected and high sensitivity to interest rates.
The referendum vote to ‘Brexit' has only added to the sense that interest rates globally are likely to stay lower for longer. Even in the United States, the pace of any moves towards interest rate ‘normalisation' remains uncertain. Despite this, it seems clear that the path of official interest rates in the US will eventually be upward from here.
Strategies that don't tightly track indices can invest in securities similar to those contained in the aggregate benchmark, but will often invest selectively in assets such as emerging markets, leveraged bank loans or high yield in order to enhance the yield and manage risk. Most people are familiar with the argument that assets like emerging markets and high-yield credit offer better potential returns, but will also consider these assets to be risky, especially compared with a portfolio that mirrors the aggregate benchmark. However, analysis of the data tells a slightly different story.
Here we have analysed the risk and yield characteristics of two hypothetical asset mixes. The first is a mirror of the Barclays Global Aggregate benchmark. The second serves as a proxy for a diversified, less constrained investment strategy: While it contains a significant weighting in assets that mirror the benchmark, it also contains weightings in non-core assets - local- and hard-currency emerging-market sovereigns and high-yield credit. By looking at their comparative duration, value-at-risk and yield-to-worst metrics, we can see where the diversification into non-benchmark assets has improved the risk profile of the benchmark-based asset mix.
The addition of the non-benchmark asset classes has resulted in slightly shorter duration for the diversified, less constrained asset mix, but more importantly exhibits improved yield-to-worst characteristics, suggesting a stronger risk/return profile. Though this mix does exhibit a slight increase in value at risk, this is small, and arguably is more than compensated for by improvements elsewhere. It is also important to note that this hypothetical diversified asset mix does not take into consideration tactical asset allocation, active currency management or derivatives strategies that could also be part of a less constrained fixed income strategy.
The improvements were largely due to the asset mix relying not just on the direction of interest rates for yield, but also credit spreads, global exposures and other factors. A less constrained or unconstrained strategy offers greater diversification and, consequently, greater ability to manage risk from having a broader investment mandate than a benchmark-tracking strategy.
Today's low-yield and uncertain rate environment puts at risk fixed income programmes with asset allocations that adhere too closely to core benchmarks, making them vulnerable to rising rates and/or loss of portfolio value from low returns and lack of diversification. While we believe that benchmark-tracking asset allocations can still be a vital part of any pension scheme's portfolio, shifting some focus towards active management through a less constrained fixed income strategy can better position against these pitfalls. Such portfolios can prove less vulnerable to rising rates, have increased yield potential and improved diversification.
Stuart Lingard is director of global fixed income product management at Franklin Templeton Investments
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