TIMPG members are encouraged to look for “pockets of opportunity” and also to look beyond duration to add value.
Still within the thick of an environment of near-zero-bound interest rates and continued low total returns, The NeuGroup’s Treasury Investment Managers’ Peer Group met in October 2013 to discuss ways to cope with these challenges. Among members, there was a conviction that the Federal Reserve and other global equivalents will remain committed to their low-rate policies for the foreseeable future, which leaves fixed-income investors with few options besides looking for yield in alternative places—a challenge for some members as boards, while expressing a desire for yield, also are expressing strong fears of adding risk. As a result, members are resigned to seeing this “new normal” of lower single-digit bond and equity returns persist for some time. Here are some further highlights from the meeting:
1) Risk factor versus asset class allocation. Members were encouraged to think outside of traditional asset allocation methodologies for risk factor allocation. They thus were challenged to look at asset allocation in a new way and substitute risk factors as the primary building blocks for portfolio optimization rather than asset classes.
2) Compliance. Looking internally, members asked: Is “good” good enough when evaluating a compliance system? Each member has a unique combination of systems that ultimately allow him or her to end up where they want to go. All members agreed that there is always room for improvement and no system is perfect.
3) Adding yield to the investment portfolio. Look for pockets of opportunity and look beyond duration to add value. Sponsor PIMCO suggested looking at curve positioning, selling volatility and credit moves.
4) Giving the investment manager flexibility. One member company tries a different approach to get external money managers to take more meaningful bets and implement best ideas. To best use external managers’ expertise we need to give them flexibility. The group examined the delicate balance between unconstrained mandates and benchmark mandates with limited flexibility.
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A New Way to Look at Asset Allocation?
Members were challenged to look at asset allocation in a new way and substitute risk factors as the primary building blocks for portfolio optimization rather than asset classes. PIMCO’s Sebastian Page presented the benefits of using risk factors instead of asset classes to guide investment allocations. Essentially, risk factor-based allocation means looking at the underlying risk profile of the investment security in terms of credit or interest-rate risk, for example, and diversifying based on such risk criteria and not by type of security. PIMCO’s model searches for uncorrelated risk factors and builds a portfolio based on this information. Using this approach, PIMCO showed us how its risk factor model would allow investors to de-risk their cash portfolios without sacrificing yield.
Key Takeaways
1) Risk Factor allocation is built for unexpected turbulence. The risk factor model can be compared to the structure of an airplane, built for turbulence. Similar to an airplane flight, at some point, you will hit turbulence. When you will hit it is unknown.
2) Downfalls of traditional asset allocation. Mr. Page pointed out flaws with current asset allocation methodology. Of most concern is the use of historical data and use of asset classes as a means of diversifying risk. Risk factors also tend to be more stable over time.
3) Viewing risk through a different lens. Asset classes are containers, and do not speak to all forms of risk. Sebastian used the example of corporate bonds. To fully understand the risk in a corporate bond, you must break apart the risk. First separate interest risk from the spread sensitivity—they react very differently to macro environment changes. For example, the corporate bond has both interest rate and credit risk. When economic fundamentals improve, the Fed will be more comfortable raising rates. This would be good for spreads but not for duration. Risk factor allocation looks for uncorrelated risk factors.
4) How do you reduce risk? A client posed a question to PIMCO on how they could de-risk without sacrificing yield and return. PIMCO challenged the client to do the following:
- Move away from historical data
- Rethink or focus on risk factors
- Think more dynamically
- Focus on preventing large losses.
Credit Markets in Good Shape, but Maturities are Getting Longer
Mohit Mittal, investment grade credit specialist, weighed in on the market. “The general health of the credit market is excellent,” he noted. “Corporations have delivered and have produced 4-5 years of decent earnings. The maturity profile of the market though has changed.” Corporations are issuing longer-dated debt. This does put some pressure on short-dated corporate paper. There are three areas of the credit market he likes. First, sectors that will benefit from the economic rebound: sectors such as homebuilder or home supplies will perform well. Second, sectors that have seen their asset prices hit hard such as banks; these sectors will continue to recover. Lastly, the US auto and energy sectors; these sectors have experienced significant growth outpacing nominal GDP.
outlook
Asset class diversification does not equal risk diversification. By looking at asset allocation in a different context, it is possible to reduce risk and continue to maintain a similar yield. Focusing on the large losses and exactly what is your threshold or tolerance for loss allows you to maximize the amount of risk you are willing to take.
Compliance and Frustration
The credit crisis reinforced the need to vigilantly monitor risk and compliance. But the agenda call revealed members’ frustrations with most systems not being up to the task. Is there a system out there that is better than Excel? One member got the discussion rolling by sharing how his company has used investment management software PORTIA and Excel to meet their needs. Other software used in the group includes Clearwater Analytics (about half the members of the group), treasury management systems and custodian platforms are also used. However the “proprietary” system and the choice of several members is Excel.
Key Takeaways
1) Compliance begins with a consistent interpretation and a thorough knowledge of the Investment Policy. This includes educating the investment directors, managers, traders, and analysts. As part of one company’s process these same individuals receive daily holdings and portfolio composition reports for high-level compliance assessment prior to day’s trading.
2) Stopping violations before they occur. In a perfect world the system will stop anything purchased that is out of compliance. Given the different cash flow volatility and security characteristics, this company has separate Investment Policies and compliance requirements for short-term and long-term portfolios. For the short-term portfolio, trades are entered into a trade blotter (Excel based). The trade blotter creates a warning if there is a violation as the trade (proposed) is entered. One of the vendors that Paychex uses is SS&C PORTIA. They provide software and services to investment management firms around the world. For the long-term portfolio policy guidelines are entered into SS&C PORTIA’s compliance module. The portfolio analyst enters trade information into this compliance system; the system will then create a warning if there are any policy violations.
3) Compliance violations: Should they stay or should they go? The group was evenly divided as to how to handle a compliance violation, with half of the members insisting on an immediate sale. The other half of the group will give the investment manager time to sell off the position. Factoring in the decision would be the liquidity of the issue and the magnitude of the compliance breach. A question was also posed to members about which rating to use when an issue has a split rating. Most members use the lower rating, with one saying his company uses the lower rating internally, but the higher externally with managers (we figure they know what they are doing).
4) Is the fox watching the hen house? One member noted that they are reviewing compliance and gate-keeping. One internal debate they have is whether the controller should monitor compliance as opposed to the investment group. This company decided that the investment group monitors compliance. However, the investment team will submit a report to controllership. One issue it faces, and echoed by others, is the lack of investment knowledge on their behalf.
outlook
We posed the question to members: Is “good” good enough when it comes to how members rate their compliance system? Very few members rated their compliance system as excellent, yet a compliance breach could mean real money lost. As in discussions on other systems (reporting, analytical, custodial), it was agreed that there is no perfect system, but members found that pushing your vendor to provide more or better information, combining methods or systems, or involving and educating other internal groups might be enough to move the needle from good to excellent when ranking your compliance system.
Giving the Investment Manager Flexibility
Are managers able to perform to their fullest potential or are they constrained too much by the clients they serve? Looking beyond the current benchmark orientation could lead to managers taking more meaningful bets. One member kicked off a session outlining how his company has moved away from traditional benchmarks with a group of managers to encourage them to think outside the box (or benchmark in this case).
KEY TAKEAWAYS
- Set up a horse race. The company wanted to get managers to take more meaningful bets and implement their best ideas. Over time, they observed a reluctance by investment managers to express their views away from their benchmark. The company also wanted to shift manager focus away from their benchmark and to market opportunities. For a group of managers, it took away the benchmark and instead gave the managers credit limitations and duration targets. The managers had the freedom to invest anywhere within these parameters and duration targets. In this company’s case the duration band was 3 to 5 years, and credit was investment grade. The company moved eight of its fifteen “core” managers into this new framework.
- Will the managers pile into the same idea? This was one of this company’s biggest fears. The desire was to encourage different behaviors and approaches, not end up with a pile of the same securities. As it turns out, this has not happened, although careful planning before choosing each manager to move into this “strategy” has helped. The member noted that the recent choppy (not one-directional) market has really shown each manager’s unique strengths, so he does believe the end result has been more diversity.
- Implementation and evaluation are critical. Without a benchmark to measure risk, new risk metrics had to be reviewed. The member noted his company reviews the risk-adjusted return from each of the managers. Strongdownside performance was also important in the evaluation. Each of the managers was then given a scorecard that showed where they fell in the investment lineup. Manager names and actual returns were confidential, but managers understood where they ranked. One member found that this strategy encouraged more dialogue with the managers, which turned out to be very positive.
- Buy in from managers was mixed. At first managers found the lack of a benchmark to be a bit troublesome, and there was some resistance. However, in general, most managers enjoyed having more freedom. PIMCO is currently a manager that one member company uses in this strategy. The company’s investment manager said that it definitely took some time to get used to the lack of a benchmark. However, he did agree that this strategy encourages more dialogue with the client and PIMCO has appreciated the flexibility.
OUTLOOK
Three years after moving to this strategy and after careful evaluation, the company is pleased with the results, as the strategy has provided solid out performance versus the managers still using the benchmark format and old benchmarks. The engagement level with the managers has increased, as the competitive nature of the strategy has really motivated the managers! At the end of the day though, notall managers will thrive in this framework, so careful evaluation is necessary.
Adding Yield to the Investment Portfolio
Given an expectation for continued lower rates and Bill Gross’s call for adding carry to the investment portfolio, members asked, “Where is the yield? Oh yes, and we don’t want to add duration, dip too low in credit and can’t use derivatives.” Led by moderator Paul Reisz, from PIMCO, panelists comprised of sector specialists from PIMCO discussed how there is no free lunch but perhaps there’s a blue plate special.
Key Takeaways
1) Structure of the portfolio is key. Mr. Reisz suggests one way to add yield depends on how you structure the portfolio. Investors are paying more than ever for the privilege of maintaining daily liquidity in their portfolios. As you will see from several of the suggestions, most are based on giving up some type of liquidity. Tiering of the portfolio allows the investor to provide liquidity, and you can purchase “self-liquidating” assets.
2) Sell volatility. As Bill Gross noted during his session, duration is not an effective tool in this market to add return. Andrew Wittkop, Treasury, agency and derivative specialist, felt the best way to add yield is by selling volatility. Unlike the total return fund that can use derivatives, corporate cash accounts cannot. Therefore he suggests buying callable agency issues, specifically 3-year with 3-6 month call dates. He likes this trade for two reasons. First, the 3-year is the optimal point for rolldown (sweet spot being the 1-3 year) and these are short but outside the 2A-7 space, so less demand. Andrew was less positive on selling volatility by investing in the mortgage market right now. He believes the market is expensive with the Fed buying bonds here (although this pace could slow early next year).
3) Buy Mexican Treasury bills. These bills offer extra yield, and PIMCO views the country as positive. To top it off, these issues are self-liquidating; need we say more? Another idea on this theme is Brazilian bank CP. PIMCO likes the country and again, this short is self-liquidating, so no need to worry about liquidity. If you are willing to give up liquidity, higher yields await you.
outlook
Understanding liquidity needs and being able to segment the portfolio by liquidity demands will allow investors to take advantage of short duration dislocations in the market as well as provide the investor an opportunity to invest in a broader universe of securities where they can trade off liquidity for yield. In this market picking the spot on the yield curve is as important as picking the actual credit. Have liquidity ready to sell and don’t forget the advantages of the “self-liquidating assets.”
CONCLUSION & NEXT STEPS
Bill Gross began his remarks at the meeting by asking members to be “mindful of evolution and the necessity to adapt.” This theme seemed to resonate throughout the sessions, starting with the first one, in which Bill challenged members not to be afraid of rising rates and to look outside the box for opportunities in what he expected to be a very flat interest-rate market.
The next meeting of the TIMPG will be April 22-23, 2014 at Dimensional. Topics to be discussed will include Portfolio Positioning, Benchmarks and Custodian Banks.