Portable Beta In Modern Fixed Income Design
Authored By: Kamyar Hazaveh | Publish Date: 10/04/2017
Authored By: Kamyar Hazaveh | Publish Date: 10/04/2017
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 (See Figure1).
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 S&P/TSX Composite Index and FTSE/TMX Canadian Fixed Income Universe 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 that despite having positive expected return overall, 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.
The Composition Of Portable Beta In Fixed Income
Data Source: Bloomberg and Signature Global Asset Management
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.
Modern Fixed-Income Design With Benchmark Replication, Portable Beta And Portable Alpha
Kamyar Hazaveh is head of rates for the Signature Global Asset Management Team.
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