As a tactical asset management firm, we seek to offer a full range of downside risk managed investment strategies, covering all parts of an investor's portfolio. We believe that controlling drawdown and smoothing volatility is a critical objective, as periods of capital loss often coincide with the need for liquidity (e.g. getting fired during a recession), which ultimately forces the realization of losses, eroding the capital base and damaging a portfolio's ability to recoup losses.
Market conditions in the past 30+ years have been favorable for traditional long beta exposure in fixed-income, providing significant total returns with little volatility. Historically, high and declining nominal interest rates served as a powerful return stabilizer within fixed-income. However, with rates now at all time lows, the stabilizing impact of yield is reduced – and even worse, with rates poised to rise, this factor may now serve as a source of capital loss.
We believe a tactical fixed-income approach is more relevant today than it has ever been before.
For seven years, the approach we've been known for – particularly in the tactical equity space – has been embracing cash as a valid alternative asset class when our momentum models identify a bearish outlook.
We do not believe this approach is necessarily applicable within the broad fixed-income space, and therefore our tactical fixed-income portfolios do not "go to cash" like our equity portfolios.
Fixed-income varies from risk free to risky.
Relative to other asset classes, equities tend to simply be varying degrees of "very risky."
Fixed-income, on the other hand, has varying degrees of risk. On the safer side, you have short-duration U.S. Treasuries, often the very definition of "risk free" within the market. On the riskier side, you have high yield bonds or emerging market debt.
But even long-dated U.S. Treasuries may be considered "high risk" in the right scenario. And that's because...
Fixed income has two betas instead of one.
Equities, broadly, tend to be sensitive to one thing and one thing alone: economic growth expectations.
Fixed-income, on the other hand, has two primary drivers: interest rates and credit spreads – both of which have a complex relationship with economic growth expectations and inflationary expectations.
That means instead of simply having a single sensitivity to dial exposure to, as we often do with tactical equity, we now have two. We not only have to determine the interest rate exposure we want, but also the credit exposure.
We embrace a momentum-driven approach for many asset classes because we believe that sensitivity to different risk factors are ultimately distilled into returns. However, in fixed-income, momentum is not always applicable because...
Income is a key component of total returns.
With fixed-income, investors can generate significant returns even if prices don't move. This means that income is a massive component of the total return.
According to Nuveen, from 1/30/1976 to 3/31/2014, income made up 93.3% of the Barclay's Aggregate Index's total return. Even in the low interest rate environment of 3/31/2009 to 3/31/2014, this number was still as high as 83.9%.
Below I have estimated the annualized yield (assuming no reinvestment and 0% return on cash) and price return of the iShares Core U.S. Aggregate Bond ETF (AGG) . On average, the magnitude of yield is 3.5x that of price return.
For fixed-income, the high relative magnitude of yield versus price return is true no matter the risk profile. Below I plot the same data for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) . Again, on average, the magnitude of yield return is 3.85x that of price return. In 2010 and beyond, the magnitude of yield has been 5.2x that of price return.
Of course, this relationship is largely environment driven. With the iShares 20+ Year US Treasury ETF (TLT) , in years with significant credit events ("flight to safety" – 2008, 2009, 2011) or significant interest rate events (2013, 2014), price return swamps yield. In "normal" years, however, the magnitude of yield was 1.8x that of price return.
As a point of comparison, here is the same graph for the SPDR S&P 500 Trust ETF (SPY) :
On average, the magnitude of yield is only 0.15x the magnitude of price return (ignoring the 2011 outlier). Being tactical in equities makes sense as the price return swamps the yield component in the short-run (though, dividend reinvestment over the long run accounts for a significant component of equity market total returns). So moving from equities to cash sacrifices very little of the total return profile on a relative basis between price return and yield.
Moving from fixed-income to cash-equivalents, on the other hand, can be incredibly detrimental to overall returns because the yield component is such a large piece of the return stream. While it may make sense in certain environments with certain instruments (e.g. long-dated treasuries in a duration driven environment or high yield in a credit driven environment), there are many environments when the potential yield sacrifice for price-return control makes little sense.
But perhaps most importantly...
People use fixed income for a variety of reasons.
Investors buy equities for growth.
Investors buy fixed-income for several reasons, including: capital preservation, diversification, and income generation.
Since equity markets cannot go up and down simultaneously, accessing growth and protecting capital are not objectives that are at odds with one another in a tactical equity portfolio.
The same is not true within fixed-income, where the decision to preserve capital and "go to cash" may be in direct opposition of an income-based need the investor has.
Therefore, while almost all tactical equity strategies are constrained to a "protect and participate" type mandate, a tactical fixed-income portfolio could focus on a variety of objectives.
A tactical fixed-income portfolio with a primary focus on income generation will likely look very different than one whose core objective is portfolio diversification – even if they both have a secondary objective of capital preservation.
Our approach to tactical fixed-income
So if we believe that fixed-income requires a unique approach to being tactical, how do we do it? Newfound offers two tactical fixed-income strategies with different core objectives.
The first is our Target Excess Yield (TEY) portfolio, an unconstrained fixed-income ETF strategy which aims to offer a yield at fixed levels above 1-3 year short-term U.S. Treasuries with minimum realized volatility. For example, if the current yield is 0.3%, our TEY +4% would target a 4.3% yield level and try to do so with a minimum volatility portfolio.
This portfolio seeks to satisfy income needs as its primary objective with capital preservation as a secondary objective. Therefore, this portfolio will not "go to cash" like our tactical equity strategies –nor will it use our core momentum models to selectively remove exposures. Rather, it will rely on the accuracy and stability of yield and covariance estimates in constructing a portfolio.
As yields and covariances evolve throughout time, the portfolio will tactically ratchet to a configuration in which it believes there is the most stability.
An Alternative to Core Bonds
The second tactical fixed-income portfolio we manage is our Total Return strategy.
In Total Return, we seek to create the "core bond" experience that investors have become used to over the last 30+ years – income, diversification, and capital preservation – without taking on the same interest rate risk as a traditional core bond portfolio.
To do this we use a three-sleeve, multi-strategy approach to target three objectives: income generation, portfolio diversification, and equity volatility hedging.
To meet the first objective, we employ our TEY +4% portfolio.
To hit the second objective, we utilize our Dynamic Alternatives portfolio, which provides exposure to a thoughtfully designed core of liquid alternative strategies. The portfolio also tactically introduces up to 50% equity exposure, seeking to take advantage of market tailwinds.
We currently utilize long-dated U.S. Treasuries to meet the third objective.
We then risk-balance these three sleeves so that each objective is equally represented in the portfolio.
In aggregate, we have a tactical fixed-income portfolio that will dynamically re-allocate to changing risk factors, but remains constrained in meeting the core objectives many investors look to fixed- income to achieve.
The opportunity cost of going to cash in fixed-income portfolios is often a non-starter as investors commonly expect more than "just growth" out of this allocation.
Year-to-year, on average, the relative magnitude of yield to price return in equities is approximately 0.15x. For core fixed-income, this number jumps to 3.5x, meaning that going to cash to mitigate price volatility can sacrifice a considerable opportunity in yield-based return generation.
While we believe that a tactical approach to fixed-income is more relevant today than it ever has been before, we cannot blindly apply the methods we utilize with equities and call it a day. Rather, we must thoughtfully consider the important differences not only between the asset classes themselves, but the objectives for which investors utilize the asset classes to make sure how we are tactical does not ultimately do more harm than good.
In Our Models
We rebalanced our Multi-Asset Income portfolio this week.
We added to our positions in bank loans, convertible bonds, and international dividend stocks.
We trimmed our positions in corporate bonds, preferreds, mortgage REITs, and long-dated U.S. Treasuries.
These changes were driven by a mix of changing momentum signals, leading to some asset classes being phased in (e.g. convertible bonds) and others being phased out (e.g. long-dated U.S. Treasuries).
Another significant cause of the re-allocation was the changing risk-adjusted yield profile of the universe. Specifically, our risk-adjusted yield measure for preferreds has dropped by 25% in the last month – moving it from by far and away the most attractive position to 3rd place, just behind bank loans.
In aggregate, the changes did little to our forward yield and volatility estimates (approximately 6.3% and 5.5% respectively), but dropped the weighted average correlation to 10-year U.S. Treasuries from 0.42 to 0.37. While a small change, it indicates the portfolio’s growing aversion to duration sensitive instruments.
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