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A lot of the strategies on the absolute-return spectrum are relatively new, which presents
a unique challenge for investors because looking at their past performance either yields very
little data or, quite frankly, yields glorious data no matter what manager you look at, because
the last five years certainly have been a great time to invest in fixed income regardless
of whether you were betting on interest rates or credit spreads.
So it's really important to make intelligent, forward-looking forecasts almost with respect
to which team really has what it takes to succeed in a very different kind of environment
for fixed income, and that really is the unique challenge. And one of the ways that performance
can be evaluated is not just on the basis of who has outperformed or not, but also on
the basis of running correlation numbers--correlation versus interest rate risk, correlation versus
credit risk--and really figuring out which approach most or best fits your portfolio
in terms of which risks you are trying to mitigate.
While past performance certainly is no guarantee of future results, an investor's or portfolio
management team's philosophy tells you a lot about how they're going to approach investing
into the future.
And one way to tease that out is to really ask them questions and listen to how do they
describe the portfolio management process. How do they describe the investment process?
How do did it come about? How did they come to the conclusion that a strategy like this
should be launched by their team? What sort of core competency or philosophy are they
looking to capitalize on that they think is unique to their knowledge? Listen to how they
describe the strategy? Are they focused on total return? Are they focused on maximizing
yield? Are they focused on keeping a lid on volatility? Can you really have all three
delivered in the same strategy? So really try to identify whether they have a true understanding
of what their goals are and how they're going to risk-manage them.
As I mentioned earlier, looking at past performance is not always going to be indicative of how
a team's going to perform in the future, because every single traditional fixed income team
has delivered pretty much fantastic results over the past five years.
So looking beyond that, and trying to understand what has been their experience with long/short
strategies to the extent that you believe absolute returns should take advantage of
strategies on the alternative side of the market as well as hedging strategies in the
portfolio. You want to be sure that your team has experience with those markets.
One way that an investment team should be able to demonstrate to you what they've been
able to deliver over and above just relying on the market-to-carry strategy is separating
their beta returns from their alpha returns in the strategy.
On the beta side of the portfolio, they're making basically a price versus value decision.
They're finding where they think value in the market is. They're putting capital to
work there and they're letting the market carry the capital through appreciation.
On the alpha side of the portfolio, ideally they're looking at lower beta or no beta opportunities
that are not dependent on market directionality and, therefore, hopefully really underscore
the investment management team's skill as opposed to just the market carrying their
strategy.
To some extent, in your evaluation process of these strategies, you want to be sure that
there is a strategic initiative behind growing the absolute-return expertise and that it
doesn't exist simply as a vault on to an existing strategy or a vault on to an existing process
that has worked for years just as a way to capitalize on a hot asset stream. You want
to see commitment from the firm in terms of the resources that this team has in terms
of how they're incentivized and in terms of how they're thinking they're going to maintain
their competitive edge into the future.
Ideally you would want to see this team incentivized or compensated for their absolute returns--for
their absolute performance--as opposed to relative performance versus a benchmark. This
should be a strategy that continues to work for your portfolio even in an environment
that's not necessarily benevolent for bonds. So you want to make sure that the portfolio
management team is compensated based on the absolute-return performance they deliver.
Because absolute return is a go-anywhere strategy, which includes going into the alternative
parts of the market and not only the traditional parts of the market, it certainly requires
tremendous resources to deliver the strategy successfully.
So in evaluating which manager is right for your portfolio, certainly take into account
what types of resources does the management team have? How many research analysts are
they capable of relying on? And, again, do those resources have experience on the alternative
side of the market?
We talked a lot about a non-constrained or specifically an absolute-return strategy being
able to go into a lot of different opportunities across markets. However, there should never
be confusion with respect to what types of risks your strategy is taking on. You should
know at all times exactly what the risk profile of the strategy is, what markets it's playing
in, and what environments it's going to do better or worse in? And that involves a fair
amount of transparency from the investment team, and you should absolutely demand that
transparency at all times.