Boldly entering the alpha universe
Fixed Income as an Alpha generator The latest round of European legislation governing the retail fund industry, Ucits III, has enabled a framework for an ‘unconstrained’ approach to fixed income investment. This has resulted in the emergence of a new range of fixed income funds with the potential to generate higher alpha for investors. For fixed income fund managers, the ability to manage investments to a new ‘unconstrained’ mandate is highly significant because it enables them to venture beyond their traditional remit of government and corporate bonds into the vastly expanded and alpha-rich fixed income universe. What this means for investors and their advisers is that it’s time to re-think the role of fixed income and consider three important benefits:
- Potential scope to target high excess returns for fixed income market risk;
- Low volatility of the asset class; and
- Continuing low correlation with other traditional investments, such as equities.
What’s more, the new breed of alpha-seeking fixed income vehicles do not require a significant increase in the total amount of risk taken. This kind of approach is termed ‘active alpha’, or fixed income plus. Expanding opportunities to release Alpha Twenty years ago, a fixed income fund manager was typically limited to domestic government bond markets and really only had to make three key decisions; the direction of the market; the allocation to corporate bonds and the selection of individual securities. Today, however, with dozens of sectors and sub-sectors within global bond markets, thousands of opportunities exist and specialisation has become essential. Among the new strategies that the active alpha fund manager can deploy are high-yield (non investment-grade) bonds, active currency management, emerging market debt, mortgage- and asset-backed securities and, of course, active country management. The diversification benefit These new opportunities offer both the potential for improved returns and the benefit of low correlation both with each other and with traditional strategies. Under UCITS lll there is also greater freedom for the fund manager to use derivative instruments in pooled funds both to manage risk with precision and strengthen positions in those areas where managers have conviction. In addition, the risk management techniques available to managers today are much more sophisticated than previously and can help construct more robust investment portfolios. When diverse strategies with low correlation are skillfully blended in the portfolio, the combined risk can be less than the sum of its component parts. Managers with skill change these allocations tactically as the environment dictates to generate return. What is the benchmark? One appeal of a fixed income plus approach is that this higher added value approach can be imported on to recognised benchmark indices. For instance, investors may select a portfolio measured against the Sterling Broad Fixed Income Index, but this will not restrict the manager to invest purely in the UK market, as active returns can be sought from across a wider and potentially higher yielding opportunity set. One thing advisers should be aware of in selecting an active alpha fund manager is that in order to pursue this investment approach successfully in today’s fixed income markets, the investment team requires a combination of specialist expertise, risk management capability and a comprehensive global network. Only fixed income specialists have the scale and resources to offer this.
