Download Unconstrained fixed income: generating consistent returns

RUSSELL INVESTMENTS
Unconstrained fixed income:
generating consistent returns
David Millen, Director, Investment Communications, EMEA Investment Division
INTRODUCTION:
Unconstrained Fixed Income (UFI) strategies can provide consistent returns with
moderate risk, over shorter timescales, and with the added benefit of income
generation.
We believe UFI is a compelling approach for investors whose timescales and
tolerance for big drawdowns are limited. In today’s low return and potentially
volatile environment, strategies that can generate growth and income
consistently over shorter timescales are scarce and valuable.
The appeal of UFI spans all investor types. UFI can play an important role for
DB and DC pension plans, charitable foundations, individual investors, and
multi-asset growth funds.
To implement UFI successfully, investors need access to an array of
sophisticated skills. These include a comprehensive understanding of the
opportunity set, flexible portfolio construction that adapts to changes in the credit
cycle, and specialist management insights across the full range of credit,
currency and interest rate opportunities.
To address this need we have launched a new Unconstrained Bond Fund
(UBF)1 that targets returns of LIBOR + 3% per annum on a three-year timescale,
with expected volatility of 6%.
UBF benefits from:

Russell Investments’ disciplined investment approach that combines
capital markets insights, tactical asset allocation, manager selection, and
factor capture in one integrated and dynamic process, on a global scale

Differentiated portfolio construction that harnesses the return and
income-generating power of short dated BB2 rated credit, whilst
managing credit risk through diversification, and enhancing returns
through opportunistic strategies

A multi-asset management style emphasizing dynamic allocation,
effective diversification, credit risk mitigation and best of breed managers
and strategies across all segments of the fixed income markets
In the first part of this paper we set out our approach to UFI and in the second
part we describe UBF.
1
Inception date of the new strategy was 7th September 2016
2
Bonds rated BB by S&P (equivalent rating Ba by Moody’s) are the highest-rated non-investment grade bonds.
Russell Investments // UFI: generating consistent returns
DECEMBER 2016
Part 1 Seeking consistent returns from fixed income investing: our
Unconstrained Fixed Income approach
1.1 The role of Unconstrained Fixed Income
Unconstrained Fixed Income (UFI) investing focuses on delivering returns for a given level
of risk, free from the restrictions of a benchmark. That freedom creates the opportunity to
invest more selectively across a wider range of opportunities. It also creates wide-ranging
flexibility to manage credit, interest rate and currency exposures.
UFI is part of a wider multi-asset investing trend that focuses on a given investment
outcome, and that uses a wider opportunity set to achieve that outcome. We see UFI as
part of a spectrum of three multi-asset solutions. Multi-asset growth investing targets the
highest returns but carries the most risk. Multi-asset credit targets a lower risk/return part
of the spectrum, and is fully exposed to credit risk and the resulting drawdowns. UFI has
the lowest risk/return profile of the three, and aims to mitigate credit risk and drawdowns
through diversification.
UFI can invest
selectively across a
wide range of
opportunities, and
has wide-ranging
flexibility to manage
credit, interest rate
and currency
exposures
1.2 Guiding principles determine our investment approach
Understanding the drivers of added value and the properties of various asset types is key
to multi-asset investing. These insights, combined with proper articulation of a return and
risk target, help us to identify the best combination of strategies to engage with.
For UFI mandates, we apply the following beliefs that shape the way we design, construct
and manage portfolios.
We believe credit
should be the core
return driver
Figure 1: UFI investing – our beliefs
Source: Russell Investments. For illustrative purposes only
1.2.1 Credit spread as a core return driver
Over the last twenty-five years credit assets have produced comparable returns to equity,
but typically with less volatility. The chart below shows the performance of a range of
asset classes (including global equity) over the period 31st December 2002 to 31st
December 2016. The investments highlighted inside the orange dotted circle are wellknown components of the credit universe and together fall on or near the efficient frontier
of risk/reward combinations. Each of these credit asset classes has their own distinct
characteristics, performance patterns and cycles; hence they can be used in combination
to create highly efficient portfolios.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
Credit assets have
produced comparable
returns to equity, but
typically with less
volatility
DECEMBER 2016
2
Chart 1: The wide range of fixed income offers attractive absolute return
characteristics
10%
Hard EMD
ANNUALISED RETURN
8%
High Yield
BB 1-5
High Yield
6%
Real Estate
MSCI World Net
Loans
LCCY EMD
4%
2%
LIBOR
0%
0%
5%
10%
15%
-2%
-4%
20%
25%
Commodities
VOLATILITY
Source: Bloomberg – 31/12/2002 to 31/12//2016 – USD returns.
1.2.2 Crossover credits and short duration offer efficient access points
For investors seeking consistent returns, the standout category is short-dated BB 1-5 year
High Yield (HY), highlighted in the chart above in orange. This type of security typically
exhibits not only the lowest risk of the credit classes, but also attractive returns. A number
of third-party manager studies 3, and our own manager research experience, demonstrate
that bonds rated below/on the cusp of Investment Grade (IG) have some of the best
performance consistency and highest Sharpe ratios. Over the last 10, 15 and 20 years,
bonds in this ‘crossover’4 space have achieved at least 90% of the returns of the S&P 500
with less than half the risk. Specifically, we believe that HY issues rated BB and with a
maturity of 1-5 years represent the ‘sweet spot’ for credit.
For investors seeking
consistent returns,
the standout category
is short-dated BB 1-5
year High Yield
In terms of risk, 1-5 year credits have a relatively short time to maturity, and thus any mark
to market effects are shorter term in nature. Investors in the BB space have the further
cushion of a high running yield to absorb any losses from defaults. Similarly the yield
cushion will help absorb bond price losses during the journey to maturity, so we believe
investors will typically at least break-even51in the short-term.
At Russell Investments we have a specific focus on 1-5 year BB corporate credit, which
we call the core yield engine. We believe this core engine is a highly efficient way to
access the credit premium. (This is also one of the most liquid parts of the market, at a
time when market liquidity is stressed).
Using the core engine in a UFI portfolio results in lower sensitivity to interest rates than
traditional aggregate fixed income strategies. The core credit engine is in the ‘sweet spot’
with a high Sharpe ratio: slightly less return than traditional aggregate strategies, but
much less risk. The short duration positioning mitigates the risk from rising yields and
losses from borrower defaults.
The chart below illustrates this effect in operation, with the information ratio from BB
credits rising sharply as their time to maturity shortens.
We have a specific
focus on 1-5 year BB
rated corporate and
structured credit - our
‘core yield engine’ for
generating consistent
returns
3
Most recently, Arif and Brownell, August 2015 ‘Crossover Bonds: Catching the Rising Stars’.
Specifically, the cross-over space comprises the lowest investment grade/highest non-investment grade
ratings (S&P BBB/BB, Moody’s Baa/Ba). Bonds that cross this well-defined boundary between investmentgrade and non-investment grade status encompass qualities of both segments.
5
The ‘break-even’ point is w here a bond price falls to a level w here the total return equates to zero.
4
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
3
Chart 2: Targeted credit risk: the core yield engine information ratio
Source: Russell Investments schematic illustration: excess return of BB 1-5 over HY universe/volatility.
Over the course of a market cycle we believe investments in this space should deliver
returns equivalent to LIBOR+3%. There will be setback periods when markets sell off,
however the short duration and pull to par should generate a fast recovery, and historically
outsize returns have followed shortly after big drawdowns.
This is illustrated in the chart below. This shows the performance experience over the last
20 years. The annual returns are shown by the light blue bars. The cumulative returns are
shown by the ascending lines.
Chart 3: Core yield engine: return similar to equity and high yield but less risk
450%
140%
400%
120%
350%
80%
250%
60%
200%
40%
150%
20%
100%
0%
50%
0%
-20%
HY 1-5 Total Return
HY Total Return
CALENDAR YEAR RETURN
100%
300%
TOTAL RETURN INDEX
Over the course of a
market cycle we
believe investments
in this space should
deliver returns
equivalent to
LIBOR+3%
S&P 500 Total Return
Source: Russell Investments as at 31st December 2016.
This period includes the tail-end of the 1990s’ equity bull market culminating in the tech
boom and bust, the subsequent market recovery, then the 2008 GFC, leading to the
current phase of Central Bank intervention and extraordinary policy measures. All-in-all,
the period covers a wide range of investment environments.
The annual year returns are predominantly worthwhile positives, averaging over 6% per
year across the whole period. There are two setbacks during the period – a relatively
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
There were two
setbacks for credit
during 1997 through
2016 – although in
each case the
negatives were more
than recovered in the
following year
DECEMBER 2016
4
minor -3.5% in 2002, and a more serious -16.2% in 2008. However, in each case the
negatives were more than recovered in the following year, with 2003 and 2009 both
posting outsize returns.
1.2.3 Diversifiers and drawdown management are critical
Credit sectors exhibit cyclical returns and a strong correlation with equity markets. Even
with the greater risk-adjusted returns from the core yield engine, meaningful sell-offs can
occur from time to time.
Chart 4: High Yield Drawdown History
DRAWDOWN EXPOSURE (%)
0%
-5%
-10%
-15%
-20%
-25%
Drawdown
Source Bank of America Merrill Lynch 1-5 Year BB Cash Pay High Yield Index: Historical data from
December 1999 to December 2016. Draw downs illustrate the extent of each fall from the previous highest
closing value.
For those investors that need consistent returns over a relatively short timescale, at this
stage of the cycle reliance on the credit premium alone may test their patience.
Traditionally government bond duration was an attractive way to diversify credit, but the
long-term performance expectation for government bonds is currently poor. Hence, a welldesigned UFI product needs to incorporate additional features to achieve better
performance consistency, notably diversifiers, return-enhancing opportunistic investments,
and dynamic allocation (including allocations to cash).
To mitigate the
impact of potential
credit drawdowns,
investors with shorter
timescales need
diversification, and to
enhance returns they
need opportunistic
investments
1.2.4 Opportunistic trades are important to driving returns
Opportunistic trades are important to drive return. The core yield engine provides
attractive returns but is subject to episodic setbacks. Adding diversifiers to credit usually
creates an opportunity cost, because it is hard to find a range of effective diversifiers with
equivalent return potential. Hence we need to augment returns as and when opportunities
arise, by allocating dynamically to high conviction trades with better return potential.
1.2.5 Dynamic management of the cash allocation is crucial
Dynamic management of the cash allocation is crucial to risk mitigation and to maximising
flexibility in timing new investments.
Risk premia are subject to cycles, and the pay-off for taking risk varies substantially over
time. During periods when risk premia are low, holding cash can provide valuable
flexibility. After decades of strong market returns, investors have become accustomed to
benefit from full market exposure and to discount the risk of setbacks. Recently, returns
have been enhanced and volatility artificially suppressed by the monetary policies of the
world’s central banks. In fact, markets have no obligation to provide continuous positive
returns, either from beta or alpha strategies. When valuations are high, risks become
more elevated and volatility is likely to spike. On that basis, we expect more frequent
market volatility events of the kind we experienced in early 2016. Holding cash in reserve
provides valuable optionality for outcome-oriented investors, as volatility events create
opportunities to buy into markets at more attractive valuations.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
5
1.3 Who can benefit from an UFI strategy and why?
A compelling UFI strategy offers consistent returns, moderate risk, and income
generation. Consequently, it can play an important part in both institutional and retail
investor portfolios. It can also play a flexible role in multi-asset portfolios.
For Defined Benefit (DB) pension trustees, UFI addresses two specific needs:

A means of diversifying away from traditional risk premia and longer-term growth
assets in pursuit of greater performance consistency

A return-generator well-suited to the de-risking phase of the DB pension journey
and to the problems of a negative cash-flow profile. In these cases, UFI offers
investors with lower risk tolerance an alternative to multi-asset growth and multiasset credit strategies
UFI can play an
important part in both
institutional and retail
investor portfolios. It
can also play a
flexible role in multiasset portfolios
For those Defined Contribution (DC) pension plan members, and for those individual
savers, that have shorter-term time horizons and lower tolerance for losses, UFI can be a
valuable strategy. These investors need to be prepared to accept meaningful levels of risk
over a 3-year timescale; however a well thought-out UFI strategy of the kind we have
described will fall with credit markets but should recover quickly. This strategy’s risk/return
trade-off is likely to represent the sweet spot in the spectrum of pooled retail funds. For
individuals paying retail fees, it can generate consistent returns net of charges. It is also
well-suited to income-seeking investors, generating a significant yield premium over
cash and Treasuries.
For charities and foundations UFI’s reliable income generation and lower-risk profile
can be a good fit with their ongoing spending commitments.
Lastly, in order to meet their return objectives in a late-cycle environment, multi-asset
growth fund investors need to diversify away from traditional asset classes into
strategies that can generate worthwhile returns on a shorter timescale and with good
downside risk characteristics. Credit strategies generally have been popular with multiasset funds for some time; increasingly however as traditional risk premia become less
attractive, the lower-risk attributes of UFI are becoming more compelling in this space.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
6
Part 2: Russell Investments’ approach to UFI investing: introducing our
new Unconstrained Bond Fund (UBF)
2.1 Design, Construct, Manage – our process for unconstrained investing
In Russell Investments’ portfolio management process, we design each product to target
specific portfolio objectives, construct a real-world portfolio of strategies and exposures to
execute that objective and manage the portfolio dynamically to seek to achieve targeted
portfolio outcomes.
2.1.1 Design – managing an unconstrained bond portfolio for maximum return
consistency and sustainable income generation
In the design phase, we create an investment roadmap aimed at a specific investor need.
First we establish clear objectives, then we use our capital markets insights – expressed
through our strategic beliefs – to model strategic asset mixes and to create the framework
for ongoing management of the product.
One of the overriding needs for investors now is consistent return generation to create a
reliable stream of income with moderate risk. We have set a performance target for UBF
of LIBOR+3% over a 3-year horizon, with expected volatility of 6%.
In our portfolio
management process,
we design each product
to target specific
portfolio objectives,
construct a real-world
portfolio of strategies
and exposures to
execute that objective,
and manage the
portfolio dynamically to
seek to achieve
targeted portfolio
outcomes
The design concept for UBF is highly dynamic, but founded upon our guiding principles.
The primary part of the portfolio is the core yield engine, which over time will produce a
reasonably consistent return and yield. The risks arising from it are managed with a book
of diversifying alpha and factor strategies. Returns are augmented from time to time
with flexible investments from the opportunistic book.
In the same way that the best multi-asset growth funds are always alive to opportunity and
allocate dynamically to capture opportunities as they arise, UBF is designed to be very
flexible in allocation terms and ready to move quickly as markets change. The design
concept therefore builds in very wide allocation ranges for the principal components, as
we show below:
Figure 2: Product Profile
We have set a
performance target for
UBF of LIBOR+3%
over a 3-year horizon,
with expected volatility
of 6%. UBF is designed
to be very flexible in
allocation terms and
ready to move quickly
as markets change
Source: Russell Investments. For illustrative purposes only. Not to be relied upon w hen making investment
decisions.
Similarly, UBF’s overall portfolio duration is designed with a wide range of 0-8 years.
Typically, we anticipate portfolio duration of 1-4 years. In early-cycle conditions UBF may
go longer than this, conversely in late-cycle/high valuation conditions it may go below 1
year.
UBF is designed to maximise performance consistency. Inevitably however, given
changing market conditions and the wide range of resulting portfolio characteristics, there
will be some variability. In early cycle/more attractive conditions we expect UBF to achieve
higher absolute returns than in late cycle/higher valuation conditions.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
7
Income is an important component of return for many investors. Consequently we aim to
include an income-distributing share class in UBF that pays away coupon income
quarterly.
2.1.2 Construct – combining the right components in UBF
In the construct phase we create the actual UBF portfolio, using carefully chosen
components to achieve the performance target, given current market conditions. These
choices are determined by three factors: our strategic beliefs derived from our capital
markets research, by our manager research insights, and by our ability to create custom
smart beta portfolios.
The Fund incorporates our best research ideas, and includes both our highest conviction
third-party managers and custom smart beta portfolios. Currently we have selected the
mix set out in the following table. We describe each component below:
Table 1: UBF manager mix
STRATEGY
MANDATE
UNDERLYING
ASSET
ALLOCATION
%
DERIVATIVE
OVERLAY
EXPOSURE
%
Core Yield
Post Advisory Group: US credit specialist
25%
—
Core Yield
Hermes Investment Management: credit
manager w ith global expertise
25%
—
Opportunistic
Putnam Investment Management: mortgage
bond and mortgage prepayment risk specialist
15%
—
Diversifier
H2O Asset Management: volatility strategies
expert
15%
—
Diversifier
Russell Investments: real yield strategy
—
15%
Diversifier
Russell Investments: currency strategy
—
15%
Cash
20%
—
Total Exposure
100%
30%
In the construct
phase we create the
actual UBF portfolio.
The Fund
incorporates our best
research ideas, and
includes both our
highest conviction
third-party managers
and custom smart
beta portfolios
Source: Russell Investments. For illustrative purposes only.
2.1.2.1 The core yield engine
Our research identifies credit as a valuable return driver and short dated BB HY as the
sweet spot. Therefore this will be the core focus area for UBF in the first instance. Our
actual allocations will vary depending on market dynamics and the relative merits of
competing ideas in the diversifying and opportunistic segments.
This is an area that requires specialist stock-picking skills, experience, and research
excellence. We use one or more third-party managers in this space. We will typically
favour firms with rigorous bottom-up fundamental credit research and analysis, strong
risk-management and downside protection skills.
We have currently selected two managers with experience of running shorter duration and
higher quality portfolios:
Post Advisory is a Los Angeles-based boutique focused on US HY investments. The
boutique is an independent subsidiary of Principal Global Investors. The current team has
been in place since 2012 and has demonstrated a solid blend of bottom-up fundamental
analysis and active sector rotation. This, coupled with a defensive bias in the portfolio, has
led to excellent returns for their flagship portfolios. Furthermore, Post has experience
running shorter duration and higher quality accounts.
Hermes is a London-based asset management firm wholly owned by the BT Pension
Scheme. The credit team at Hermes provides an excellent complement to Post as they
have a truly global footprint. They also have experience managing short duration and
higher quality mandates, and add further value by their skill in implementing via both cash
and credit derivatives.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
Our research identifies
credit as a valuable
return driver and short
dated BB HY as the
sweet spot. Therefore
this will be the core
focus area for UBF in
the first instance. Our
actual allocations will
vary depending on
market dynamics and
the relative merits of
diversifying and
opportunistic ideas
DECEMBER 2016
8
2.1.2.2 The opportunistic allocation – accessing the high-risk end of fixed income
Different segments of the fixed income markets can generate significant returns at various
times. UBF will not have permanent exposure to credit segments outside the core yield
engine. Instead allocations will be made to individual segments, either when the
risk/reward balance is tilted to the upside or when there is a strong portfolio construction
reason to allocate.
Currently we have identified an opportunity with US mortgages. Our research team has
identified Putnam’s mortgage strategy as an attractive investment opportunity for the UBF
portfolio, as this provides exposure to two areas that we believe offer attractive return and
diversification properties: mortgage credit and mortgage prepayment risk. This strategy
would be expected to benefit from the current valuation opportunities in residential
mortgages and Commercial Mortgage-Backed Securities (CMBS). We expect the Putnam
strategy to add further value through mortgage prepayment-sensitive securities, which
benefit from a stable or rising rate environment creating excellent diversification
properties.
Putnam have extensive expertise in managing both mortgage credit and mortgage
prepayment securities. They have the quantitative infrastructure to exploit mispricing in
both markets, which is a combination of skills that is uncommon.
2.1.2.3 The diversifiers
The diversifying components fall into one of four categories:
1. Currency and interest rate factor strategies
2. Targeted alpha strategies
3. Duration management
4. Liquidity management
Currency and interest rate factor strategies
The first category harnesses our strategic beliefs regarding the risk premia available in
currency and government bond markets. Specifically:
• We believe currency can generate higher returns than cash through the use of
systematic strategies. The currency return sources are carry, valuation and trend.
The diversifying
components fall into
one of four
categories: currency
and interest rate
factor strategies,
targeted alpha
strategies, duration
management and
liquidity
management
• We believe that bonds issued by sovereign countries with higher real [inflation-adjusted]
yields have a greater likelihood of outperforming those with low real yields.
We exploit these factors through our custom smart beta portfolios using currency forwards
and bond futures respectively.
Targeted alpha strategies
We have identified a long volatility portfolio as a strong diversifier to the core yield engine.
Long volatility strategies seek to use option strategies that perform well in periods of rising
volatility. These periods of rising volatility also tend to occur when credit strategies come
under pressure, thus long volatility strategies are excellent diversifiers.
We have hired H20 Asset Management to manage our long volatility exposure. H2O is an
accomplished volatility manager. The strength of their macro views allows them to
understand where the option market is presenting true valuation opportunities. They also
look for opportunities in volatility markets across all of equities, currencies and bonds. This
gives them an unusually wide perspective relative to other volatility managers, and helps
them identify more alpha-generating ideas, which is critical for the success of these
strategies.
Duration management
Duration management allows us to alter the balance of risk in the Fund by adjusting the
exposure to the term premium. We manage this exposure directly through a futures-based
interest rate overlay. The Fund may also employ other overlays, for instance to manage
currency risk.
Liquidity management
Liquidity management gives the Fund additional flexibility. Holding cash can provide
valuable optionality. At 31st December 2016, UBF’s liquidity reserve was approximately
20% of Fund assets. This unusually high level reflects both the prevailing rich level of
valuations, and the risks associated with a change to Central Banks’ policy support for
bond markets.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
In the manage
phase, we
dynamically manage
the portfolio using a
combination of
specialist resources
and skills
DECEMBER 2016
9
2.1.3 Manage – adapting UBF to changing conditions
In the manage phase, we dynamically manage the portfolio using a combination of
specialist resources and skills. These include:
• Our up-to-date research insights into third-party managers and fixed income strategies
• Our strategists’ insights into capital market dynamics, allied with
• Our fixed income analysts’ appraisal of the relative attractiveness of the principal subsegments of the credit markets.
2.1.3.1 The importance of specialist manager research
With such a wide opportunity set available for the Fund, we have specialized our fixed
income research team to align with the principal sub asset class categories. Each member
of the team has a specialist responsibility, ranging across local currency emerging market
debt, US mortgages and prepayment securities, leveraged credit and convertibles among
many others.
These specialist skills allow the analyst to play a role not just in identifying skillful
managers, but also identifying strategies that work well together, and being sensitive to
the best time to deploy such strategies, thus fully integrating our industry leading research
capabilities into the portfolio management process.
To this end, our analysts ask five key questions when analyzing a strategy, only one of
which is “Does the manager deliver alpha?”
Figure 3: Manager Research - the 5 critical questions
Our specialist
manager
researchers do not
simply identify skillful
managers. They aim
to find strategies that
work well together
and to determine the
opportune timing to
incorporate a new
strategy
Source: Russell Investments. For illustrative purposes only.
Our analysts answer these questions by conducting manager research and monitoring, as
well as capital market analysis on their subsectors. The two activities are symbiotic: strong
detailed capital market knowledge leads to greater insight on how a manager has added
value, while constant contact with managers with multiple strengths and view-points gives
us broad perspective on the drivers in the market.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
10
2.1.3.2 The importance of a disciplined investment process
Credit returns go through cycles. To maximise consistency of returns we need to stay very
aware of market conditions and to manage UBF’s strategy and manager mix effectively
through the credit cycle. In order to do so, we need both a robust process for analysing
market drivers and a fixed income team that is fully aligned with that process.
Our process revolves around three building blocks – the business cycle, valuation and
mark et sentiment (as measured by momentum and other technical factors) – and three
investment horizons – strategic, dynamic and tactical. In this cycle, valuation and
sentiment (CVS) process, the importance and interaction of these three fundamental
market drivers differ for each time horizon. We believe that cycle and sentiment matter
more than value over the short-term, and that value matters most over the longer-term.
This structured decision making process helps minimise behavioural biases, focus debate
on the right issues and create clarity in decision making. The output from this process
gives clear signals indicating a hierarchy of relative preferences across the main asset
classes.
Our investment
process revolves
around three building
blocks – the
business cycle,
valuation and market
sentiment (CVS) and
three investment
horizons – strategic,
dynamic and tactical
Our strategy team provides asset class views across all capital markets, including fixed
income, equities, alternative investments and currencies. The team includes eight senior
strategists based in four different locations across EMEA, the Americas and Asia Pacific.
Drawn from a variety of different backgrounds, team members have previously worked for
instance at the US Federal Reserve, one of Europe’s leading sovereign wealth funds, and
some of the top global investment banks.
Our fixed income research team is unique in the market in that it not only researches the
best strategies to implement, but also provides capital market research on the various
fixed income subsectors. This, combined with the top down strategy input, gives a
comprehensive view on relative preferences across sectors and subsectors.
The inputs from the fixed income research team and the strategy team are wrapped
together through a regular cycle of meetings in order to generate quality decisions.
2.1.3.3 Dynamic management through the credit cycle
With the help of these inputs, we aim to anticipate moves in the credit cycle, and
dynamically manage UBF’s asset mix to:
•
mitigate downswings by de-risking into cash, Treasuries and uncorrelated returnseeking diversifiers (such as currency and real yield strategies, and specialist
manager strategies)
•
enhance returns by taking positions opportunistically in higher-yielding fixed
income classes (longer duration HY, EMD, convertibles, non-agency mortgages,
bank capital)
•
actively manage the asset mix within broad parameters
We dynamically
manage the asset mix
to mitigate credit
downswings and
enhance returns
The following chart provides a schematic of the progress of the credit cycle and the likely
positioning of the core yield engine at each stage. Opportunistic trades will be allocated as
and when they are identified.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
11
Figure 4: Dynamic Allocation: Evolution through the cycle
Cycle overextending:
Spreads through long
run averages, defaults
low. Leverage building.
Yield engine 40-50%
Capitulation
Spreads extremely wide,
economic fundamentals
very poor.
Yield engine 50-70%
Growth and Stability
Spreads: average
Yield engine 40-60%
Recovery
Spreads wide,
fundamentals improving
Yield engine 50-60%
Source: Russell Investments. For illustrative purposes only.
2.2. Why Russell Investments?
Russell Investments combines multiple skillsets across capital markets research,
investment strategy, asset allocation, factor research, manager research, trading and
implementation. We harness those skillsets to provide a total outsourced capability in
designing, constructing and managing bespoke multi-asset portfolios.
Our 30 years’ experience has led to a very differentiated way of managing unconstrained
fixed income portfolios, specifically:
• Seamless integration of our investment process – We combine capital market
insights, tactical asset allocation, manager selection, and factor capture in one
integrated and dynamic process, on a global scale.
• Leverage strategic insights – We leverage our understanding of capital markets to
identify risk premia and to understand their behaviour over time. The resulting strategic
beliefs underpin the way we design, construct and manage UBF.
• Blend alpha and beta using leading specialists – We use a best-of-breed approach
to hire the leading specialist third-party managers in each credit segment. We
complement these managers with non-correlated systematic strategies in areas where
alpha opportunities are not cost-effectively exploited by managers, and with
opportunistic strategies to enhance returns.
2.3. Why UBF?
UBF draws on the complete array of Russell Investments’ skillsets to address the needs
of today’s investors. Its key features include:
• Total Return approach –Target: LIBOR + 3% gross of fees with 6% expected volatility.
• Lower sensitivity to interest rates than traditional aggregate fixed income strategies.
The core credit engine is in the ‘sweet spot’ with a high Sharpe ratio: slightly less return
than traditional aggregate strategies, but much less risk. Short duration positioning
mitigates the risk from rising yields and losses from borrower defaults.
• Multi-asset management style, featuring dynamic allocation and effective
diversification across best of breed core yield, opportunistic and diversifying strategies.
• Real-time management by Russell Investments’ bond specialists, to manage risk
exposures to credit and term premia, and to monitor third party managers.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
12
Appendices
Appendix 1 Biographical Notes
Adam Smears, CFA
Head of Fixed Income Research, Investment Division
Undergraduate degree in Classics and History, McGill University in
Montreal 1997; CFA. 2001
Adam Smears is Head of Fixed Income Research at Russell
Investments. Adam is the lead PM of the firm’s UFI strategies.
Before joining Russell Investments, Adam spent 9 years at Skandia
Investment Group where his most recent duties included running
the investment research group as head of investment research,
covering all asset classes.
From 2004 onward Adam was responsible for the fixed income
research team and was also the lead PM for the stronglyperforming Skandia Strategic Bond Fund, which was ranked Bronze
by Morningstar/OBSR. Adam also worked at Fidelity and RBC
Dominion Securities.
Appendix 2
Chart 5: Backtest performance
Peer-relative returns
Source: Source: Russell Investments as at 30 September 2016. Based on model asset allocation of 50%
cash, 50% BB 1-5 year US HY. 15% Russell Investments Global Adjusted Real Yield, and 15% Russell
Investments Currency Factors. Net of 65 bps fees. In Euro.
The back-test data uses the principal components of UBF, but includes no allowance for
alpha, opportunistic strategies or dynamic allocation. It comprises fixed weight allocations
to the Bank of America Merrill Lynch BB 1-5 year US HY Index, Russell Investments’
currency and real yield strategies, and USD LIBOR 3-month cash hedged back into Euro.
On this simplified basis UBF would have featured in the top quartile of the survey group
over all periods longer than 1 year. UBF would also have exceeded LIBOR +3% over all
periods shown.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
13
For Professional Clients Only.
Unless otherw ise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of
issue and, to the best of our know ledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is
subject to change and does not constitute investment advice.
The value of investments and the income from them can fall as w ell as rise and is not guaranteed. You may not get back the amount
originally invested.
Any data on past performance, modelling or back-testing contained herein is no indication as to future performance. No representation is
made as to the reasonableness of the assumptions made w ithin or the accuracy or completeness of any modelling or back-testing.
Any forecast, projection or target is indicative only and not guaranteed in any w ay.
Applications for shares in the fund are subject to the terms and conditions set out in the fund's prospectus, Key Investor Information
Document (KIID), memorandum and articles of association. Investors and potential investors are advised to read these documents (and in
particular the risk w arnings), as well as the further information contained in the annual and half -yearly reports before making an investment.
Copies are available free of charge on request from Russell Investments Limited.
Issued by Russell Investments Limited. Company No. 02086230. Registered in England and Wales w ith registered office at: Rex House, 10
Regent Street, London SW1Y 4PE. Telephone 44 (0)20 7024 6000. Authorised and regulated by the Financial Conduct Authority, 25 The
North Colonnade, Canary Wharf, London E14 5HS.
UKI-2017-03-28-0841
EMEA 1252. First used: December 2016.
Russell Investments // Unconstrained Fixed Income: Generating Consistent Returns
DECEMBER 2016
14