One way to achieve potentially higher returns, without impacting overall portfolio risk, is to significantly increase active fixed income risk – an approach known as “active alpha fixed income investing”.
By thoughtfully combining three key elements, an investor can successfully implement this approach. First, there must be a broad opportunity set of strategies and risks to employ in a portfolio. Second, managers must possess the skill to exploit these opportunities on a consistent basis. Finally, different sources of active risk must be combined in a way that produces optimal risk diversification benefits. Active alpha fixed income investing employs a risk budgeting framework that harnesses these three elements in order to target the highest level of absolute returns for a given level of risk.
There are various ways to implement active alpha fixed income investing. Broadening sector exposure and employing derivatives are two methods required to achieve the potential benefits of this approach. Depending on a client’s risk tolerance, leverage can also improve the risk budget of almost any strategy.
Regardless of its implementation, active alpha fixed income investing seeks to identify the optimal balance of opportunities, skill and diversification benefits to maximise targeted excess returns.
Improving performance
Active alpha fixed income investing can push up the efficient frontier for a bond portfolio to higher expected returns for any level of risk. Furthermore, taking more active risk actually extends the efficient frontier of fixed income investments further to the right. (See Chart 1.)
The traditional portfolio line ends earlier than the active alpha portfolio line since the amount of risk that can be taken is typically limited. By taking active risks across a broader range of strategies, the amount of fixed income risk can increase to improve portfolio performance.
Clear capacity
A typical institutional portfolio might have 65 per cent equities and 35 per cent bonds in terms of its asset allocation. However, in the active alpha fixed income investing framework, it is more important to focus on risk allocation. In Chart 2, contribution to total portfolio risk is dominated by equity market exposures (89.8 per cent), with bond market exposure a modest 2.2 per cent.
Assuming the bond allocation employs 100 basis points of active risk/tracking error, active bond portfolio management contribution to total portfolio risk is a mere 0.1 per cent and clearly has the capacity to increase.
The calculations assume equity index volatility of 16.8 per cent annualised, active equity tracking error of 5 per cent annualised, fixed income index volatility of 4.5 per cent annualised, and active fixed income tracking error of 1 per cent annualised.
Data is based on strategic long-term assumptions made by GSAM’s global investment strategy’s group.
If the active risk from bonds in the sample portfolio (65 per cent equity/35 per cent bonds) was tripled from 100 basis points to 300 basis points of tracking error, the rewards could be substantial. Since fixed income is 35 per cent of the portfolio, the result of tripling the active managers’ tracking error adds 70 basis points of standalone risk to the portfolio. (See Chart 3.) The standalone risk shows the individual risk exposures (two active and two passive) simply summed together, ignoring diversification benefits.
At first glance, adding 200 basis points of tracking error might seem aggressive if viewed in isolation. However, viewing risk at the total portfolio level yields a compelling insight: because active fixed income risk is the smallest risk in the portfolio and is uncorrelated with any of the other larger risks, the additional 200 basis points of active bond risk leads to only a 4 basis points increase in total portfolio risk. This marginal increase results from diversification benefits.
Meanwhile, the portfolio benefits from an increase in excess returns. In this analysis, which assumes a modest information ratio of 0.5, 35 basis points additional expected return is achieved. With only 4 basis points of additional risk, this is a compelling 8-to-1 risk/reward ratio.
Expected returns and risk, as measured by the standard deviation of returns, are statistical estimates of hypothetical average returns of economic asset classes, derived from statistical models. Actual returns and risks are likely to vary from expected returns and risks. Expected return and risk models apply statistical methods and a series of fixed assumptions to derive estimates of hypothetical average asset class performance. Reasonable people may disagree about the appropriate statistical model and fixed assumptions.
These models have limitations, as the assumptions may not be consensus views, or the model may not be updated to reflect current economic or market conditions.
Accordingly, these models should not be relied on to make predictions of actual future account performance. Goldman Sachs has no obligation to provide recipients hereof with updates or changes to such data. There is no guarantee that the above results can or will be achieved.
Maximising returns
The success of active alpha fixed income investing is ultimately determined by combining three basic elements: a broad opportunity set combined with manager skill and inherent diversification benefits.
Generally speaking, the wider the opportunity set, the better. In the fixed income markets, there are thousands of securities for investors to evaluate, trade and incorporate into a portfolio. Likewise, there is a multitude of diverse active strategies that can be employed, such as interest rate, country, currency and sector.
We can divide the opportunity set into top-down macro strategies, such as interest rate exposure associated with duration risk, yield curve flattening, steepening, or curvature, and bottom-up relative value strategies associated with security selection.
Peer group analysis of active fixed income managers across a number of different strategies concludes that managers are skillful. In fact, the median manager has a fairly high information ratio, often above the conservative 0.5 assumption employed in the prior analysis.
The combination of many unrelated active strategies potentially reaps an enormous diversification benefit. When a large number of active strategies are employed, the benefit from risk diversification permits a higher level of active risk to be taken in each individual strategy while still keeping the total active risk constant. The result is a potentially superior translation of total active risk to active return for any risk profile.
Risk budgeting framework
A broad investment opportunity set, investor skill and diversification benefits are necessary ingredients, but do not alone guarantee successful active alpha fixed income investing. A risk budgeting framework that effectivelycombines these elements is also required.
An example of three risk budgets – narrow, intermediate and broad opportunity sets – is shown in Chart 4. The column labelled “optimised target” shows the amount of risk that should be assigned to that strategy to best balance investment skill, diversification benefit and potential return. The column marked “constraint” indicates a maximum tracking error, which accounts for externally imposed investment constraints.
The narrow portfolio is limited to sovereign/agency debt, whereby only duration risk and some relative country risk are allowed. The intermediate portfolio would be considered a standard core strategy, as flexibility in sector allocation allows for inclusion of governments, mortgages, asset-backed and investment grade corporate.
Lastly, in the broad portfolio, the opportunity set is opened up further to include active currency, high yield and emerging markets.
Target excess returns more than double, as you move from the narrow to broad portfolio. This is due to gaining access to higher information ratio strategies combined with access to greater diversification benefits with the information ratio improving from a relatively anaemic 0.31 to a much more inspiring 0.73. The broad portfolio is a vivid example of the potential of active alpha fixed income.
Implementation
Broadening the asset classes in a portfolio and employing derivatives are considered essential for successful active alpha fixed income investing. In these cases, clients can make their fixed income investments work harder by only slightly changing their existing portfolio.
The merit of employing a broad opportunity set is discussed above. To implement this breadth of investment opportunity necessitates a complete “tool box” in order to allow the manager to build portfolios that capture the array of diverse investment views. Derivatives are an essential part of the tool box that facilitate the implementation of different strategies independent of each other and permit greater risk management. They allow not only risk to be deployed where desired, but also to hedge involuntary risks within the portfolio.
By offering return potential not traditionally associated with fixed income mandates, active alpha fixed income investing can redefine the role of bonds in a portfolio. However, its power lies in its flexibility. Regardless of the amount of active risk an investor seeks, this framework serves to identify the optimal mix of opportunities, skills and diversification benefits to maximise targeted excess returns.
Jonathan Beinner is managing director, chief investment officer and co-head of global fixed income and money markets at GSAM. Iain Lindsay is vice-president, global fixed income and currency at GSAM. Scott McDermott is vice-president, global investment strategies at GSAM. For more information, please contact: Iain Lindsay. Tel: +44 (0) 20 7552 5219. E-mail: iain.lindsay@gs.com or visit our website at activealpha.gs.com
