Unconstrained investing, one of the latest buzzwords in asset management, means nothing more than being flexible in one’s investment universe and approach in order to deliver the objectives that clients set. For some investors, the use of sophisticated tools to profit in both up and down markets may be new - but for Western Asset, this approach is business as usual. Read about how it all started - and how you can profit from this strategy today.
Ken Leech, Western Asset Chief Investment Officer:
Unconstrained investing is the biggest development in the industry over the last 10 years, but it is also the most misnamed asset class of all time: it means so many different things to so many different people. I believe that the most important thing is to determine which assets one wants to invest in; then, with what level of volatility, and third, select the sources of risk. We have strategies where the risk comes from spread products, but in others, it comes from the macro strategies. Some strategies have volatility of 4%, in line with the U.S. market, while it’s 8% for others. The key is that in each case, the strategy has defined its asset base, its volatility range and its risk sources. So it’s not all that unconstrained. We believe more in defining the characteristics well, so our expectations are completely aligned with the client’s.
The Pasadena, California, based manager has been successfully managing unconstrained programmes for over two decades, having been a pioneer in the mid-1990s with its global multi-sector strategies. These strategies opened the world of High Yield and Emerging Markets (EMs) to many institutional investors who had traditionally focused on developed markets only. The move came as a natural evolution from the growth of the manager itself: When Western Asset established its first overseas office in London in 1996, the investment team added to the global strategies the opportunities they found in European credit and local markets – it just made sense to expand the sectors and sources of return available to investors. This meant that some of the global strategies evolved to become a solution that could generate returns from both capital gains as well as income.
Mike Zelouf, head of London Operations and Client Service & Marketing, and one of the founders of the London office, tells us how it all happened:
“We back-tested the risk and return of various sector combinations and concluded that a combination of growth-sensitive sectors such as high-yield corporate bonds and EM debt, coupled with more interest-rate sensitive and higher quality sectors in developed markets (such as US investment-grade corporate bonds and agency mortgage-backed securities) could generate a favourable risk/reward profile. In fact, that has proven to be the case consistently over market cycles during the past 20 years.
The reason this design has stood the test of time so well is because each sector has distinct risk drivers that are not always highly correlated. For instance, an unconstrained strategy can include corporate bonds (which bears corporate default risk), mortgage-backed securities (prepayment and convexity risk), emerging market securities (developing country sovereign credit risk), and global government bonds (industrialized country interest rate and currency risk)."
A revolutionary approach
“The mid-1990s were an exciting, albeit volatile, time for global bond investors. In addition to traditional “hard currency” government and credit markets we actively participated in the nascent peripheral markets of Italy and Spain as well as in Danish and Swedish mortgage-backed bonds. We participated in the growing convergence trade in Poland, Hungary and Greece ahead of the launch of the euro currency in 1999. We were also early investors in Mexican, Brazilian, Turkish, South African, Indonesian and Indian domestic bonds and currencies. The onset of the single European market also spurred the development of euro investment-grade and high-yield corporate bonds in which the strategy participated selectively."
EMs have evolved as an asset class: currencies and volatility swap direction over the past decade
Source: Bloomberg 13 September 2017. The index used is the J.P. Morgan GBI-EM Global Diversified Composite Unhedged USD Index, while volatility has been measured by 1-year rolling standard deviation. RHS is Right Hand side. Past performance is no guarantee of future results. Please find definitions in the disclaimer.
It may seem commonplace today, but the introduction of a programme that would have half of its assets in high-yield and EM debt was considered extraordinary at the time. High-yield markets were still developing while EM debt management was in its infancy. Western Asset’s focus on surrounding the better expected return asset classes with high-quality bonds and duration to seek the benefit of lower correlations and help protect drawdown during periods of credit market volatility was considered very novel.
But that philosophy of combining higher return assets with risk-reducing strategies has stood the test of time.”