Unconstrained fixed-income investing has recently come into prominence due largely to two factors. First is investor desire to avoid having their portfolios tied to benchmarks whose composition may not reflect the optimal or desired components of their investment needs and objectives.
The second stems from the strong consideration that after 35 years of falling bond yields to multi-generational lows, the risk of principal loss inherent in tying fixed-income investments to benchmarks with longer durations may not be worth taking. But as this “unconstrained” approach to fixed-income investing has taken off, it still leaves considerable confusion and disagreement over what, exactly, unconstrained investing is or should be. Indeed, amidst this confusion the only widespread agreement within the industry is that unconstrained investing means different things to different people.
We believe the very term “unconstrained” is the most ill-fated label possible. Immediately after broaching the prospect of unconstrained programs the first question a client asks quite appropriately is, “What are the constraints?”
One consideration some have proposed is that these should be “best ideas” funds without being tethered to a benchmark. But if this is the approach then a firm can have only one program; after all, how can you have more than one “best ideas” strategy?
Western Asset’s Client-Focused Approach
At Western Asset we have been successfully managing unconstrained programs for over two decades, having been a pioneer in the mid-1990s. We are fortunate that our strategies have achieved significantly positive returns and fine long-term track records.
Our approach is to be completely client focused. In our collaborative discussions with clients over the decades, we have found investors vary widely in their risk tolerances, their preferred fixed-income asset type and the nature of the risk they are willing to assume. Some investors are US centric, some have a more global bent. Many are focused on income as their primary motivation whereas some are more focused on total return. Many of our clients are very comfortable with credit risk while others wish to limit credit exposure but are more willing to take interest-rate, or “macro” risk. We believe there is no “one size fits all” approach. Instead, we believe in offering a range of our best strategies to meet the varying concerns and objectives of our clients.
The keys to having a successful program and client relationships are clarity and transparency. We feel that many of the unconstrained programs in our industry are somewhat ad-hoc and investors are not always clear as to the nature of the risks inherent in each or among the different offerings. We are devoted to establishing clarity and transparency immediately with our clients, and before further discussion or entering into specific programs.
In addition to client guidelines, we start with clarity about the three key parameters by which we identify every unconstrained strategy:
2) Opportunity Set (what type of assets will the portfolio hold?)
3) Sources of Alpha (what are the risks and returns likely to come from?)
These considerations make it very straightforward for clients to understand precisely what they should expect from their programs. How much risk am I willing to take? What types of securities am I comfortable with? How much latitude will the program have? Where are the sources of risk and reward? How much volatility in returns am I comfortable with?
These considerations are crucial for clients who have decided to allocate away from a traditional benchmarkbased program. Often the question here becomes, will this “unconstrained” approach beat my benchmark? As everyone who has studied markets and the efficient markets hypothesis understands, it is hard enough to beat one benchmark—it would be foolhardy in the extreme to posit that you could beat two. Total return “unconstrained” approaches designed with no benchmark are attempting to achieve positive returns in line with their volatility targets and risk budget sources; therefore, a traditional benchmark that happens to have exceptional results can generate better returns.
Think of allocating away from stocks into bonds. If the bond performance is excellent, that is good news. But one cannot fault the bond manager for failing to beat the stock market. That is the decision of the asset allocator. Indeed, it is this concept of “serving multiple masters” that has persisted in muddying the discussion and analysis of unconstrained fixed-income investing programs. Many investors, hopeful that unconstrained investments would generate higher returns than “Aggregate” indices due to a combination of greater latitude providing greater alpha and/or higher rates leading to lower benchmark returns have often been disappointed, predominantly because interest rates have continued falling in recent years.
Another difficulty traditional fixed-income investors have with unconstrained investing is in evaluating their managers. In the absence of a benchmark or easy peer group comparisons, this can be difficult. The approach that finance theory would suggest may also take the allocator out of their comfort zone. Unconstrained investing can be judged by how the manager has adhered to various parameters—volatility, composition, risk budget and latitude. But after that, what about the performance? Is it good? Bad? So-so? The most common approach is to judge performance relative to volatility (e.g., Sharpe ratio/information ratios). Drawdown, or the amount of one’s worst case performance during a period, is another gauge of performance. The use of correlation studies is also commonplace. How correlated are returns to different asset classes? Our preferred method is for our clients to have the clear expectation of superior returns relative to target volatility.
Western Asset’s Investment Philosophy
As in any field, the “four Ps” of investment are important to evaluate—philosophy, process, people and performance. Western Asset has adhered to our value-driven philosophy and use of diversified strategies for over 40 years. Our process has evolved as markets have expanded but the basic investment philosophy has not changed. For unconstrained investing, people and performance are important to evaluate.
Unconstrained investing requires many of the skills inherent in successful fixed-income benchmark investing, but there are differences and having dedicated teams is important. Similarly, the length of track record is probably even more important in this field, because as is the case with any new investment style, it is easier to say “I can do it” than to actually succeed over long periods of time. In this still relatively young investment space, a five-year track record easily puts a program in the top quartile, whereas 10 and 20-plus year track records are rare and therefore more valuable.
Why are established track records that may seem short relative to more established investment fields so important? Simply, it is the most important source of information that one has to go on. Is the program doing what I expected it to do? Is the volatility what I expected? Is the manager staying on the course they originally explained? Are we getting “style” drift whereby the assets and the risk budget in the program have now changed? So as elementary as it may seem, the consistency of the investment approach is the first question the track record may answer. Next, the investment results shine light in the time-honored way on whether the manager has delivered alpha relative to risk taken.
The case we lay out is one of having clearly defined programs across a variety of parameters, with dedicated teams to provide the best opportunities to achieve superior risk-adjusted returns. This menu of programs is designed to give clients a meaningful breadth of choice, and to provide significant differentiation in theirrespective approaches. We have been doing this successfully for 20 years, albeit with a much increased and focused effort over the last decade. We believe that investors looking for a non-benchmark (unconstrained) fixed-income solution can count on our investment philosophy and approach, which has carried our firm for over 40 years, to be effectively translated into our clients’ portfolios. We believe that by providing clarity about the volatility, opportunity set and sources of alpha, investors can pick the approach that best fits their needs. Importantly, we believe each of these approaches can, and has provided, results in line with our clients’ understanding and goals.