- A more considered portfolio combines different return drivers, including capital preservation, portfolio diversification and income
- The role of liquidity is particularly important in fixed income investing
- Alpha is rare and valuable, and active managers should be given sufficient time to generate returns
During the current 'low for longer' yield environment, including fixed income strategies in your investment portfolio can help diversify sources of return and allow for more robust risk management.
In the Netwealth webinar, Re-focusing on fixed income in a low-yield environment, BlackRock’s Head of Australia Fixed Income, Craig Vardy, and Head of Portfolio Analysis and Solutions, James Kingston, discuss their framework for building efficient, fixed income portfolios using both index and alpha strategies.
“During COVID-19, it has been stressful, yet interesting,” says James.
“The way markets have moved and the way we have changed as a society have helped us to rethink how we work and how we invest. We have faced challenges and questions around how we structure our portfolios.
“Which is why we are refocusing on fixed income in conversations with our clients.”
The portfolio construction process
When Craig and James build portfolios and model portfolios at BlackRock, they follow a process that comprises four distinct steps:
- Benchmark – Translating investor outcomes. Clearly identifying the client’s investment objectives
- Budget – Evaluating risks and opportunities. Deciding where the investor wants to incur costs and take risk
- Invest – Identifying cost-effective and efficient holdings. Determining the most appropriate vehicles to implement the strategy
- Monitor – Keeping a “hand on the wheel”. Regularly measuring success, rebalancing with discipline and considering the fixed income sleeve in the context of the entire portfolio
A more considered portfolio combines different return drivers
Step 2, Budgeting, is worth considering in more detail. It involves risks and opportunities.
Active management (alpha strategies in a portfolio) requires thinking about how much active risk to take and how much one can deviate from the benchmark to achieve the desired outcome.
During this stage, Craig and James think about where they are going to allocate to, away from the strategic benchmark. They rely on three active asset allocation buckets:
- Capital preservation
- Portfolio diversification / SAA
Active asset allocation will likely involve tactical trades to either bolster resilience or add more risk (e.g. to take advantage of an opportunity).
“As we move towards higher-octane active funds, we take more budgeting risk, potentially increased downside risk, and, obviously, potentially pay more cost. We think about where we’re allocating to, tactically and in terms of strategy.”
Another consideration is liquidity, which is important in fixed income investing.
Looking at the data of a typical investment-grade bond ETF from mid-February to the end of April 2020 (a period in which we saw a lot of market volatility) reveals that the underlying buy-sell spread of a basket of single bonds was around 2.6%. The underlying spread of an ETF, on the other hand, was less than 0.2%.
This shows that, as a liquidity tool, such ETFs in portfolios are beneficial, as they offer the flexibility to trade fixed income instruments when the underlying market may be relatively ill-equipped.
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Considerations for alpha strategy selection
At the height of the volatility associated with the COVID-19 pandemic, many BlackRock clients, here and internationally, had three options, all of which involve the three ‘R’s:
- Reset the portfolio back to asset allocation weights
- Take advantage of market movements, and potentially add value and performance into the portfolio
- A lot of BlackRock’s clients went back to the drawing board to redesign their portfolios, incorporating new exposures to help manage risk more effectively
Investors require sufficient liquidity, of course, to quickly rebalance their portfolios through the implementation of any of these three options.
“To give you an idea, a typical 60/40 portfolio with our US colleagues went down to 50/50 in the height of the volatile markets.
“The market can move very quickly. If you need to rebalance, having the liquidity to do so is vitally important.”
Another consideration for budgeting is who to allocate to and how to allocate.
“Alpha is rare and valuable,” says James. “So, finding a good alpha manager takes time, and you have to give them the time to generate the returns.”
If there is insufficient time, if the investor hasn’t engaged an alpha manager, or if the investor lacks the ability to monitor asset performance, then an index exposure is a viable alternative.
Other aspects to consider
Beyond the numbers, investors also have to think about other aspects, such as asset class efficiencies.
With some asset classes, it is easier to generate alpha than with some others. For example, in markets where a high amount of information is publicly available and where the assets are highly liquid, it is typically more difficult to generate out-performance.
“We also have to think about regime dependency, the market regime are we in, and how those asset classes are going to perform.” says James.
“We should also think about total cost. What are we willing to take in terms of the total cost of the portfolio, from the perspective of both the ongoing charge and performance?
“Always look beyond just the numbers and think about other aspects of the manager and of the ETF strategy (if you’re selecting ETFs). Think about what you’re using, and why you’re using it.”
Budgeting in context
It’s important to remember that budgeting is just one step in a four-step process that BlackRock uses to build portfolios, with specific emphasis on fixed income – the four steps being: benchmarking, budgeting, investing and monitoring.
The final step, monitoring, is as important as any of the others.
It is essential that investors monitor their objectives on an ongoing basis by regularly asking key questions. Have their objectives changed? Are there any unintentional risks in the portfolio that the investor wasn’t aware of? Do they need to undertake additional due diligence on the portfolio and the manager selection? And have their views on the market changed?
As a result, the investor will be in a good position to rebalance their portfolio to align with their goals going forward.
Find out more about fixed interest investing
Watch our webinar on Re-focusing on fixed income in a low-yield environment for additional insights, or contact Netwealth.
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