To benchmark or not to benchmark?
That is the question. Or is it? Seek income directly if that’s what your client wants, and ignore the traditional benchmarks, were key messages from AMP Capital’s bi-annual Global Fixed Income Research Forum.
AMP Capital has been focusing on further customising its portfolios to meet the specific goals of clients.
“Rather than just allowing a portfolio manager to outperform a benchmark that itself may be going up and down, we say, ‘no, don’t think like that’, just deliver me stable income,” says AMP Capital Senior Investment Director Jeff Brunton. “No benchmark at all, just stable income. We don’t want managers to think of the benchmark as their starting point – at best its represent the opportunity set – so we ask them to go and deliver an investment strategy that will match what a customer desires.”
At AMP Capital, all traditional fixed interest funds have exceeded their benchmarks’ return over the past five-year period. This may be useful information for clients to know when choosing a fund manager, but it should not be the basis on how underlying fund managers make key investment decisions, according to AMP Capital Senior Portfolio Manager Stephan Hannaford.
The standard benchmark, the Bloomberg ausbond composite 0+ maturities index, incorporates a mix of government, semi-government, supranational and corporate bonds as well as a small amount of mortgage-backed securities and is market value weighted.
“The benchmark is inefficient because it naively provides exposure to important attributes such as income, liquidity and defensiveness based on market averages,” Hannaford told the forum. “It doesn’t give adequate exposure to credit and liquidity premia, therefore providing insufficient income.”
The solution, according to the AMP Capital Global Fixed Income team, has been to build a new framework that systematically creates tailored solutions to meet the individual needs of investors. In the context of a typical 60/40 portfolio (ie: 60% equity and 40% fixed income), the AMP Capital optimised portfolio has more credit, a duration of nine years versus the standard five years; and a lower allocation to cash and liquid securities.
“Interestingly, this gets the fixed income portfolio more in line with the duration of global bond benchmarks, where issuance is longer dated and average yields are lower, which takes duration longer,” says Hannaford.
The framework also allows the reference portfolio to be modified to suit investors’ individual appetite for factors such as different income levels, greater control on drawdowns or different levels of liquidity.
The question of how to optimise access to the credit risk premium in the corporate bond market was also addressed at the forum.
AMP Capital Senior Portfolio Manager of Global Fixed Income Matthew Sleight told the audience that the standard benchmark does an inadequate job of optimally accessing the credit risk premium. His team has created a superior reference portfolio – basically its own credit benchmark – that it believes more efficiently captures credit risk in the corporate bond market. In the US market, the AMP Capital credit reference portfolio suggests meaningfully different exposures to that of the benchmark indices.
“Our analysis tells us the standard index is underexposed to industries such as consumer staples, utilities, pharmaceuticals, transport, while it is unnecessarily exposed to banks, investment banks, technology and consumer discretionary,” says Sleight.
“We identify a better allocation to credit by incorporating our understanding of risk and return. We’ve defined the credit reference portfolios as a better starting point than traditional benchmarks. Returns can be further improved upon by using active credit selection within industries,” he says.
In the Australian market, AMP Capital Portfolio Analyst Credit Global Fixed Income Manroop Singh also found the opportunity to build a superior reference portfolio relative to the benchmark.
The issue in Australia is the dominance of banks as credit issuers in a highly-concentrated market.
“The domestic credit market can be crudely denominated into banks and non-banks,” says Singh.
“What would happen if you had a zero allocation to banks? Well its return prospects are higher but so too is its volatility. And the increase in volatility isn’t adequately compensated for by the higher return. So this would be a sub-par way to access the credit risk premium. This highlights the benefits of diversification.”
While managing short-term risk is important to many funds, there can be another side to this equation: funds can profit from the strategy of buying the risk others are seeking to get rid of. Known as volatility risk premium capture, it can be handy tool for enhancing and diversifying returns in the context of a balance fund, according to AMP Capital Global Fixed Income Portfolio Manager Alexson Lee.
“Volatility itself is volatile,” says Lee, meaning that there is opportunity to access a risk premium by selling protection against the expansion of volatility.
“Increasing numbers of investors are looking at volatility as a separate asset class,” says Lee. “In particular, volatility risk premia compensates investors for selling volatility protection and it can be regarded as a type of carry strategy. Similar to other carry strategies, it has historically delivered attractive incremental returns and can be expected to continue to do so.”
More insights from our Global Fixed Income Forum 2017