Benchmarking at home

CURRENCY
Foreign fixed income returns can be quite attractive(see “Foreign Debt Performance,” right)are in foreign currencies. An important additional issue when investing in fixed income markets abroad is to protect fixed income yields and returns from the impact of changing currency exchange rates. For example, when the Canadian dollar rises against the U.S. dollar, the returns on U.S. bonds decline when translated into Canadian dollars. This currency effect can be largely overcome by using currency hedging. In fact, currency management does not have to be restricted to simply a hedging role. Active currency management is another proven source of alpha, and can therefore be added to the previous list of sources of return from foreign fixed income investing.

SAFE DIVERSIFICATION
One issue is frequently raised when Canadian plan sponsors discuss foreign fixed income: their plans’ liabilities are in Canadian dollars, and their asset/liability modeling therefore uses Canadian bond benchmarks. Giving up these familiar and suitable benchmarks is difficult to do. Fortunately there is no need to do so.

Modern investing techniques permit Canadian pension funds to keep their Canadian benchmarks and still benefit from investing in foreign fixed income asset classes. These techniques ensure that the domestic liability profile of the plan is maintained while the opportunity set facilitating the creation of added value is enhanced. Specifically, by using a so-called “overlay” approach, a Canadian pension fund can explicitly keep its domestic bond benchmark and prescribe an additional return target above the return of that benchmark. The plan can then “import” the desired additional returns from the sources mentioned, such as emerging markets debt, global high yield debt, and so on, in a carefully risk-controlled manner.

In addition, by ensuring that these alpha sources have low correlations with each other, the pension fund also gains further benefits of diversification and lowers overall risk accordingly.

There are two steps to consider:
1. Replicating the underlying Canadian benchmark, and
2. Actively adding value to meet the additional return.
Replicating the Canadian benchmark is best achieved using derivatives such as a total return swap(any swap in which the non-floating rate side is based on the total return of an equity or fixed income instrument with a life longer than the swap). This will deliver a small but tightly managed tracking error and will meet the goal of fitting into the plan’s existing benchmarking and asset/liability modeling framework.

For the active added value portion of the portfolio, the manager would look to the plan’s target for the additional return above the benchmark’s return and will use this together with reasonable risk/return assumptions to derive a target risk budget required by the plan. The manager can then allocate this risk budget across the chosen alpha sources to deliver an optimal portfolio for meeting the pension plan’s requirements.

The allocation of the risk budget to each strand of risk is thus based on a framework that considers the ability of the respective alpha source to deliver its additional return and risk targets. This process further facilitates the construction of a realistic diversified pool of strands of risk. In this step, it is appropriate to use conservative assumptions to ensure that the portfolio construction remains robust.

PORTFOLIO CONSTRAINTS
Analysis of risk and reward also supports the case for expanding the universe of permissible fixed income investments, as this facilitates the construction of the portfolio from higher quality trades. Generally speaking, the more constraints that are placed on the portfolio, the more the manager must look to the riskier parts of the constrained universe of opportunities to meet the plan’s return goals.

In fact, in addition to gaining access to multiple sources of risk and alpha, the “benchmark + overlay” approach also allows plan sponsors to consider improving utilization of the risk budget even further by permitting both long and short positions, creating a symmetric opportunity set for the manager to use on behalf of the plan. This facilitates greater opportunity to generate excess returns, and allows the alpha managers the freedom to deliver risk targets throughout the investment cycle.

Because the unconstrained manager can take advantage of both upswings and downswings in the bond markets, while a long only manager can only take advantage of the upswings, mathematical theory suggests better riskadjusted returns for the unconstrained funds. Assuming symmetry of market upswings and downswings, the unconstrained manager has twice the opportunity to make expected returns, while the volatility of the portfolio is greater by a factor of only about 1.4, resulting in a notably higher information ratio.

CAVEAT
Plan sponsors need to keep an additional point in mind when considering a “benchmark + overlay” approach to fixed income. The different foreign fixed income alpha sources discussed have low theoretical asset-class correlations. However, it is important to make sure that the manager has successfully achieved very low correlations in practice as well, otherwise the process will not meet the plan sponsor’s overall goals. This means that the plan sponsor and consultant must carefully examine not only the theoretical asset class correlations but also those achieved by the various global fixed income managers under consideration.

By implementing a “benchmark + overlay” approach to fixed income investing, Canadian pension plans can access the returns available from foreign fixed income investments within a strict risk-managed framework, while keeping their familiar Canadian bond benchmarks and thus recognizing their Canadian-based liabilities. In a sense, Canadian plans using the “benchmark + overlay” approach can travel the world for fixed income opportunities without ever leaving the safety and comfort of home.

Daniel James is a senior portfolio manager in ABN AMRO Asset Management’s London-based fixed income team. Simon Segall is vice-president, institutional sales and client services at ABN AMRO Asset Management in Canada. simon.segall@abnamro.com, daniel.james@uk.abnamro.com.