NEW YORK -- When the Illinois Municipal Retirement Fund wanted to beef up returns in its fixed-income investments last year, it asked J.P. Morgan Investment Management, New York, to develop a product that would include nontraditional asset classes such as emerging markets debt and private placement mortgages along with its core sector.
Walter Koziol, director of investments at the Oak Brook, Ill.-based $11.8 billion pension fund, said managers worked with J.P. Morgan to design an opportunistic vehicle that would add extra value by investing in extended market sectors.
The objective is to achieve a return of 150 basis points over the Lehman Aggregate Bond index benchmark during a three- to five-year period.
"It's too soon to test results," said Mr. Koziol, adding he is optimistic about the strategy. "It's very difficult to add value to an index without giving managers flexibility. Opportunities exist out there. And this product, which combines investments in the core sector plus extended market sectors, offers them."
In addition to private placement mortgages and emerging markets debt, the extended sectors include high-yield bonds and non-dollar denominated bonds.
The new portfolio is set up to permit managers to move in and out of the various sectors, depending on market activity, within predetermined parameters. Its core allocation can run from a minimum of 0 to a maximum of 70% of the portfolio, while the extended sector portion can go from a minimum of 0 to a maximum of 25%.
"The managers on this have been in and out of the marketplace, mainly in, taking advantage of opportunities as they arise," Mr. Koziol said.
The Illinois pension fund initially invested $428 million in the strategy in April, added another $60 million in September and $91 million more in January. As of Jan. 31, that $579 million had swelled 10% to $635 million.
Two dozen J.P. Morgan clients, including Illinois Municipal, have had the firm restructure their fixed-income portfolios in some way in the past nine months, said Gerry Lillis, co-head of J.P. Morgan's fixed-income group, North America. The changes followed analyses of each fund's fixed-income portfolio by the firm.
The analysis is part of what the firm calls its Fixed Income Risk/Return Framework -- a proprietary product customized for institutional clients to help them improve results in their bond portfolios.
"We look at three key disciplines in building a client's risk return profile," Mr. Lillis said. Those are: tactical changes in weighting, duration and changes in interest rates.
"The goal is to build a portfolio that's better than the index, but without adding risk. Which index is used depends upon the duration situation. How much extra return can you get? Can you withstand these decisions, given the changing nature of some of these markets? Once risk and return are set, we have to see if we can meet those expectations. Return goals may have to be lowered," he said.
J.P. Morgan uses both historical data and forward-looking assumptions for its frameworks.
Some clients are working under constraints that can't easily be changed. They may not be permitted to invest in emerging markets or triple B bonds, for example. In that case, the firm might try to build efficient portfolios by using specialist managers or creating one diversified portfolio, Mr. Lillis said. The framework is tailored to optimize returns within a client's constraints.
Since launching its Risk/Return Framework nine months ago, J. P. Morgan has added $8.8 billion in new fixed-income business and provided tailored analysis for 52 clients, Mr. Lillis said. The firm manages $250 billion in assets, with $100 billion of that in fixed income.
The Risk/Return framework was developed in 1993 in response to IBM Corp.'s request for a product that would include extended markets such as emerging market and high-yield debt not normally found in the core Lehman Brothers Aggregate Bond index. "J.P. Morgan invested in all those asset classes, but they didn't offer a product," said Jae Park, senior investment manager, fixed income, at IBM's $60 billion pension fund.
Working with Stamford, Conn.-based IBM, J.P. Morgan created Global Extended Markets, a single portfolio of nontraditional fixed-income sectors designed to complement IBM's core fixed-income holdings, Mr. Park said.
IBM began implementing the strategy at the end of 1994, at the same time it started to downsize its pension fund staff and increase the assets it was managing externally.
Over three years ended Dec. 31, 1997, the GEM portion of the fixed-income portfolio managed by Morgan for IBM has produced sparkling results, returning 456 basis points above the Lehman Aggregate Bond index, with 311 basis points of tracking volatility. "That's a very aggressive tracking number, especially when you compare it to J.P. Morgan's active fixed-income product, which beat the index by 70 basis points, with a tracking volatility of 70 basis points during the same period," Mr. Park said.
When added together on an annual basis, the active and GEM portfolios outperformed the benchmark by 230 basis points with a 160-point tracking volatility.
"That's beating a lot of big firms out there," Mr. Park said.
This risk/return approach makes sense these days, said Richard Ennis, principal, Ennis, Knupp & Associates, Chicago. "We're advising clients to adopt a broader approach in their fixed-income management. Instead of hiring specialists, they should look for broad mandate fixed-income management. The Lehman Brothers Aggregate Bond index now includes only one-quarter of all fixed-income opportunities for investors."
The $26 billion State of Maine Retirement System, Augusta, a client of Ennis, Knupp, has used this approach successfully, getting superior returns compared with the Lehman Brothers Aggregate Bond index, without incurring greater volatility, he said.
Investing in fixed income is not like investing in equities, where it's important to hire specialists to manage different asset classes. Fixed-income markets are so interrelated that it's logical to hire investment managers who have the ability to choose from sectors beyond the core investments, Mr. Ennis said.