Unconstrained bond strategies not for the button-down types

For some asset owners, getting more yield out of fixed income means letting go.

Unconstrained strategies have the flexibility to shift tactically from traditional fixed income into bond alternative strategies, but it's often a difficult sell to investment executives at pension funds, endowments and foundations who are used to working with a benchmark.

“Pension funds are wary about unconstrained strategies, because of the inability to hedge or model the portfolios like you can with traditional fixed income,” said Don Plotsky, head of the product group, Western Asset Management Co., Pasadena, Calif. “Still, there are a lot of pension funds thinking unconstrained. Ultimately it's a decision between the client making the asset allocation vs. the manager making the asset allocation.”

The $14.5 billion Illinois State Board of Investment, Chicago, had invested in “deconstrained, core plus mandates” in the early 2000s, said William Atwood, executive director. “Since that time we have allocated to discrete, defined strategies — the drivers being primarily to better identify and monitor investor skill and to retain greater control over portfolio construction, asset allocation, and risk.”

Added Mr. Plotsky: “The biggest issue is the flows away from investments with a traditional benchmark like the Barclays Agg (Barclays Capital Aggregate Bond index) to unconstrained fixed income. Low yield and high duration is not where you want to be today.”

Another concern for investors is what exactly they will be getting into if they go into unconstrained fixed income, which Steve Center of Callan Associates called “a whole different beast” compared to core bonds.

“Are they fixed income or are they alternatives? A lot of strategies are less fixed income and more alternatives,” said Mr. Center, vice president, global manager group, fixed income, at Callan in San Francisco. “We've stressed overall to our clients to ask themselves why they have fixed income in the first place. Is it a return-seeking asset or a diversifier of risk? A lot of investors are forgetting the drivers of a fixed-income portfolio, the benefits of having fixed income in their portfolio.”

Still, unconstrained fixed-income managers say there are rewards for those who do loosen the reins.

“Multiasset or unconstrained approaches not only diversify investment classes, they diversify different forms of risk,” said Matthias Scheiber, senior portfolio manager, multiasset strategies, Schroder PLC, London, “They get the risk premium by shifting weights from one risk to another, swapping out one kind of risk for another. Pension plans are becoming flexible by being smart about the alpha in fixed income, but now they're looking at bonds and equity dynamically.”

Schroder managed $90 billion in multiasset strategies as of March 31, mostly for institutional clients.

“Public plans, endowments and foundations are looking more for diversification and more of these are making the move to unconstrained,” added Mike Swell, managing director, Goldman Sachs Asset Management, New York. “It's more tactical, allows the manager to be freer to make moves over a broad range ... The big swings within the strategy is based on our views” on emerging markets, loans and other debt. “The liquidity is less than core but better than long corporates.” Goldman Sachs would not disclose how much it manages in unconstrained fixed income, but the firm has $486 billion in assets managed in public fixed income.

“Simply put, it's a flexible, global approach,” added Jack Flaherty, investment director, fixed-income investments, GAM, New York. “We're conservative, but we do go into all asset classes with two purposes: diversification or risk mitigation, and absolute return.” GAM manages $17 billion in unconstrained fixed income.

Western Asset's Mr. Plotsky said asset owners themselves are being flexible in how they approach unconstrained. “Many institutional investors are looking at an unconstrained strategy as a long-term investment,” he said. “Others may use it as a tactical strategy but will return to core when fixed income stabilizes.” Western Asset manages $17.2 billion in unconstrained fixed income.

Still, allowing the managers to make broad asset-class moves on their own can be daunting — and expensive, said Callan's Mr. Center. “It's a very expensive trade to do,” he said.

“The benefit of having that defensive posture outweighs the cost of not having that defensive posture. It's been more common to see clients slow to rebalance to fixed income from equities, allowing allocations to drift to a higher band of equities” to take advantage of a runup in equity returns, particularly in 2013.

Unconstrained fixed income is part of the $9.2 billion University of Notre Dame endowment's 15% target allocation to what Scott Malpass, vice president and chief investment officer, called “marketable alternatives,” which also includes multistrategy, hedge funds, structured products, direct lending, high-yield fixed income and distressed debt.

“We feel we get higher returns with the same risk as (core) fixed income” from marketable alternatives investments, Mr. Malpass said.

There still are good reasons to stay in fixed income, said Schroder's Mr. Scheiber.

“Fixed income is needed because it's a diversifier and is defensive in case of equity losses, and as a liability hedge against a variety of risk: interest rate risk, inflation risk, longevity risk, alpha risk, growth risk, Treasury risk,” Mr. Scheiber said. “The more you derisk, the more you're hedging. There's still a demand for long corporate bonds because of this.”

The reason pension plans are in fixed income really hasn't changed even if the kinds of fixed income have, Mr. Scheiber said. “You're still in fixed income looking for the income, diversification and liability hedging.” n