Finding Opportunity in Market Volatility

Reams was founded in 1981 by several people who worked for the in-house pension group at Cummins Inc. Cummins was our first client and we were given open guidelines with objectives to achieve a real rate of return and maximize total return. From the very beginning, we sought value in all sectors of the fixed-income market, including high yield, foreign currencies, foreign markets and emerging markets. I think Reams may have been one of the first firms with an investing style that later became known as Core Plus. Our ability to manage this way from the beginning, with few constraints, is also one of the reasons why we were early in the unconstrained space. Over time, however, client guidelines have become more specific with objectives focused on beating a benchmark. We have evolved with this style of investing but if you look at us from year to year and quarter to quarter, we will have more variance relative to the benchmark.

The genesis of our product lineup was born out of client needs. An existing client would ask us to pursue a different strategy to fulfill a different need. First, it was a more intermediate kind of duration, then low duration, long duration, core rather than core plus, real return, or unconstrained. Clients became comfortable with our approach, our follow-through and how we define risk, and they would trust us with new assignments.

At Reams, we've always believed that volatility makes the world more interesting—and gives you better opportunities — because it causes mispricings between assets. We believe, and our investment philosophy is based on this premise, that volatility is the key driver of price changes in the market. So, interest rate volatility, credit volatility, equity-market volatility, currency volatility — as they move through time, cause relative value differentials to take place. We employ macro and bottom-up strategies to uncover and then respond opportunistically to these movements.

It depends on the type of portfolio you are managing. For example, if you are managing in a low-duration space, which we do, income will be the dominant factor because there is very little to do in terms of big price changes or capturing capital gains. The biggest thing in low duration is the avoidance of mistakes. Looking back at 2007 and 2008, I think one of the things that people didn't talk about enough was how many low-duration managers mis-defined risk and were using subprime securities and things like that. They took on tremendous downside potential for a little bit of extra income because yield is so important in low-duration portfolios.

Moving farther out on the maturity and risk spectrum, we believe that yield in general isn't going to be the primary factor driving how you fare from a total return perspective. It goes back to how volatility works. It's our belief that over time, you will get more opportunities to add value through changes in price, which comes through changes in volatility, rather than just focus on absolute yield.

In a market like this where it's relatively calm, you'll find across all our products that we are fairly neutral with respect to risk. We are very liquid, very clean, and we have a yield deficit relative to benchmarks. Other managers may be overweight credit, overweight risk because yields are low and volatility is low, so it seems kind of safe. We think just the opposite.

It comes back to our starting point. In 1981, the original Lehman Index existed but it certainly wasn't used as a risk benchmark. As time progressed, the market became set on defining risk as volatility relative to the benchmark. People are very comfortable with this definition and that's how the vast majority of asset managers have come to manage portfolios and manage risk. We think it's not necessarily in the client's best interest.

Over the past several decades, there's been this ability to latch onto an index, which is conducive for growth in assets, but it has caused a kind of hollowing out of managers. If you get a period where bonds have 0% to 2% return, which we think is likely, latching yourself onto an index and calling it a victory is not going to work. You need to at least imagine a world that's not like the last 30 years and ask, how is the investment going to be used, what's the best way to use it and what's the best way to define risk?

We define risk first by asking clients, is the way you're managing assets giving you a reasonable chance to achieve your investment goals? And the second way we define risk is the permanent loss of principal. When we look at securities, the first thing we do is to ask, if there were to be a default, or something that you can't foresee occurs, what is your recovery going to be and what kind of impairment are you going to have?

Risk is not this variance relative to an index in a short period of time. Using the current environment, if the index, which yields about 2%, returns 2% in the next three to five years and that does not come close to achieving your investment needs, then that's a risky investment strategy to us. The fact that an investor matched the index with volatility relative to the index of virtually zero but didn't reach their investment goals, that's risk to us.

We need volatility, primarily interest rate and credit volatility, over a full market cycle. Those are ideal conditions for us and we've seen enough of them — 2007 to 2012 — it's kind of like the gift that kept on giving.

The flip side of that would be, what's the least ideal market for us? The answer is a year like last year, when not much happened. That's kind of the anti-perfect market, where volatility flatlines.

If you're looking at a longer-term horizon of three to five years or two to four years, I think that environment will have reasonable pockets of volatility, which is the ideal environment for us.

We can't know the future, and from our perspective, we shouldn't pretend to. At Reams, we respond to volatility in the market — if and when it occurs. If volatility continues to be low, we think that a relatively neutral risk position and a high degree of liquidity in the portfolio is what you should be doing.

People often ask us what happens if we have another 2008. I think 2008 was mischaracterized: it was an enormous opportunity for managers who had the ability and insight and wherewithal to capture returns, which were spectacular.

We're due for another one. It won't be exactly the same, the causes won't be exactly the same, but it always looks the same. It looks like people panicking and fleeing and trying to sell things that nobody wants to buy. That's our best opportunity.