Outcome-oriented Investing: An Approach to Integrating Your Australian Fixed Income and Equity Sub-portfolios
One of the key roles of fixed income allocations within multi-asset portfolios is to act as a diversifier for more volatile exposures, such as equities. Yet despite its role as a diversifier, the management of fixed income and equities exposures are often viewed as separate investment decisions. Given the complimentary nature of exposures, it follows that adopting a framework where the management of the diversifier is more directly linked to the outlook for the asset class being protected has the potential to generate superior outcomes. The overall approach to managing the portfolio becomes more outcome-oriented by incorporating a more integrated view, giving investors greater ability to achieve their desired investment outcomes.
Often the fixed income exposures are managed based on a specific outlook for interest rates and credit spreads with exposures managed accordingly. The complication with adopting such an approach is that it risks ignoring the role of fixed income allocations as a risk diversifier. To overcome some of the issues, an alternative approach is for the investor to proactively manage the fixed income sub-portfolio to ensure that the exposures are consistent with the overall investment objectives. Such an approach requires that the investor adopt a more holistic approach to considering portfolios rather than viewing each sub-portfolio in isolation. The important point with regard to achieving the desired outcome is to note that the fixed income portfolio is being utilised to provide interest rate duration, which in turn is acting as a ‘buffer’ for the investor’s equity portfolio. It is therefore important for the investor to consider the level of duration in terms of the overall investment objectives rather than in isolation. This approach seeks to utilise the two longer-term relationships of (a) the negative correlation of interest rate duration, and (b) the positive correlation of credit spreads with equity markets over the economic cycle to manage overall risk within a portfolio (see Figure 1 below).
The investor can then determine the quantity of interest rate duration in the portfolio according to their view on the outlook for equities. The more pessimistic the view on the outlook for equities, the more interest rate duration the investor wants in their portfolio. Conversely, the more optimistic the investor is regarding the outlook for equities, the less interest rate duration they want in their portfolio. Effectively, the investor can now think of the duration within the total portfolio in a dynamic sense based on their view of equity markets.
Turning to the question of implementation, the initial issue is ascertaining the key factors that will determine the outlook for equity markets, as this is the linchpin of the integrated process. In this simplified example, it is assumed that there are two inputs to equity forecasts; namely (a) valuation, and (b) outlook. It is worth highlighting that no assumptions are made regarding how these inputs are formulated by the investor or the level of conviction the investor may have in a particular view. Within such a framework, the level of interest rate duration an investor aims to incorporate into the portfolio is driven by the downside risk potential within equity markets, as captured by valuation and outlook. An example of this level of ‘insurance’ is set out in Figure 2 below, with the level of insurance desired increasing as equities become more expensive and the outlook more negative. Given that over the longer term the bias to equity markets will be toward ‘Fair Value’ with a ‘Positive’ outlook, Phase 4 can be considered as the ‘Neutral’ stance of the fixed income sub-portfolio.
Having ascertained the trade-off between duration and equity risks, the investor must now turn to determining how the interest rate duration will be structured to achieve the desired level of insurance. There are now two ways that this duration contribution can be achieved or implemented. For the purpose of illustrating how a fixed income portfolio may be constructed, the Australian bond market is broken down into three main sub-indices:
1. Short Duration Corporate Credit: Bloomberg AusBond Credit 0-3 Yr Index (ticker code: BACR03)
2. Mid Duration State Government: Bloomberg AusBond Semi Govt 3-7 Yr Index (Bloomberg ticker code: BASG37)
3. Long Duration Commonwealth Government: Bloomberg AusBond Govt 7+ Yr Index (Bloomberg ticker code: BAGV7)
Figure 3 below shows the relative interest rate and credit risk for each of the three sub-indices.
Other sub-indices can be used, though the objective remains the same: to separate the two main risk components associated with the Australian fixed income market; namely interest rate and credit risk, i.e. the more interest rate risk in a sub-index, the less credit risk. Again, the reason for separating the fixed income portfolio into two main types of beta exposures is to more efficiently manage overall exposures given the different interactions between not just interest rates but also credit spreads with equities over the cycle. By doing this, the investor is in a superior position to manage the risk trade-off within their fixed income portfolio.
The initial approach is for the investor to apply a static allocation to the fixed income sub-portfolio. With this approach, the investor proactively manages the duration within the fixed income portfolio itself to achieve the desired duration contribution within the total portfolio. Figure 4 below shows the potential allocations required by each of the three sub-portfolios to achieve the duration target within the total portfolio.
This example also highlights the importance of separating beta characteristics between the sub-portfolios. This is critical, as the investor ideally needs to control multiple risks within fixed income portfolios. Accordingly, at the extreme, when the investor considers that both equity valuations and the outlook are negative, not only do they have long duration but there is also no exposure to credit within the fixed income portfolio. This is important because there are often common, negative factors impacting both equity markets and credit spreads. By separating the different exposures, the investor has more control over the composition of risks within the fixed income portfolio. This in turn gives the investor greater ability to ensure that the overall portfolio characteristics are in line with their investment objectives.
The alternative approach is where the investor, while maintaining a static composition and duration within the fixed income portfolio, proactively manages the actual physical allocation to the fixed income portfolio to achieve the desired duration exposure. With this approach, the investor is structuring the fixed income portfolio to maximise the standalone risk/reward characteristics. Based on the outlook for equities, the investor will manage the physical allocation to the fixed income portfolio to achieve the desired level of insurance. Figure 5 below shows the scaling of allocations, relative to a pre-determined ‘Neutral’ allocation, required to achieve the desired level of insurance.
The key is that the duration characteristics sought by the investor are being provided by altering the allocation to the fixed income portfolio rather than the characteristics of the fixed income portfolio itself.
Which approach is best really depends on the requirements or views of the investor. To better understand this, it is worth highlighting that while the two approaches can be calibrated to be equivalent in terms of interest rate duration, they are not equivalent in terms of total portfolio risk. This arises as the negative beta for returns from interest rate duration to equities is materially less than one, meaning there are two questions an investor must ask themselves when determining which is the better approach:
1. Is there sufficient scope for the level of interest rates to provide a suitable buffer? Put another way, there needs to be sufficient downside potential in interest rates so that they can rally materially should the equity market outlook deteriorate. In the event that interest rates are too low, simply increasing the interest rate duration within the fixed income sub-portfolio may not provide the desired return buffer.
2. How much conviction does the investor have in their forecast for equities? This is an important point, as by physically lowering the allocation to equities the investor has a greater impact on the overall beta of the portfolio compared to simply altering interest rate duration within the fixed income portfolio. Unfortunately, the greater impact on portfolio beta from changing the physical allocations can be a double-edged sword, i.e. there is the upside if the call is correct but also the opportunity cost if the call is wrong. Accordingly, altering the duration within the fixed income portfolio may be a more effective way of reflecting lower-conviction views regarding equities as the opportunity costs associated with being wrong are lower. In contrast, where the investor has a very high level of conviction regarding the outlook for equities, altering the physical allocation to fixed income may be a more efficient way of implementing the strategy.
Which is the best approach to integrating the management of equity and fixed income sub-portfolios will depend on weighing up these two factors and indeed may vary from investor to investor as well as over time.
It is important for investors to proactively manage the characteristics of fixed income portfolios over the investment cycle to ensure that they optimise the defensive benefits associated with combining them with equities. Accordingly, there are solid grounds for investors to consider a more holistic approach toward managing exposures within fixed income portfolios. Specifically, investors can manage the exposures within the fixed income portfolio based on their outlook for equity markets and the level of insurance they require. This provides investors with greater scope to ensure that the overall portfolio is managed in accordance with their desired investment objectives.
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Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...