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Fixed Income Management Evolution or Revolution? June 2008 Susan Buckley, Managing Director, Active Management Division

Fixed Income Management Evolution or Revolution? June 2008 Susan Buckley, Managing Director, Active Management Division. Discussion Agenda. The Traditional Approach to Fixed Interest Evolution or Revolution? – The separation of Alpha and Beta Accessing Fixed Interest Beta Risk and Return

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Fixed Income Management Evolution or Revolution? June 2008 Susan Buckley, Managing Director, Active Management Division

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  1. Fixed Income ManagementEvolution or Revolution?June 2008Susan Buckley, Managing Director, Active Management Division

  2. Discussion Agenda • The Traditional Approach to Fixed Interest • Evolution or Revolution? – The separation of Alpha and Beta • Accessing Fixed Interest Beta Risk and Return • Meaningful Fixed Interest Alpha

  3. The Heritage of Fixed Interest….. • Traditional Approach was based on the concept of Strategic Asset Allocation (SAA) • Fixed Income was mainly used as a risk reduction allocation within diversified portfolios • Active returns were low, and the weighted contribution of the assets to the total portfolio return was negligible. • Downweighting of the asset class, within portfolios, in order to search for alternatives that added more meaningful return. • This encouraged fixed interest managers to evolve and remain meaningful.

  4. Traditional Fixed Interest Management • Fixed income portfolios were historically managed relative to a specific benchmark. Eg. UBS Composite Bond Index, Lehman’s Global Aggregate • BUT, these benchmarks embody a number of complex issues. • The 2 major inefficiencies relate to: • Duration problem – duration of benchmark comes from issuer preferences and is not necessarily duration that a given investor should hold. • “Bums” problem – the biggest debtors have the largest weight in the benchmark. • The recent growth in size of the credit market has also caused a number of issues.

  5. Bond returns have disappointed Australian Investors….. • Fixed Interest market (beta) returns have disappointed in recent years • Australian Fixed Interest underperforming cash returns

  6. Weaknesses of the Traditional Approach • Pre-occupation with benchmarks and a reluctance to hold significant allocations to assets which fall outside the benchmark. • Strategic asset allocations tend to be static for long periods, even in the face of significant changes in market valuations. • Active mandates are allocated in accordance with SAA weights – possibility of insignificant contributions. • Active managers tend to be analysed by investors on an unweighted basis

  7. Evolution or Revolution? – The Separation of Alpha and Beta • Fixed Income portfolios can provide significantly different risk and return outcomes, depending on composition and construction. • Beta Policy • Developed to provide market return stream from risk premia • Allocations include sector exposures, country allocations, credit limits, inflation exposure and overall duration. • Structure of Beta portfolio should reflect investment objective and risk preference of client • Alpha Policy • Aimed at construction of absolute return portfolio that provides: • Diversification (multiple alpha sources) • Consistent return stream • Outcome not tied to changes in Beta portfolio

  8. Accessing Fixed Interest Beta Risk and Return • Sources of Fixed Interest asset return are driven by four fundamental factors: • Real Interest rate risk - Credit Risk • Inflation uncertainty - Illiquidity Risk • Exposure of traditional beta sources to conceptual risk premiums: • Some asset classes are more effective in accessing risk premia

  9. Methods of Beta Replication • Physical Index Replication • Full replication is the lowest risk - but is highly complex. • For example Lehman Global Aggregate Portfolio contains over 12,000 issues • Enhanced indexing – investing in large sample of bonds such that portfolio risk factors match index risk factors • Synthetic Beta Replication • Shown to be effective – achieved by utilising market inovations • Instruments used include: • Bond Futures • Interest Rate Futures • Interest Rate Swaps • Mortgage Futures • Credit Default Swaps / Indexes

  10. Achieving Meaningful Alpha Reasons why fixed income alpha can be meaningful • Improved diversification of alpha sources with switch to absolute return from fixed interest benchmarks • Flexibility to adjust underlying betas without disrupting alpha sources • Low correlation to Beta • Greater capital capacity with use of derivatives and overlays • Alpha becomes more scaleable

  11. Breadth – Improving the Opportunity Set Fixed interest provides a BROAD opportunity set • Global • Access to the entire capital structure • Access to the entire risk curve

  12. What Does Diversified Fixed Interest Alpha Look Like?

  13. Scaleable – Largest Global Markets - Currency and Fixed Interest Fixed interest provides SCALEABILITY due to its broad opportunity set • Availability of fixed interest derivatives markets • Highly liquid • Economies of scale QIC is using less than 2.0% of capital to generate 25bpts of fixed interest alpha over $50bn ie. $125m pa target • Achieved via derivatives for strategy implementation and beta hedging

  14. Sourcing Alpha from Breadth of Opportunity Set

  15. Uncorrelated to Other Sources of Return Fixed interest alpha can provide UNCORRELATED returns The fixed interest alpha used in measuring correlation is taken from QIC Global Fixed Interest overlays and the GFI Alpha Fund. The correlations are based on over four years of data.

  16. What’s So Good About Low Correlation? The fixed interest alpha used in measuring correlation is taken from QIC Global Fixed Interest overlays and the GFI Alpha Fund. The correlations are based on over four years of data.

  17. Achieving Meaningful Alpha Returns To access fixed interest alpha successfully requires: • Global capability • Flexible mandates that allow derivatives • Strong risk systems and governance • Robust investment process • Absolute return focus

  18. Derivatives and Risk Control Global derivative capabilities requires: • Experienced fixed interest staff • Wide selection of counterparty contacts and ISDA agreements • Global coverage across the major financial centre (London, New York, Tokyo, Hong Kong & Sydney). Risk Control: • Understanding the risk factors attached to the derivative instruments • This is particularly important for new instruments such as credit derivatives and inflation swaps • Stress testing, VAR analysis is crucial

  19. Packaging Fixed Interest to be More Meaningful – Going Forward • Explicit focus on Client’s total portfolio objectives • Think about risk and adding value at fund level • Get away from irrational capitalisation weighted debt indices • Target fixed interest betas that meet client objectives • Make fixed interest alpha meaningful • Improve capital efficiency

  20. Separating Fixed Income Beta and Alpha for Improved Client Outcomes… Beta Alpha • To achieve clients’ overall objectives

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