Fund management: Yield evaporation good for active managers

In one of the best caveats Euromoney has seen for quite some time, Janus Capital’s Bill Gross tweeted the following on April 21: “German 10yr Bunds = The short of a lifetime. Better than the pound in 1993. Only question is Timing/ECB QE.” 

The ECB is fuelling the biggest bubble we have seen since the launch of the single currency Franck Dixmier, Allianz Global Investors

Oh, just that, then. Timing in the wake of ECB quantitative easing is something that everyone on the buy-side is struggling to get right and tackling with a wide range of strategies. “There is distortion coming from a range of measures including QE, negative deposit rates and ample liquidity,” says Franck Dixmier, managing director and CIO fixed income Europe at Allianz Global Investors.

Allianz’s global bond portfolio accounts for 20% of the €40 billion in assets under management from Frankfurt. “We think that the ECB is fuelling the biggest bubble we have seen since the launch of the single currency,” says Dixmier. “There is total disconnect between fundamentals and asset prices.”

Vexing question

The question of how to manage a fixed income portfolio in this situation is a vexing one. Guillaume Lasserre is head of absolute return and solutions at Lyxor Asset Management in Paris. He argues that the current yield environment calls for greater adoption of smart beta strategies. Lyxor has €6.5 billion under management in its diversified European government bond offering. The strategy was launched in September 2013 and was specifically targeted at bank clients needing to manage their liquidity buffer. It is now being expanded to other institutional investors.

“Yield to maturity is a good way to look at things with a buy and hold strategy. But when you have an active smart beta strategy, while yield is important, it is not everything,” Lasserre says. “It is important to take care over credit risk in government bonds. We have applied smart beta techniques to the government bond portfolio to achieve risk balance across the fixed income universe and manage the global risk of the portfolio. This is the backbone of the strategy and on top we have active overlay.”

After years of transition towards passive strategies, the direction of travel might now be changing back as fixed income investors in Europe face up to today’s negative yields.

“Active versus passive becomes interesting when assets are overpriced,” says Richard Ford, European head of credit at Morgan Stanley Investment Management. “There is a move by the market towards active management: just because something is in an index doesn’t mean that you should own it. There are some investors, with generic pools of capital that have guidelines restricting the investment opportunity set, which will have to buy assets daily correlated to what the ECB is buying,” he says. “In the short term this isn’t a problem, there is low running yield but not capital losses. However, in the future if these assets rise in yield those pools of capital start to generate losses or at least opportunity cost losses. This will raise questions.”

Dixmier at Allianz argues that today’s markets necessitate a more focused active approach. “Smart beta is still beta,” he points out. “Investors might be wise to consider reducing beta exposure because what happens when the ECB is no longer there? I am convinced of the need for active management. 

“The market is ever more discriminating and idiosyncratic risk is on the rise. Passive investing could be a painful mistake for those obliged to stick with a benchmark,” he says, “given the asset bubble that is building. You have to be agile and flexible. You have to be able to capture performance in every environment.”

Convexity

“We are building a convex portfolio,” says Dixmier. “The cost of convexity is very low today. When we purchase volatility, we purchase calls as they are cheap. We observe little interest on the call side. Investors are interested in hedging the performance of the Bund. On the put side, they want to protect their portfolios.” 

That kind of active management comes at a price. But Dixmier’s sobering declaration that “fixed income portfolios have never been so risky”, should focus investors’ minds on if that is a price worth paying. “To manage this risk, it is advisable to arbitrage between benchmark-lite portfolios and active strategies,” he advises. 

Just how exposed passive portfolios are depends on how long this bizarre period of negative yields in Europe persists.

“I don’t think that it is inevitable that yields in Europe will continue to fall,” says Ford at Morgan Stanley. “You have to look at relative value on a global basis. The assumption that sovereign yields in Europe will all go to minus 20bp assumes stable global yields. But as US yields rise the relationship between US and European yields widens to a point where even excess demand pulls euro yields higher.”

That cannot happen soon enough for many. Dixmier believes that there is now overwhelming pressure for the Fed to hike sooner rather than later and he will be relieved when this happens. “We do not think that the Fed has any margin for manoeuvre in the event of an external shock to the US economy,” he says. “This worries me as an investor.”