Given the current expectations of rising interest rates, it could be opportune now to choose an absolute return strategy to diversify a traditional fixed-income portfolio. In this précis of a more detailed article, Ben Steiner, senior portfolio manager at FFTW in New York, the dedicated global fixed-income specialist partner of BNP Paribas Investment Partners, explains why.
The current interest-rate environment will no doubt give many investors pause for thought in anticipating that interest rates are likely to rise, while knowing that fixed income will still feature in their asset allocations.
Most investors view fixed income as relatively safe and as being a lower-risk allocation compared with, say, equities. However, when rates rise, the mathematics of bonds means US dollar prices need to fall for fixed-income securities with a positive duration. Most investors benchmark their fixed-income portfolios against a positive-duration index, which leaves them facing a conundrum: even if they can consistently outperform a bond-market index, the total return in a rising-rate environment may still be negative.
Broadening traditional core fixed-income strategies to ‘plus’ sectors may not help in rising-rate environments, either, because such portfolios are still benchmarked to a positive-duration index, and because spread compression can only help to enhance relative returns. To compensate for this, some investors may allow their managers to manage portfolio duration asymmetrically – for example, to have it range from 0 years to the benchmark duration plus two years – but this still does not entirely solve the problem that negative returns are likely to be realised.
A further step takes us to an absolute-return framework, where portfolio interest-rate risk can be positioned to benefit in both falling and rising-rate environments. This means portfolio duration is managed within an absolute duration constraint, for example plus or minus three years.
How do absolute and relative-return strategies compare?
In short, absolute-return strategies are not managed relative to an index of assets. The table below summarises the main differences:
|Relative return focus||Absolute-return focus|
|Strategy’s performance target||Outperforming a combination of assets in the investment universe (often a benchmark index, traditionally market-cap weighted)||An alternative target, e.g. cash interest rate + xxbp; a risk-free rate or the rate of inflation|
|Fund manager’s opinion neutral||Allocation of assets at benchmark weight||The manager can choose not to hold assets at all|
|Fund manager’s opinion negative:||Underweight assets of opt for off-index: both have consequences that limit the manager’s ability to express a negative view in the portfolio allocation||The manager can express negative views freely (probably via derivatives)|
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