The Portfolio Construction Files

Breaking the constraints to find returns

Michael Gruener |30-Jul-2018


Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

Constraints, constraints, constraints

Most conversations I have with clients evolve around constraints. Risk constraints, cost constraints, benchmark constraints and other investment considerations typically frame investment conversations – and we excel at using our technology, experience and expertise to provide solutions.

But is that enough? Investors have grown increasingly sophisticated in deploying different investment approaches to achieve their goals. Our view is that the full investment toolkit should be considered: a blend of indexing and alpha-seeking strategies often meets the investment objective.

Many objectives can be achieved by having broad-based market exposures, but we believe some require skilled navigation of the opportunity sets across markets. Events in 2018 have reminded us that volatility can be triggered by different events, and can create dislocation and relative value opportunities. In fixed income, investors are increasingly turning to alpha-seeking strategies to help mitigate risks and capitalize on opportunities. Over half (57%) of all 2017 flows into alpha-seeking strategies went to fixed income strategies, according to Broadridge Saleswatch, and this trend has extended into 2018.

The reason for this is well known: the search for yield remains challenging. It requires a skilled and nimble approach to achieve consistently. Investors now have more indices at their disposal and can be a lot more selective about their benchmark. Yet they still need to anticipate which indices are likeliest to help them achieve their investment goals – and need to understand the drivers of that benchmark’s returns. 

Traditional fixed income benchmarks don’t necessarily provide positive returns all the time. They are driven by interest rates, which in turn are driven by central banks. By our calculation, more than two-thirds of the risk in most fixed income indices is driven by duration, - and duration is a risk in the current environment, we believe.

Adopting an alpha-seeking strategy can help mitigate this risk, but there are different ‘intensities’. Most alpha-seeking managers are constrained by their stated benchmark. Further along the spectrum you have ‘high-conviction’ approaches, which loosely refer to a benchmark. Finally, ‘unconstrained’ strategies aim to achieve positive returns irrespective of what market benchmarks do.

Unconstrained strategies have the ability to seek out opportunities across a wider spectrum than most benchmarks allow. They can achieve a higher yield and lower interest rate sensitivity compared with traditional fixed income investments, while maintaining a similar level of overall portfolio risk. This is key for the objective of achieving attractive risk-adjusted returns across interest rate environments.

Our fixed income team’s central thesis for the rest of this year is that there is little upside in duration risk because the upward trajectory on interest rates remains firm in the US, even if there are hiccups along the way; that there are opportunities to selectively add risk in emerging markets and exploit specific credit opportunities in Europe; and that the short-duration part of the US curve is attractive. That being said, we believe it is prudent to maintain some duration as it has historically functioned as a buffer against a risk-off events.

An unconstrained approach is able to act on this investment thesis and exploit numerous additional opportunities identified by the investment teams. As investors think more holistically about their portfolios and seek to minimise correlations and risk exposures, unconstrained funds may have a greater role to play.

Michael Gruener
Managing Director, is Head of BlackRock's Europe, Middle East and Africa Retail business.

Diversification and asset allocation may not fully protect you from market risk.

Risk management cannot fully eliminate the risk of investment loss.

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