Published in Professional Pensions' Specialist Investment Managers' Guide, 03 April 2008:  Hymans Robertson has recently published an in-depth survey analysing Absolute Return Bond (ARB) strategies across nearly 40 investment managers. These strategies aim to deliver returns (typically 2-3% p.a. gross of fees) in excess of cash. We believe that the case supporting their use is strong and that they will eventually become the mainstay of institutional active bond management for UK pension funds.

UK active bond management
UK pension funds have traditionally measured their active bond managers against a Sterling ‘composite’ bond benchmark, including UK Gilts, UK Corporate Bonds and Index-Linked bonds.

In recent years, managers have often been given the chance to opportunistically invest outside of the UK bond benchmark. Many now invest in asset classes such as emerging market debt (EMD) and high yield. Initially, these off-benchmark bets were made on a ‘long-only’ basis. However, the adoption of derivative instruments has also allowed managers to exploit negative views on off-benchmark markets.  Active bond strategies have become increasingly distanced from their UK benchmarks and in many cases are now best viewed as ‘portable alpha’ propositions.

ARB strategies will be the next major development in bond mandates for UK pension funds. These seek to deliver absolute returns, with performance measured against cash (or LIBOR). A key demand driver will be the neat ‘fit’ they offer with swap based LDI solutions. ‘LDI + ARB’ appointments are becoming commonplace, with schemes packaging a liability hedge in combination with bond ‘alpha’.

What is different about ARB strategies?

ARB portfolios differ from traditional Sterling bond portfolios in a number of ways;

• Objectives: ARB managers are tasked with generating positive absolute returns in excess of cash. This might be regardless of whether returns in the underlying bond markets are positive or negative.
• Strategy and asset class diversification: ARB approaches usually adopt a ‘go anywhere’ global approach. Managers are not typically constrained to specific regional or fixed income asset classes (the LIBOR benchmark itself does not form a starting point for the manager’s investment universe). ARB products often invest in a diverse set of investments including government bonds, credit, high yield, secured loans, EMD, currency, ABS and, in some instances, commodities.
• Use of Derivatives: Although instruments such as futures and swaps are already an integral part of most Sterling bond mandates, ARB approaches rely much more heavily on their use, as they isolate specific risk factors and strip out market risk. The extensive use of interest rate swaps and futures, options and credit default swaps (CDS) is commonplace.

Do all ARB strategies work in the same way?

No. The current ARB products on the market encompass a wide array of investment approaches and styles. However, a number of distinct categories are beginning to emerge:

• ‘Beta plus:’ These approaches make long-term allocations to duration and credit markets. Whilst some tactical asset allocation takes place at the margin, a meaningful proportion of the target return is sought through the income, or yield, that these markets offer. Managers argue that riskier bond asset classes should provide excess return over LIBOR in the long term, and that their active management ‘on top’ should help to insulate losses during bear bond markets.
• Diversified ‘pure alpha:’ These products are, in theory, able to deliver absolute returns irrespective of bond market direction. They are hedge funds, typically incorporating a large number of long and short positions. Performance attribution and monitoring can be complex due to the number of (and interaction between) positions. Most approaches have a long bias. Timing short positions in ‘spread’ sectors is difficult. The market rewards investors for taking on credit risk most of the time and, conversely, penalises them for being ‘short’. Short positions can therefore represent an ongoing cost which is hard to bear.
• Specialist sector: A number of ARB managers operate within a niche sector of the bond market. These managers believe that their exclusive focus and expertise (for example, within EMD or European credit) will generate skill based performance. Specialists usually argue that their sector of focus offers rich pickings through in-built market inefficiency or difficulties associated with investors gaining access.
• Best ideas: ARB approaches generally rely on a diverse set of strategies. ‘Best idea’ approaches are far more concentrated, allocating risk to around five to ten high conviction positions.  Their attractiveness is based on a belief (from the manager) that conviction is matched with increased probability of success. Most also offer a secondary benefit of being much easier to track / understand.

Pension schemes looking to benefit from manager and strategy diversification might look to employ more than one of the above categories.

Conclusion
The ARB market is set for significant asset growth and a flurry of new, innovative products are already being marketed to UK pension funds.  Some involve a long-term allocation to market risk. Others are more hedge fund like in nature.

Two seemingly similar ARB strategies with identical performance targets can involve very different levels of volatility and sources of investment risk. More than ever, it is important that trustees understand the techniques that their active bond manager will use; the cash benchmark provides no real reference as to the exposure and risks that they will take in attempting to beat it.