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Building Unconstrained Fixed Income into a Portfolio

Managers should include unconstrained fixed-income with a core-based strategy, not as a replacement.

Unconstrained investing can mean different things to different people. In our view at Franklin Templeton, unconstrained bond funds can function as a long-term, benchmark-unaware approach that works alongside a more traditional core-based or liability-driven strategy.

For one thing, the opportunity set across the fixed-income universe is much broader than the markets represented in the Barclays U.S. Aggregate index, or Agg. Global corporate and government debt, municipals, high-yield corporate and bank loan debt can potentially provide additional sources of return and access to growth in markets that may outperform U.S. fixed-income sectors.

Unconstrained investing is often associated with having no guardrails. In our view, however, it simply means that a portfolio manager is untethered to any characteristic of a benchmark. Risk management remains a critical component of the portfolio construction process, to be sure. The important distinction from an investor’s perspective, though, is that an unconstrained manager has more levers at his or her disposal, as well as more sources of potential uncorrelated returns. These mechanisms can work together to broaden available investment opportunities and reduce concentration relative to the benchmark.

Moreover, managers of unconstrained portfolios have the latitude to fully incorporate their best investment ideas, whereas in a traditional core fixed-income portfolio, the manager is bound to a benchmark, like the Agg. In anticipation of rising rates, a constrained manager may adjust the portfolio’s duration to be, say, 20 percent shorter than the benchmark’s. This duration can still be fairly long, however, representing a concentrated absolute risk in the portfolio. An unconstrained manager, on the other hand, can substantially reduce or even eliminate duration, if appropriate. Basically, a manager can actually express a true view and not a view versus the benchmark.

Granted, institutional investors need at least some core fixed income in their portfolio to serve as a defensive position or as a hedge against a declining equity market. Global bonds don’t necessarily serve either of those purposes on their own. Also, given that most U.S.-based institutions have U.S. dollar-denominated liabilities, a complete swap of core fixed income for global bonds could result in a foreign exchange mismatch.

Nonetheless, incorporating some global debt can accord portfolio managers forex flexibility. An unconstrained manager could exercise net negative positions in the Japanese yen and the euro to benefit from currency depreciation tied to quantitative easing measures from the European Central Bank and the Bank of Japan. Such a strategy could also help to provide downside protection during periods of volatility in emerging-markets currencies. Finally, a great deal of academic research supports the view that foreign exchange markets are inefficient and that select managers can continually add investment return over time. For global unconstrained fixed-income managers, active foreign exchange management has been — and will remain — a key source of return.

As a first step, we think investors should define risk properly as it relates to their investment objectives: Is it the risk of loss in absolute terms, the risk of not meeting a particular objective or the risk of underperforming a benchmark or peers? In our view, unconstrained investing focuses on the first two concerns. From there, we believe several different characteristics merit closer consideration, such as Sharpe ratios, Libor-plus and pure nominal return hurdles.

Over the long term, unconstrained fixed-income strategies can complement core holdings and potentially deliver total return and provide stability for investors. We believe it is important to seek managers with long, proven track records who have significant global resources to support research across all areas within the opportunity set. Also critical is that unconstrained fixed income remain at the core of a manager’s investing philosophy, as opposed to a “We can do that too” strategy. After all, though the concept may sound intellectually appealing from a pure return perspective, practical issues continue to be a challenge.

Scott Lee, based in San Mateo, California, is the head of institutional sales–U.S., and Brian Zeiler, in Boise, Idaho, is senior vice president of institutional sales, both at Franklin Templeton Investments.

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