If we believe that interest rates will rise, we want to be exposed to short-term bonds as much as possible, and this is the big challenge in this strategy. Ideally, we would have a very short duration because the LIBOR itself has no duration. Of course, if we think that interest rates will fall, we’d want to be as long as possible. But because of our discipline, we wouldn’t take excessive risk on duration; we would stay within reasonable limits. Even if we absolutely love the market, we recognize the fact that we don’t have a crystal ball, and it wouldn’t be prudent to place the duration way beyond the duration of LIBOR. We keep in mind that one of our major objectives is to maintain consistency over time.

On the sector side, we rely on our specialists in all the different sectors. We have mortgage specialists, corporate bond, emerging market, and high-yield bond specialists. Depending on our outlook on the economy and the yield, we will put together the portfolio. If we think that the economy is relatively stable or doing very well, and if we like highyield bonds, we will have below investment grade bonds in the portfolio as well.

The number of bonds depends on the environment, but we usually hold many bonds because we insist on diversification. Right now we have over 100 bonds in the portfolio but, usually, we hold about 60 or 70 bonds.

Q:  When interest rates are rising and bond values are falling, how difficult or easy is for you to generate alpha?

A: That’s probably the most important issue for our strategy. It is nice to out-yield LIBOR in all environments, but when rates are rising, you have no other way of winning, unless you go short.

Duration is really the measure of the percent change in the price of your bonds for a unit change in the interest rate. For example, if interest rates rise 1%, a 5-year duration bond will be hit with 5%, and you would lose 5% of the value of that bond. For a bond with 1-year duration, the negative impact on the price will be 1%. You’re also getting paid the coupon, and if your loss refers to just one bond in a diversified portfolio, you might be alright. But if your entire portfolio has a duration of five years, it may take a while for you to recover.

That’s why in a rising interest rate environment the duration should be as short as possible even negative, and then the yield should be as high as possible. Right now LIBOR is around 5.4% and you need to be making more than that on your bonds. Bonds that don’t have a lot of interest rate exposure but pay 5.70% or 6%, work well in that environment. But such bonds carry some other risks. Without interest rate risk, you would either have to deal with structure risk or, most likely, with credit risk.

Q:  What are the challenges in generating excess return in the opposite scenario, when rates are declining?

A: When rates are falling, you need to make sure that you have a long duration. The ideal case would be to anticipate the falling rates and to move to a longer duration early enough. But if you didn’t capture that moment and your duration is still short, you missed the boat. Basically, if rates fall by 1%, you add 100 basis points of performance on a 1-year duration bond. But you have to be aware why interest rates are falling. For example, in the case of an increased risk of a recession, there is a flight to quality, and rates fall because everybody rushes to short-term treasuries. In that scenario, you would do well staying purely in 2-year or 5-year Treasuries with no credit risk.

Q:  What types of risks do you perceive and how do you manage them?

A: The major risks are the interest rate risk and the spread risk. But there is structure risk as well. For instance, mortgage- backed securities may be rated AAA and have no credit risk, but they still carry structure risk. This aspect has to be managed as well.

Q:  Historically, how much alpha have you been able to add using the enhanced index strategy?

A: Again, it depends on the environment. In some environments we’ve added over 100 basis points, but in the last few years it has been extremely difficult because of the inverted yield curve. On average, since inception in 1994, our strategy has added around 60 basis points of alpha, although in certain periods we have added 120 basis points.

Q:  Is there a certain environment that is particularly difficult and may lead to negative alpha?

A: These are the periods with inverted yield curve, widening credit spreads, and rising interest rates. Each of them can cause problems and all three of them at once are especially challenging.

Overall, our strategy is suitable for investors who don’t necessarily seek the highest possible alpha but seek a core equity exposure to the broad market that is efficient and stable. Our strategy will not underperform significantly but it’s not going to outperform significantly either. And the main driver of the return remains the stocks in the S&P index despite the fact that bonds provide the alpha portion. There is still strong correlation with the index and this remains an equity strategy.