Sector allocation begins with an analysis of all sectors. We try to establish relative value among the sectors and to identify where the greatest value opportunities are. Next we look at supply and demand and estimate the impact of these trends on yield spreads and prices. Then we analyze the instrument environment and its impact on various sectors of the market. Based on relative value, we establish target portfolio allocation percentages for each sector, emphasizing the sectors we believe are undervalued.

Q:  How do you identify new investments?

A: The new idea generation begins with the analyst or the trader and often is in some type of collaboration. The analyst who is the industry specialist becomes aware of the new issues and we begin researching them for suitability. The trades would be in part dictated by particular market opportunities and are brought to the analyst for further review and to the portfolio manager for final approval.

If we identify a prospective investment, we perform a highly detailed review to assess its suitability for individual portfolios. A lot of people are responsible for a variety of factors: credit risk, industry analysis; rating developments and daily pricing; management review; issue structure and so forth. Technical market conditions are another important aspect. They include supply and demand, mutual funds, individual hedge funds, etc. A specific issue analysis is always placed in the context of the industry and the sector in order to assess relative value.

Q:  Would you describe your risk management process?

A: Risk is something that we manage very tactically. We actively rotate the 12 sectors based on relative value. When we utilize the less efficient credit-like sectors, we try to avoid risk by staying in more benchmark, more liquid issues. But the cornerstone is granularity or small position sizes. Half a percent or a quarter of percent is not going to devastate your portfolio. We stay well-diversified by issuer with most positions averaging less than 1%; with those less liquid names we take even smaller positions.

We avoid interest rate risk by trying to neutralize it. We match portfolio duration to our benchmark and match yield curve distribution to the benchmark and avoid significant pre-payment or call risk. We use derivatives strategically, not for yield enhancement. We hedge currencies when appropriate for the shareholders and for dollar price management.

The portfolio review is another method of oversight. We have standard portfolio reviews, sector reviews & sector allocation meetings, making them formal and mandatory on a monthly basis. We review daily anything that is out of realm or has big price swings. Anytime we purchase a credit that’s below AA, we have a formal review and require a full-blown write-up.

Q:  Some fund managers start with a macro view and then construct the portfolio along those lines, others start with a bottom-up analysis. Where do you stand?

A: It is a combination between the two. Our top-down approach is the sector analysis and allocation; our bottom-up is the fundamental research, which is issue selection. We have a macro overview, but since we don’t anticipate interest rate moves, it is based on sector bets. As we construct the portfolio, both of the approaches are based on relative value. The disciplined sell strategy is an essential part of our portfolio construction process. Our sell decisions are driven by relative value. If the fundamentals deteriorate, or the price has appreciated too greatly, the security becomes a candidate for a valuation review and possible sale.

Q:  One of the difficulties in investing in fixed income has been relying on rating agencies. How do you handle this difficulty?

A: We actually have set up a rating database here. When we look at a credit, we attach a score internally. We overlay relative value to better identify credits and to see if the market is already pricing based on what we found about from the rating agencies and the security. But you are right. Often you would have a credit for which there is troublesome news and the rating agencies would lag. And in the last credit cycle we saw some of them downgrading first on bad news and asking questions later. So you need your own proprietary research, which for us is about 70-80%.

Q:  Can you give us an example of picks that have worked out and picks that haven’t worked out? How did you change your process?

A: One screen that worked out was on Fleming Companies. There was negative price movement and the credit analyst could not find any solid concrete evidence on what was going on. We looked at the credit derivatives market as a second overlay and saw that spreads were dramatically wider than the cash market, which typically means that there was some news that we weren’t privy to. We sold the underlying position and a week later their main purchaser of the food wholesale business went bankrupt.

On the other side, right now the autos are getting very cheap for their rating from a valuation perspective. Market technicals dictated change as opposed to pure fundamentals and the auto companies, which are investment grade rated, are trading as CCC credit. For our model this is a huge buy signal, however, when we set down to discuss the purchase, nobody felt comfortable adding the position, knowing that they could easily go to below investment grade. So we had to revise our process. The model said buy, but there were other factors to be considered out of our normal process.

Some of the mistakes that we’ve made include being too model-like or too systematic, where spreads widening 15 basis points signal that the sector is cheaper and we feel that we have to increase our position. However, sometimes we haven’t been able to act on that because we couldn’t find something that we liked. Just because something is cheaper doesn’t mean that it is a buy.

Q:  I may be wrong, but my experience is that the U.S. inflation rates measurements tend to be incomplete and do not include some of the major components of inflation as they would in some other countries. How do you counter this situation?

A: I agree. I think that CPI is not a good benchmark of overall inflation. Twothirds of the CPI is wage inflation, which because of productivity enhancements, is not existent. Healthcare, commodity inflation, and housing prices aren’t truly reflected in the CPI. But there are ways to hedge yourself and take advantage of this. When we see it, we call for a sector allocation meeting and potentially allocate more to the inflation-protected securities, both government and corporate.