Q:  What are the core beliefs in your way of money management?

A: This is an enhanced index strategy that provides core exposure to the S&P 500 index, but is optimized to add excess return with less volatility and greater consistency of returns.

We chose an enhanced index strategy because, historically, asset managers haven’t done the best job in beating the S&P 500 in the large-cap core category of funds. And while there are different ways to create value in the enhanced index space, we chose to do it by investing in S&P futures and using the free cash to add alpha through the bond market.

But it remains an enhanced index strategy and its goal is to be consistent with the S&P 500 and to optimize the volatility of the fund versus its benchmark. The tracking error of the fund is low and we expect it to stay that way because this is what our investors are looking for – market exposure with consistent performance.

Q:  What are the strategy and the process that help you to achieve these goals?

A: We believe that you need a disciplined process to achieve consistency. We start with investing in the S&P futures market, which is very large, very liquid, and has an implied financing cost which is equivalent to short-term interest rates, or LIBOR (London Interbank Offer Rate). So, in order to beat the index, we need to beat LIBOR. We do that by using short-term bonds because our firm has a track record in beating short-term interest rates using short-term bonds. In summary, we add value by using short-term bonds to beat LIBOR.

We use various bond market tools and techniques, including duration and sector rotation. Philosophically, we believe there’s a sweet spot on the yield curve, which is between 1 year to 3 and 5 years of the yield curve. As you roll down the yield curve, the risk/reward potential improves.

We also believe in diversification and we maintain a diversified portfolio of Treasuries, agency bonds, corporate securities, mortgage-backed and asset backed securities, some high-yield bonds, and emerging market bonds. That’s the overall spectrum of vehicles at our disposal. Although the Treasury and the agency bonds sometimes underperform LIBOR, there are certain periods when they are useful for liquidity purposes, for example, when there is a flight to quality. So, in our portfolio, the whole broad fixed-income spectrum can play an important role.

Q:  Why do you prefer bonds with shorter term maturities?

A: Historically, the typical yield curve has had an upward slope. There are many theories on the reasons, but the reality is that the longer the period for which you lock up your money, the more you should be compensated, and that’s reflected in the upward sloping yield curve. Everything else being equal, you should be paid a higher yield in a 5-year bond than in a 2-year bond.

But the difference between the 5-year and the 2-year yield isn’t always as great as the difference between the 6-month and the 2-year yield. So we believe that there is a sweet spot in the front end of the curve. And since there is no free lunch, the longer the duration of the portfolio, the more you are subject to the volatility of interest rates. The impact on the value of your bond due to interest rate changes will be greater for the bonds with longer duration. Because we seek consistency, we need to manage the duration of the bonds relatively close to the duration of our liability, which is the LIBOR.

That’s the rationale for keeping the duration short. Nevertheless, due to interest from our clients we have different durations in our separate accounts. If there is enough demand, we could open a fund with longer-maturity bonds, but that will be a different product. Overlaid with the S&P 500 futures, it should provide even higher alpha, which will also come with higher volatility and tracking error.

Q:  Could you explain the rationale behind using the S&P futures?

A: This is an equity fund despite the fact that it uses short-term bonds. The index funds would buy the basket of stocks of the underlying index, either all of them or an optimized selection. In those cases the return to the investors will be the return of the S&P 500 minus the expenses. In active strategies, the managers make active bets against the index by underweighting or overweighting certain sectors or stocks with the idea to generate alpha or excess return above the return of the S&P 500.

In our case, the goal is to get the return of the S&P 500 plus alpha without the added volatility and with a low tracking error. Just like active strategies, we aim for a return above the return of the S&P 500, but with more consistency. That is why we are willing to tolerate alpha that is lower than that of an active manager. But since many active managers have a hard time beating the S&P 500 anyway, our strategy has been quite attractive. Essentially, this is an S&P 500 enhanced index strategy that provides added value through various techniques in the bond market.

So the S&P 500 futures pay the S&P 500 return minus LIBOR. That provides exposure that is consistent and well-correlated with the S&P index. We still have access to the cash because we didn’t need to spend all of it to get the S&P 500 exposure, and we can invest that cash in the bond market. Then, all we have to do is beat LIBOR, which is our cost. If we beat LIBOR, we beat the S&P 500.

In our case, the futures can be viewed as a cost center. That cost has fluctuated and needs to be managed but only from a cost standpoint and there’s no active equity betting. Nevertheless, we have to roll the futures on a quarterly basis and we have to make sure that their exposure is accurate. We always aim to have a 100% exposure, not 95% or 105%, as we just reflect the market with the futures. And that takes a fair amount of infrastructure.

Q:  What’s your approach for selecting the bonds you invest in?

A: We use a top-down approach, where we start with the broad factors such as interest rates, inflation, and macroeconomic trends including GDP growth, etc. We also look at technical flows. Then, of course, from a sector standpoint, we estimate the credit climate. For example, we may consider the chances of a recession, the rate of growth of the economy, if the spreads are too tight, if they will tighten further, etc. All of those factors are part of our outlook.

Once we have laid out the broad outlook, we can decide on the duration of the portfolio, the sectors in which we should invest, and the parts of the yield curve that we should overweight or underweight. Basically, those are the three main decisions that we have to make.