When you mention an assembly line, most people probably think of Henry Ford[1]. Auto assembly lines have a defined sequence, where often more than 5,000 components (as many as 30,000 counting each screw, nut, and bolt) come together as the shell and chassis meet before the final staging for tires, battery, fluids, and gasoline. It was and is an engineering marvel, and has evolved even further with the processes for producing cell phones, aircraft, and spacecraft, to name a few.
What about the portfolio construction process? There are elements of science and sequence, and also some “art.” Characteristics such as duration, key rate exposures, option-adjusted spread duration, yield, and tracking error are often targeted at the portfolio level, while the actual components – the underlying bonds themselves – can vary. Passive index managers, using replication expertise, can create portfolios with very low tracking error, though performance can be affected by an untoward idiosyncratic event such as a default or downgrade. Active management comes in several flavors (Ford vs Chevy, Lexus vs BMW, Toyota vs Subaru, etc.), where the underlying bets can be significantly dissimilar. To simplify, managers can make macroeconomic bets, use sector rotation, and/or rely on bottom-up security selection. Off-benchmark macro exposures and significant active sector exposures will typically drive tracking error due to their related systematic factors, while large relative individual security exposures will increase idiosyncratic tracking error.
How does the assembly process for investment grade portfolios work at IR+M? Ideas can come from anywhere – an analyst, a portfolio manager, our dealer coverage, or perhaps a new deal in the market or an issuer road show. Research analysts make recommendations on the issuers and sectors under their purview, and also highlight material ESG factors. Our sector specialists evaluate all the options on the table, and ultimately share their best ideas, which are well telegraphed across the desk. From there, our PM team has a firm grasp on our Investment Committee’s desired level of risk tolerance, and evaluates available opportunities within the context of relative value, portfolio need, and client guidelines. Portfolio level, sector, and idiosyncratic risks are assessed to ensure metrics are well within tolerance (much like a piece of door trim molding might not fit just right, and gets rejected). Specifically, portfolio duration and key rate exposures across the curve are kept within tight tolerance bands, and maximum sector and individual security risk limits are scrutinized.
The resulting portfolio is not designed to perform in response to the movement of rates, currencies, or other macro factors – or leverage – but is more of an all-weather portfolio (“Built Ford Tough ®”) where individual security selection drives results. Overall, there are often more opportunities when spreads are wide, which will typically lead to more risk in the portfolio, while in tight spread environments, risk exposures and tracking error will tend to be closer to the benchmark. Over time, about 70% of our value added (performance relative to the benchmark) comes from security selection, with the remaining 30% from asset allocation across sectors.
Active portfolio management is not “set it and forget it” – it’s not a basic mode of transportation that is uncomfortable on the highway or has no A/C on a hot day. At IR+M, the “vehicle” is adjusted to current market conditions. In rough markets, it becomes a durable 4WD that can crawl up a rocky slope to get you to the top; in smooth markets, it becomes a powerful V8 that comfortably runs all day at 80mph. The ability to adapt the portfolio to market conditions allows active management to outperform passive over time. And just like with car shopping, where there are many models to choose from, fixed income portfolio construction also comes in many styles, whether macroeconomic-focused, sector-oriented, or bottom-up. We believe that assembling a diversified portfolio of our best ideas, and scaling risk appropriately for the level of spreads and available opportunities is the more durable, consistent way to add value.
