Tim Gardener was disgruntled. “I worry about the corporate bond space. If you invest according to market capitalisation in the corporate bond space, you invest the maximum amount of your allocated money in the most indebted companies, all else being equal,” Gardener said in an interview at AXA Investment Managers’ London office on May 25. “Lending more of your money to someone with a huge amount of debt, rather than some who has got less, doesn’t strike me as a winning strategy.”
Gardener worked for more than 23 years in the UK at Mercer Investment Consulting and its predecessor company, Wyman, rising to become global chief investment officer before exiting in August 2010. He struggled “on and off” with clients’ use of market capitalisation- weighted indexing as a low-cost way of buying bonds. The strategy was used “because there wasn’t anything else,” he said. Before the financial crisis broke, he advised pension funds to not track the UK corporate bond index because it then directed more than 60 per cent of capital to financial companies. At one point, Lloyds Bank, which was later bailed out by the government, accounted for about 7 per cent of the index, Gardener recalled. “I had nothing against financials at the time but it seemed that they borrowed an awful lot of money,” he said.
Gardener wanted a smarter way of investing in the beta, or common risks, of credit markets that does not have the flaws of funds which passively tracked market-cap weighted indexes. Such funds don’t adapt to changing markets and buy new bonds regardless of the creditworthiness of issuers. There was, however, one major problem. “I’m not a Rob Arnott,” Gardener said, referring to the Research Affiliates founder who pioneered fundamental indexing as an alternative to market cap-weighted funds. “I could see the problem but not the solution.”
In 2012, as head of institutional client strategy at AXA Investment Managers, he challenged the company’s fixed income team: “What I want is something that is buy-and- hold as far as possible, and is designed to catch as much of the spread of a corporate bond over a government issue, without taking any bets.” The team trialled complex ways of tracking corporate bond indexes. They were expensive and opaque, and none worked as well as a strategy similar to an equal-weighted index-tracking fund, which puts companies of all sizes on the same footing. “It annoyed our rocket scientists,” Gardener said.
The fixed income team drew on their experiences managing buy-and- hold credit portfolios for insurance funds with different return targets. The “smart beta” strategy they developed uses proprietary screens to gauge the creditworthiness of debt-issuing companies. It buys securities that are at least two rungs above a lower credit rating. This prevents the strategy from being forced to sell downgraded securities in order to stay within mandate covenants. Trading discipline is also important.
Much of the “smartness” of the strategy is buying securities as cheaply as possible, Gardener said. “If you don’t, it just cripples you,” particularly since the portfolio sells one-eighth of its assets each year to maintain a constant duration. The proceeds from these sales, plus income from coupon payments, are re-invested.
“As much as the credit filter is important, how you deal in the marketplace and manage downgrades are just as important.”
Bond investors can gain make gains as valuations rise and coupon payments are made or lose all of their capital if issuers default. Buy-and- hold credit investors should therefore prioritise the “buy” part of their strategy, according to Gardener.
“You’ve got to make sure that you don’t buy the duds,” he said. “The difference between this and active management is that we’re not trying to find the best securities. We’re trying to take out the worst stocks and diversify as widely as possible with the rest.”
The strategy does not invest large sums of money in the debt of any one company. “If you’re investing in an environment of uncertainty, very naïve diversification is a good thing,” Gardener said. “Because almost by definition, the things that hit you most are the things you haven’t thought of.”
Investors should seek out active managers with genuine insight into the relative quality of bonds and financial market and macroeconomic conditions. “I genuinely believe there are some investors out there with vision. The average fund manager doesn’t have any more vision than the man on the street about the way the world is going.”