James Waldron, The Future Fund (right)

Australia’s sovereign wealth fund is seeking to raise the value of its credit portfolio by increasing its exposure to direct lending and emerging market debt and shifting away from traditional fixed-income assets.

James Waldron, director of debt at the $162.5 billion Future Fund, said for many investors, credit is a defensive asset class. But for him, this is not the case.

“We have a very concentrated portfolio and we can do that because we are not worried about diversification in the credit portfolio. We take duration out of the picture straight away – duration is managed at the total fund level where there is an overall target for duration,” he said at an Investment Magazine conference on Fixed Income and Credit.

“It might look as though we have a reasonably unbalanced credit portfolio, with two key strategies – direct lending and emerging market debt – but we believe it makes more sense from an overall fund perspective.”

Specifically, Waldron has been buying distressed debt, opportunistic high-and low-grade private debt as well as event driven mortgages. But the fund’s debt team is also looking at a raft of new credit opportunities that have emerged in the banking sector as banks are forced to hold more regulatory capital. Examples of these include peer-to-peer lending, trade finance and bank capital relief financing.

“It’s a reflection of where we see value, where we see diversification and the types of risk premia we desire at the fund level as opposed to just wearing a credit hat,” he added.

Thinking of the dynamic asset allocation process which is integral to everything the fund does in credit, the big question for Waldron is how to look at credit on a for like-for-like basis versus other asset classes.

“That’s obviously quite difficult,” he conceded.

What makes it particularly challenging is the fund’s total portfolio approach to investing means it does not operate with a fixed strategic asset allocation and avoids silos across asset classes. As such, credit assets need to earn their place in the total portfolio.

To that end, the sovereign wealth fund has developed a measure called an Equity Equivalent Exposure. Waldron calls this a simple measure. “Think equity beta or market risk,” he said. “We are trying to tie back the level of equity beta or market risk inherent in each area of credit that we are considering before comparing it across asset classes.”

Waldron talks about taking an “old school” fundamental approach to managing credit. Yet, he takes pains to point out that this style can easily play alongside a systematic approach. Importantly, the fund has a particular formula to breakdown the sources of return.

According to Waldron, the somewhat stylistic formula tells him where the portfolio is being paid in credit. A clear benefit of this approach, he goes on to say, is to better evaluate the performance of external managers.

“It helps you to avoid some of the external managers who will tell you they’re adding value but who are, in fact, running quite lazy risk premia strategies such as momentum strategies,” he said.

“They can tell you the return they think they can achieve, but until you pull it apart and test the components, you can’t really know.”

“Whilst a stylistic representation, the formula is an important way of dealing with manager pitches and it can drive a better conversation on how much we should be paying them.”

How and where managers can add value obviously depends on the strategy and levers they’re given. Varying the beta in the portfolio and taking advantage of market volatility over time can be one aspect, Waldron explained. Strategies such as direct lending may encompass the potential for fee income or prepayment penalties as additional sources of return.

Generally speaking, the debt specialist has three core beliefs that determine how portfolio managers look, and think, about credit.

First and foremost, Waldron believes credit underwriting is paramount. He is a big believer in fundamental analysis and admits to being nervous about implementing strategies that rely too heavily on ratings-based approaches or indices.

“Obviously, there are a number of flaws in the way that things are rated and certainly this is the case with index construction, so we think you can do better by doing fundamental credit work,” he said.

Second, credit risk premia are time varying. For him, this is the core to the DAA process since credit markets are not perfectly efficient. “There are a number of different investors with different constraints and time horizons as well as changing regulations which can mean credit is quite volatile. Obviously, spreads over time don’t just reflect expectations of default risk.”

“That can drive how we think about overall credit but subsectors in credit as well.”

Alpha/beta separation is another strategy he has considered, although he has reservations about the quality of some of the indices as well as some of synthetic instruments that can be used to express the beta.

Joel Kim, a senior portfolio management at Dimensional Fund Advisors, said the trend was for a greater focus on systematic approaches, alongside fundamental, although he conceded that fixed income lagged equities.

During the conference, Kim spoke about a Dimension system that provided a breakdown of returns (and where they came from) when taking a systematic, or factor base approach, to fixed income such as duration, interest rate risk, credit risk etc.

“Systematic investing in the fixed income market is obviously something new,” he said. “What we do is a lot more familiar in the equities space where people have long looked at factor and multi-factor investing.

However, he went on to say, there is more and more data coming in now that should apply to the fixed income market which is timely since asset owners are now more careful about what they are willing to pay for.

“For example, when hiring mangers, how much diversification do you get through hiring multiple managers, especially if you take into account they tend to invest in a very similar way?  So, when things don’t go well, how much diversification do you really get? Should you diversify through multiple managers or focus on style,” he said.





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