The Observer

ARTICLES OF INTEREST

Core Plus Bond Funds: What’s All The “Plus” About?

by Ben Homsy, Leith Wheeler

Core Plus strategies promise the best of all worlds: a core fixed income strategy, with a suite of sophisticated strategies layered on top to augment the return profile while managing risk. However, our analysis suggests that most of the additional returns that Core Plus strategies provide is not generated by the sexy bells and whistles, but rather from adding exposure to (particularly sub-investment grade) corporate credit.

Introduction
The decline in interest rates globally provided a significant tailwind to fixed income portfolio returns over the past 30 years; however, the current low level of bond yields suggests that returns from fixed income over the next decade could be materially lower.

Unsurprisingly, Canadian institutional investors have been actively seeking ways to improve the return profile of their fixed income portfolios. A popular method has been to migrate Core fixed income portfolios into a Core Plus mandate that promises higher returns, particularly for institutional investors. This demand has in turn been met by a significant increase in the number and variety of Core Plus strategies offered by investment managers. Of the strategies in our analysis, one quarter had been in existence for less than five years, and another quarter for less than 10 years.

Historically, Core Plus strategies emerged as a way to add sub-investment grade credit into portfolios to boost returns, but the breadth of the investment toolkit being used today by both Canadian and international investment managers has expanded considerably.

The purpose of this article is to put Core Plus strategies under the microscope and answer the question, “What are investors actually getting from the ‘Plus’ component of their Core Plus strategy?”

What Is Core Plus?
One of the main challenges faced by institutional trustees and fiduciaries is that there is no singular definition of a Core Plus strategy. Core Plus investment managers use a variety of different tools and strategies to add the “plus” component, including sub-investment grade credit, global credit and rates, currency exposures, derivatives, private debt, hedge fund exposures, and more. However, and most importantly, each Core Plus strategy typically uses a discrete sub-set of the above toolkit, and uses them to varying degrees, making comparisons between different Core Plus strategies more difficult.

This heterogeneity of Core Plus strategies results in major differences in the degree of benchmark risk each portfolio experiences. Over the past 10 years, the tracking error (volatility of valued-added, or alpha, versus the Universe benchmark) of Core Plus managers has varied widely.

 
10 Year Tracking Error
  Min Median Max
Canadian Core Plus Strategies 0.49% 1.28% 2.18%
Canadian Core Strategies 0.40% 0.75% 1.20%
Source: eVestment and Leith Wheeler.
 
Deconstructing Core Plus: Our Methodology
We utilized the eVestment database to identify the universe of Canadian Core Plus strategies, which surfaced 25 investment managers (“firms”) who have registered a total of 30 Canadian Core Plus strategies (“products”) on the platform. Where a firm has registered more than one Core Plus strategy, we selected the Core Plus strategy with the largest assets under management. We also eliminated one which had a track record of less than three years. Our analysis was performed on the remaining 24 strategies. 

We then analysed the monthly returns of these strategies against the FTSE Canada Universe Bond Index, to determine the relative tracking error of each strategy to this common benchmark.The tracking error of a Core Plus strategy versus the Universe Index will include both Core and “Plus” active positions. In order to isolate the “Plus” component, we compared the Core Plus strategy returns to the same manager’s Core fixed income strategy (for the 18 strategies where available, as six Core Plus strategies did not have a corresponding Core strategy).

We then analyzed through both single and multiple regression the “Plus” return component (Core Plus less Core returns) of these 18 strategies against a variety of different asset class returns to identify the primary drivers of additional returns in Core Plus strategies. Because of the varying lengths of available fund and index returns, we performed our analysis both on the longest available data and also since inception of the Leith Wheeler Core Plus Bond Fund, to facilitate comparison.

What Is All The “Plus” About?
In order to generate additional returns in a Core Plus fixed income portfolio, an investor needs to take additional risk. The addition returns offered by the “Plus” component of Core Plus strategies were generally positively correlated to risk asset classes such as equities and, unsurprisingly, credit.

Specifically, the “Plus” component of returns was most highly correlated to changes in US high yield credit spreads, with the “Plus” returns correlating a median of 67% with changes in US high yield spreads, and as high as 90% for some strategies. Furthermore, in a multiple regression model that included both changes in Canadian investment grade and US high yield credit spreads, the ability to predict the “Plus” component of returns increased even further.

Importantly, this correlation of returns is to the broad market index, so it doesn’t include the investment manager’s value added from tactically allocating to credit through the credit cycle, nor any alpha that the investment manager adds via security selection.

Why is This Important?
We already know that the tracking error of Core fixed income strategies is determined primarily by the strategy’s exposure to interest rates (duration) and credit (primarily corporate credit). Sector positioning and security selection might add to returns at the margin or protect during a credit event, but the overall duration and credit allocation are the primary drivers of returns each month.

However, in Core Plus strategies, the additional tracking error in the portfolio is coming primarily from sub-investment grade credit beta, with some additional tracking error from tactical positioning and alpha.

The additional sources of “Plus” returns are not irrelevant; however, they are far less likely to have a significant impact on the overall risk and return of a Core Plus portfolio.

For example, several Core Plus strategies (particularly from international managers) claim to add value through strategies such as global interest rate trades, directional or relative rate views, or through optimizing rolldown across multiple interest rate curves.

Our view is that these claims are exaggerated. Directional interest rate strategies are difficult to get right consistently (i.e., they have a low information ratio). Meanwhile, the optimization of interest rate rolldown across multiple country curves might be possible but would rarely constitute a significant component of Core Plus returns for those strategies targeting Canadian investors. This claim is evidenced by the fact that the Core Plus strategies in our analysis (offered by international managers that did not offer Core fixed income strategies) did not exhibit higher tracking error than the broader group of strategies.

Two Core Plus strategies that had a “Plus” component that was negatively correlated to risk assets (including high yield credit spreads) included “alternative” assets such as private debt, mortgages or hedge funds in the asset mix. However, while it’s true that that private debt and other illiquid investments can, at times, offer an excellent source of additional and diversified returns, our view is that the inclusion of illiquid investments (such as private debt) in a fixed income portfolio offering daily liquidity is fundamentally flawed.

The reason is that their illiquidity denies the investor one of the main advantages of Core Plus: the ability for the manager to tactically allocate in and out of the strategy as appropriate, based on valuations and perceived risk / return trade-offs. We therefore believe that an allocation to illiquid private debt is best made on a static and stand-alone basis within a diversified portfolio, rather than inside a Core Plus strategy.

Core Plus Fees, an Important “Plus” to also Consider
Core Plus mandates typically charge a small premium of approximately 0.05% to 0.10% above Core fixed income strategies, and we find that the international investment managers offering a broader array of investment strategies (and who do not offer Core fixed income strategies for comparison) tend to be at the higher end of this spectrum.

Typically, fees are evaluated with reference to the added value that the active investment manager offers. In the case of Core Plus, any fee premium should therefore be evaluated in the context of the “Plus” component of the value added. As our analysis shows that Core Plus strategies are highly correlated to a static tilt towards credit beta, however, investors should view the incremental fees critically.

Conclusion
When looking at the varied range of Core Plus funds available to Canadian institutional investors, it is easy to be drawn towards the shiny strategies claiming to offer a wide array of investment tools. However, the facts suggest what you are really getting with Core Plus strategies is exposure to liquid credit – particularly high yield credit – with over half of the additional value-added provided by the investment manager being generated in the form of credit beta. Hopefully the manager can then add additional value through tactical allocation and security selection to justify the additional fees. If not, buyer beware.

With that in mind, the focus of any Core Plus search should be firmly on the investment manager’s ability to manage credit, including high yield credit, rather than on the other components that might seem interesting — but are unlikely to have as material impact on Core Plus returns.

To reference a common saying in Leith Wheeler’s investment meetings, “If it walks like a duck and swims like a duck and quacks like a duck, it’s probably a duck.” Core Plus strategies, at least so far, are not miraculous alpha-generating diversifiers. They are mostly just core strategies with a credit tilt.

Quack quack.



 



Ben Homsy, CFA is a Vice President and Portfolio Manager with Leith Wheeler Investment Counsel, who focuses on fixed income mandates for institutional clients.