How I Manage Money: A Short Note

Buy yield. That's the short version. What follows is only a slightly longer version. It's not complicated or technical but it does contain some jargon.

Paraphrasing Bill Bernstein*, there are four kinds of investors:

1. The “prescient one” who buys something no one has thought to invest in before or sees something before anyone else.
2. The “contrarian one” who buys what once did well but has stunk recently and everyone else hates...and can pick the bottom.
3. The “patient one” who remains diversified and holds positions in sectors even when they do poorly, relying on time to give mean reversion a chance. Time diversification is your friend. 
4. The “anxious one” who wants to know what is hot now and allocates accordingly. He watches his portfolio carefully and uses recent poor performance as the most powerful factor in sell decisions.

All of us are probably all of these things at one time or another. The fixed income investor has a different lens on these styles than an equity investor who must look for upside. Yield is the key driver of return (arguably, dividends are co-equal to growth for an index equity investor). In practice, number 3, be patient, is the most valuable and easiest way to win in fixed income. The person who most often behaves as the anxious one systematically transfers return to the patient one. This has been my way to a successful career in fixed income and I have described it over the years as simply "be optimistic" and "diversification is your friend" (I should add "diversification is for chumps" if you are an alpha-seeking equity investor).

The first two styles are harder. I look at opportunities to be prescient as rare gifts that don't come around often enough to make it the core tenet of my style. Moving into Emerging Markets in a big way before my peers was a game changer that lasted fifteen years. I stubbornly stuck to an overweight in EM after the excess return had been squeezed out, as well, so I can’t be too cocky. Insurance-linked securities, “Catastrophe bonds,” were only a small part of my portfolios but illustrate the idea of going where others haven't considered. We used them for over a decade. One trick I discovered early on was the "credit barbell." Holding high yield debt and AAA-rated debt in a ratio default-adjusted to match a single-A/triple-B-ish portfolio will have a higher Sharpe Ratio than holding just BBB corporates. The drawdowns of the barbelled portfolio can be deeper, though. These moves are not "alpha" styles, per se, but more of a factor that can be replicated passively. They generated alpha because I was early and, ideally, I know when they are getting stale and pivot away from them.

Everybody wants to say they are a contrarian. So do I. I have been successful a number of times. Often I have lacked the courage to be contrarian because I feared catching the falling knife on one side and was too complacent about stability on the other side. VALUE drives my thinking on how to be contrarian. Value arguments are somewhat easy for a fixed income investor at the sector level because mean reversion has utility when thinking about yield spreads. This drives most of my thinking around asset allocation. High yield bonds are my most frequent expression of this. In early 2008, I took high yield exposure down to 12% before the blow-up and pushed it up to 30% after. When spreads go above 1000 bps, buy. When they go below 400, sell...or not. There is a game of chicken to be played here. Spreads go below 400 in a cycle but will bump along without much volatility as the economy continues to grow, creating a carry opportunity. Over the last several cycles, the reliable signal for getting out has been when the Fed is close to finishing its tightening cycle (not beginning). Watching the non-conventional monetary policy of the Fed in the wake of the financial crisis I have less confidence in that signal today.

One can't be a contrarian if one already holds the asset that has gotten cheap. One can only hold on for the ride. Sometimes we pray for mean reversion which works at the asset class level but is intellectually lame at the security level. It’s better to take a cold look at the prospects. One of the most powerful techniques for any investor is to value an investment without regard to the price you paid for it. Ideally, I walked into the office every day with a mental position of 100% cash and said “how should I put the money to work today?” After Russia defaulted, leaving us holding a big chunk, I took the view that it was a “going concern” and the investment that had the highest upside. It took three years of 100% per year returns but we finally got our money back. I’m grateful my company stuck with me through this.

Getting our investors to stick with us through these tough times was a major communication challenge. I spent a lot of time on the road with the sales people getting bricks thrown at our heads. Take it like a grown-up. Ideally, investors understood our style and understood the circumstances where we would underperform ahead of time. They should be able to “self soothe” during drawdowns that they were warned about. That happened too rarely. I felt we were always clear about the risks in a very granular fashion. Many times, I would leave a client meeting with firm statements that the client knew what might go wrong only to have to deal with worried calls in the event. Everybody has a plan until the shooting starts. Still, spend a lot of time on your communications skills. Practice. Even if you have a crack client service team, practice on them. If they can describe your strategy back to you, good, but it is harder than it seems. 

There are a couple security selection techniques I have repeatedly found useful. The first is to pick up yield by trading away liquidity and convexity in ways that exploit the patient diversification principle. In a large multi-sector fund you can get away with this. In recent years I have looked at partnerships with illiquid alternatives providers to deliver income streams that are less in thrall to the gyrations of Treasury rates.

The second is to be on the lookout for free options. Truly free is rare but it does exist. I learned this lesson as an analyst before coming to Oppenheimer. In the early days of Treasury “Strips,” the principal piece traded to the call date with the possible, but uncertain, coupons of callable bonds. This was valued more highly than a payment to the same date without any possible future coupons. Obviously, because one offered the possibility of more cash, right? Wrong. Wrong because it ignored the circumstances under which a call would occur, circumstances adverse to the holder of the callable piece, which are lower rates. The Treasury will give you cash early and force you to reinvest at lower rates. A single Solomon Brothers trader figured this out and loaded his book before Solomon finally published their research piece revealing what became obvious. Payday!

During my tenure my team found some interesting free options.

• ARIES. This was a German government securitization of Russian "Paris Club" debt. It was issued at spreads wide to Russian Eurobonds because it was based on untradable loans. Investors failed to realize that, according to the terms of the debt, if the Russians were to prepay the loans, the ARIES bonds would not be called but become German sovereign debt. The Russians did prepay and the price rose to 144 from less than 100. We saw this option (not a certainty) at the outset.
• “WaMu” covered bonds. Until Washington Mutual went bust, the covered bonds traded in tandem with WaMu senior unsecured debt. Covered bonds are collateralized by residential mortgages with the proviso that the collateral pool is constantly replenished as bad mortgages are replaced with performing ones from the bank's inventory. As the mortgage market cratered this created an adverse selection problem for the bank while the covered bonds benefited from stable collateral. We understood that and bought substantial amounts even as spreads widened as investors put a bigger risk premium on all WaMu-branded debt. When WaMu collapsed, the senior bank bonds plummeted while the covered bonds rose.
• TALF. The Treasury let us buy non-agency mortgages in 2009, 90% levered, where the Treasury agreed to take all the losses beyond our capital commitment. This was their way of restarting the seized-up market during the crisis. We had to jump through legal hoops to get it approved but it was close to free money. We were one of the few mutual fund companies to take advantage of this deal.

I have not spent a lot of time personally on fundamental credit analysis at the company level. It was not the area I came from. I have always worked with others whose strength lay there. I do look at security selection on a structural basis. I look to the credit protections built into the structure of the security. That led me into trouble in 2008 but has worked well otherwise and has been key to spotting free options.

All the best ideas in the world might be for nought if you don’t pay enough attention to portfolio construction. I have (literally) pounded the table in team meetings to say “Don’t make unintended side bets!” If you don’t have a view on something, don’t have a bet on it. Once I had a spirited argument with another manager who had lots of interest rate duration in his high-yield corporate bond fund. They were an incidental consequence of his deliberate industry tilts. I could not get him to sell Treasury futures to immunize his rate risk. He took the principled view that his shareholders would question his use of “dangerous derivatives” not in his asset class. Fair enough, but later he still had to have awkward conversations when his underperformance showed up as “Treasury rates” exposure in his performance attribution table. 

Finally, (and this really only pertains to mutual funds) I am not ashamed to game my peer group when the opportunity presents itself. When we have a strong ranking going into the fourth quarter I am willing to spend away a few basis points of return to lock in that performance using options. When there is a large gap between us and the cohort below us, I am willing to spend some basis points to buy call structures that might boost us substantially in the ranking without dropping us if the calls expire worthless. Both of these techniques exploit the fact that ordinal rankings and absolute return don't correlate in a linear fashion. Understanding the interplay of short- and long-term performance is critical to success in this effort. Cynics may claim this is bonus gaming. Indeed some of my colleagues scoff at this. I am not actually worried about my bonus. I am worried about validating our customers trust in us on a higher frequency basis than their declared investment horizon. Investor psychology is a harsh master. Investors and their advisors watch the league tables like hawks. No sense whining about it. Understanding the difference between what investors say they want and what they actually react to is key to keeping them around for the long term.

I have mixed the terms “I” and “we” in this note. Most of what I accomplished was just putting together teams that came up with all the great ideas. Do that. I am proud of what we did together and all the fun we had doing it. Most people stayed with me for a very long time. Some people left for “greener” pastures but a sizeable fraction of those actually sought to come back after a time, which is the highest compliment I could be paid as a leader!

The financial crisis of 2008 was a watershed moment for all of us. The losses my funds experienced were the worst in our history and our shareholders redeemed billions. This was heartbreaking to me because it was our moment to show how being patient and contrarian work at their best. Imagine the poor sap who looked at recent fund performance of the Strategic Income Fund in the middle of 2008 and simply extrapolated the mountain chart to assume what the fund would achieve. They were pretty angry with me in March of 2009. Yet by the end of 2009 they had recouped their losses and by the beginning of 2011 they were even with the much more conservative index. Sleeping through the crisis would have been the best strategy for our shareholders but, alas, many people sold at the bottom. Fortunately my team did not make the same mistake. This huge drawdown was a breach of faith with our shareholders but we redeemed ourselves in the end.

Having said all this, I may be a dinosaur since everything I learned was during a 35 year (!) bull market in interest rates. While there have been ups and downs, I started in this business when the coupon on the 30-year Treasury bond was fourteen percent! We’ve seen a fairly steady march toward zero over my entire career. “When in doubt, go long,” worked every time, but now that we are close to zero that won’t work...or will it?. There is a global savings glut and aging populations will only seek out more income investments. The duration of the 30-year U.S. Treasury bond is around 20 years, so for every 100 basis point drop in yields the price will rise 20% or so. If the U.S. goes the way of Europe, negative yields are in our future. You might continue to see equity-beating returns for bonds!

* Bill Bernstein (mentioned above) has penned a number of monographs putting out thoughtful investment maxims. They are written for everyone but don’t talk down to the general reader like most of the investment self-help dreck that’s out there. You can see them at efficientfrontier.com

About me: I worked at OppenheimerFunds for 33 years. During that time I started and ran several mutual funds including a global multi-sector fixed income and an international bond fund, each of which grew to over $10bn in assets. I ultimately became CEO and stepped down five years later when the firm was sold to Invesco. Reach me at [email protected].