"Relying on expected return and volatility means taking the risk of not diversifying your investment enough"

Moving from theory to practice is often a perilous exercise. And when it is done in times of stock market turbulence, it can even be a challenge.

Yet this is what Antoine Marmoiton of Alken AM has achieved.

Thanks to the model he has developed, he can tell you whether your investments in convertible bond funds offer genuine diversification in the risks taken.

A very useful compass to face the next market shocks.

Explanations.

?For several months now, you have been working on an analysis tool that is supposed to provide a different perspective on the behaviour of convertible bond funds. Can you explain what this is all about ?

A little over a year ago, we decided to look at the convertible bond fund landscape in a more systematic way. Indeed, while we knew what we thought made our management process different from others, it made sense to try and structure our understanding of what our competitors were doing in a way that would create a fruitful discussion with investors. To do this, we created groups of funds using both qualitative analysis and hierarchical clustering, a technique commonly used in portfolio management. We found that two axes were most important: the credit quality of investments and the overall level of risk.

In itself, this finding seems to challenge some well-established patterns among investors, who are generally only interested in two parameters: the expected return and the volatility of their chosen investment. How do you explain this ?

In my opinion, this is a misjudgment that can potentially be a source of great disappointment when one wants to invest in several convertible bond funds. Indeed, as our analysis tool shows, relying on expected return and volatility means taking the risk of not sufficiently diversifying your investment. In other words, the investor risks ending up with funds that behave similarly in the face of a given market event, even though it was reasonable to expect diversification. The good news is that our work also shows that some funds really do have very different approaches to what the rest of the market is doing. So it is possible to diversify your portfolio if you really want to. 

How do you think this should be done ?

In addition to being aware of this risk of non-diversification, the investor must be totally in line with the objectives he assigns to his investments. To do this, they can set up an analysis tool like ours based on the actual performance of the products and their qualitative study. This makes it possible to break down the market of funds invested in convertible bonds into three groups: the most offensive products (group 1), both on the credit side and the equity risk side, which are currently heavily invested in the US technology segment because of the market structure; those that follow an index and a very classic strategy of seeking convexity at all costs (group 2), which account for two thirds of the market; and finally, funds with a quality or defensive profile, which focus primarily on quality or risk-reducing bonds while controlling their equity exposure.

Is this categorisation stable over time ?

Absolutely. And that is its main interest, since it allows us to see, for example, that the performance gap around the average of group 2 funds remains relatively small. This logically leads to the conclusion that investing in several products in this group is not very different from buying just one.

To conclude, I suggest we move from theory to practice. The US central bank has just raised interest rates by 75 basis points (the biggest increase since 1994!) and is hoping to see inflation fall to 3% by next year. In this context, how can this matrix help an investor ?

In order to understand the usefulness of our model, we must also take into account all that is actually happening in the economy. Recently, former Treasury Secretary Larry Summers said that it would take a US unemployment rate above 5% for five years to curb inflation in his country. If this scenario comes true, then default rates will mechanically increase among companies and investors will primarily look for convertible bonds with the best credit qualities. The work done on our matrix allows us to identify which funds are the least exposed to this risk of default. 

And how do you position yourself in relation to the competition ?

For a fund such as our Global Sustainable Convertible, this means being mainly invested in quality bonds (investment grade type). In such an uncertain phase of rising interest rates, this is indeed the most interesting part of the convertible market. High-yield bonds, on the other hand, are far too vulnerable to rising interest rates and the risk of a general deterioration in the economic environment.