October 7, 2005

Volume 23, Number 9

Beyond Active and Passive Management: Hybrid Portfolio Strategies

Fed Sticks to Rate Increases Despite Disasters

SEC Relaxes Rules in Response to Katrina

PIMCO Chief Sounds Warning on Bonds

Performance Benchmarks

Panel of Economists

Databank

Interest Rate Outlook

Beyond Active and Passive Management: Hybrid Portfolio Strategies

T raditionally, fixed income portfolio managers, including public fund managers, have subscribed to one of two primary approaches: active or passive management. Another approach, not as widely recognized, is a hybrid approach, exemplified by the “Core/Satellite” model discussed in this article. This portfolio management approach contains elements of both active and passive methodologies, essentially using both to manage a portfolio.

Defining the Differences. Active and passive methods differ on the inputs involved and the degree of analysis or activity this information requires. For instance, active management can be described as expectational because of the manager’s expectations concerning key variables including interest rates, interest rate volatility, spreads, and other factors. The active investor often takes a position on and manages duration, sector and security selection, and yield curve placement.

• “buy and hold,”
• liability matching,
• laddering, and
• benchmarking.

Regarding the last point, benchmarking is defined as building a portfolio which replicates the performance of a bond index. While these are varying ways of implementing a passive approach, they all share a nonexpectational basis.

The question of whether a portfolio should be managed actively or passively is anything but new. The consensus in the academic community has been largely in favor of passive management. At the heart of this argument is the efficient market hypothesis, which posits that prices immediately reflect all information. According to this theory, an individual investor cannot gain from buying mispriced securities, since new information is already included in prices in the market, nearly instantaneously. In practice, this has not always been the case and active management may add value in certain sectors of the fixed income market.

Apart from the theoretical reasons for passive investments, several aspects unique to the public funds arena have supported a passive investment model. The typical investment objectives of the public funds investor are safety, liquidity and then yield. Because of the descending order of emphasis, these objectives have tended to favor a passive approach over an active or total return approach. Governments are keenly aware of their fiduciary responsibility to protect the taxpayer’s funds, so to take a nonexpectational or passive approach that involves no interest rate or economic forecasting may appear more conservative. Moreover, state and local treasurers may be penalized for downside risk (underperforming a benchmark) but not rewarded for upside risk (outperforming).

Second, the passive approach is also buoyed by the reality that the responsibility of investing an entity’s funds often falls on a finance officer who is responsible for numerous other activities and may lack an expertise in investing. Finally, the limited resources of some government investors may restrict access to the information (i.e., analytical software and market data feeds that require upfront funding) that is needed to execute an active management strategy.

Implementing the Hybrid Approach. The hybrid approach of core/satellite portfolio management taps both active and passive methodologies. A large segment of an entity’s or a government’s overall portfolio forms the central or core portfolio. This is often based on an index or is otherwise passively managed, and acts as the basis or core of an entity’s portfolio. (Note that “core” in this article simply referred to a majority of a government’s assets in a passively managed portfolio. In the September issue of Public Investor, core funds refers to reserve funds that are invested for a relatively long duration and are not needed for liquidity needs.)

At the same time, satellites—relatively smaller, discrete portfolios—are created that may encompass a range of active strategies. (Refer to Exhibit 1.) A government can choose to create a single or a number of these satellites. While a nonexpectational posture is assumed for the core, expectational approaches are followed for the various satellites. The active strategies implemented can include any of the previously mentioned strategies: duration management, yield curve placement, sector and security weightings, and so on.

Oftentimes the decision to use active or passive management drives the choice to use external management. Implementing this core/ satellite model of portfolio management allows the government investor flexibility. A government can either retain the management of the entire portfolio internally—including the satellites—or alternatively, it can outsource management of part or the entire portfolio. Because of the costs associated with active management, a government is apt to outsource portfolio management of the satellites to an external investment firm. The investor would then focus on the satellites to achieve excess return, or that return over and above that of the index identified as the appropriate benchmark.

As is generally the case in portfolio management, the measure of the success of this hybrid approach depends partly on the selection of the appropriate benchmark. For the core portfolio, the benchmark serves as a target to be achieved or replicated (i.e., it tracks the benchmark returns very closely and has limited or virtually no “tracking error”). For the satellite portfolios, on the other hand, the selected benchmark returns serve as reference points to be exceeded, and it will consequently experience some tracking error or deviation from the chosen benchmarks.

Because of the dominant weighting of the core portfolio, and because it closely tracks the benchmark, the core portfolio’s performance greatly influences the performance of the entire portfolio. As a result, a government treasurer can expect the tracking error of the overall portfolio to be relatively low in keeping with the benchmark.

Exhibit 2: Example of a Core/Satellite Portfolio

The core/satellite approach requires government treasurers to explicitly segregate or compartmentalize their investments. As such, the compartmentalization imposes a discipline for risk control and it enables treasurers to undertake risk budgeting. Risk budgeting is a process of determining how much total risk an investor wants to “spend” on an investment program and allocating the risk among the different portions of the portfolio—the core and the satellites. For example, investors with a low tolerance for risk can chose to allocate a larger part of their portfolio to a core, indexed portfolio with the goal of achieving a low tracking error. Investors with a higher risk tolerance can alternatively allocate larger portions to the active satellites. Moreover, they can fine tune their risk-taking strategies by consciously choosing to accept varying degrees of interest rate versus credit risk. (Bear in mind that these investment activities would still be undertaken within the constraints of an investment policy.)

In conclusion, the hybrid approach offers an alternative to selecting either an active or a passive management approach. By combining both styles, an investor can structure a core portfolio based on a relevant index and attempt to supplement that with a satellite portfolio or portfolios. Benefits of the hybrid approach include: limiting implementation costs over those of a totally active approach, simplifying performance measurement with identification of an appropriate benchmark, and controlling risk by replicating the benchmark’s diversification.

Fed Sticks to Rate Increases Despite Disasters

D espite speculation that the Fed would hold off on increasing the Fed Funds rate after Hurricanes Katrina and Rita, the central bank continued its string of rate increases in late September. With its latest action, the Fed has increased rates for the 11th consecutive time in as many meetings of the Fed’s Open Market Committee over the past year and a half.

As important as the rate increase itself was the Fed’s statement announcing the increase, which left the door wide open for continued rate increases in the next six months. Moreover, it supports the predictions made by the Public Investor panel of economists in last month’s issue that the Fed rate increases will not be stopped anytime soon. With September’s 25 basis point increase, the Fed Funds rate now stands at 3.75 percent, with many predicting the rate will meet or exceed 4 percent by year’s end. (See the Interest Rate Analysis for additional information.)

In its prepared remarks, the committee stated, “While these unfortunate developments [related to the hurricane] have increased uncertainty about near-term economic performance, it is the committee’s view that they do not pose a more persistent threat. Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Higher energy and other costs have the potential to add to inflation pressures.” The committee indicated that it has been pursuing “policy accommodation” in recent years, and by gradually raising rates it is returning to a policy that balances goals for economic growth and contained inflation.

Two takeaways from the rate increase are, first, that the yield curve will continue to be flat. Refer to Exhibit 1 below, which shows a tight, 25-basis point spread between the 2-year treasury and the 10-year.

Exhibit 1: Yield Curve Currently Flat

Secondly, that the Fed’s implementation of monetary policy is clearly forward looking—as in the words of former Fed Chairman William McChesney Martin, “The job of the Federal Reserve is to take the punch bowl away, just when the party gets good.” In fact, it may be taking away the punch bowl before the “party” —in terms of payroll growth—has started at all.

Former Fed Governor Edward Gramlich noted that Fed rate actions necessarily must be forward looking, in order to compensate for the lag in any policy actions it takes. Specifically, there is a lag between the time inflation actually begins to pick up, and the time it is captured in economic statistics, and an additional lag between the time the Fed acts and the impact is felt. He stated that “monetary actions are likely to have some effects within a half-year of the recognition of the need for a change, perhaps even faster when authorities act on the basis of forecasts” (remarks from the Wharton Public Policy Forum Series, April 22, 1999).

SEC Relaxes Rules in Response to Katrina

The Securities and Exchange Commission late last month ordered targeted regulatory relief to companies complying with various SEC regulations. Many of these pertain to ordinary annual disclosure to areas within specified zip codes affected by the hurricane, e.g., transmittals of the annual and semi-annual reports of registered investment companies to shareholders in affected areas. For additional information, refer to the SEC Web site.

PIMCO Chief Sounds Warning on Bonds

In his monthly commentary on the bond market, “Bond King” William Gross of PIMCO sounded the alarm on low-quality offerings in the bond market. Gross, the chief investment officer of PIMCO, made the case that the Fed is working directly or indirectly to pop the apparent housing bubble through its series of rate hikes enacted over the past 18 months. These measures, if not already slowing demand, will eventually slow demand among home buyers, ultimately causing a slow-down in the economy. Gross counsels that “anticipatory” bond investors should focus on high-quality investments in a potentially slowing economy. He also foresees the need to halt or even reverse the Fed interest rate hikes in mid-2006. He also expects that a “bullish orientation towards the front-end of the [yield] curve therefore should begin to dominate bond strategies, combined with an avoidance of anything that carries those low-risk premiums that Greenspan finally diagnosed.” This includes corporate debt as well as other asset classes such as real estate and high-yield bonds—and long-term Treasuries.

Panel of Economists

Effect of Hurricane Katrina on GDP

The devastation following hurricane Katrina has affected the Gulf region and the nation in ways that have almost rivaled the events of September 11. This month,Public Investor asked its panel of economists how hurricane Katrina will affect economic growth, inflation, and interest rates.

John Silvia predicts that the hurricane will subtract 0.5 percent from GDP in the third quarter and 0.7 percent from GDP in the fourth quarter of this year. He expects that inflation will be higher next year.

Carl Tannenbaum expects that the aid that will be sent to the region will provide a stimulus that will outweigh the temporary interruption of normal economic patterns. Based on his stimulus assumption, he has increased his forecast for 2006 GDP growth. In addition, he thinks that the risks of higher inflation have risen more than the risks of lower growth.

According to Lacy Hunt, the hurricanes will cause a short-term disruption to economic growth; however, the economy was downshifting even before the hurricanes. Part of the sharp rise in unemployment claims is not accounted for by the hurricanes, and the housing sector has softened in the past few months. He expects that fiscal policy will be stimulative next year, but not sufficiently to counteract tighter monetary conditions and the rise in energy prices. Relative to wage and salary income, consumer fuel expenditures have risen 2.6 percent, which is even larger than the rise associated with the Arab oil embargo of 1973-74 and the Gulf War of 1990-91. Hunt expects tighter monetary conditions will also dampen economic growth. In the past 12 months the money supply (M2) grew just 3.4 percent year, which is a nine-year low. In addition, the yield curve has flattened substantially, which is a sign that investors expect slower growth, reduced inflation, or a combination of the two. A flat yield curve also can cause slower growth because it reduces profit-making opportunities of financial intermediaries, who in turn reduce their lending to businesses and consumers.

Low Inflation Predicted Despite Jump in CPI

The consumer price index (CPI) has increased in recent months mostly due to a spike in energy prices. However, the financial markets and many economists expect inflation to remain low over the long term. In a recent survey conducted by the National Association for Business Economics (NABE), economists predict that the CPI will increase 3.5 percent from 4th quarter 2004 to 4th quarter 2005 and will decline to 2.3 percent in 2006 due to lower energy prices. The NABE survey predicts that crude oil prices will decline from $63 at the end of this year to $55 at the end of next year. The spread between the 10-year Treasury note and the 10-year Treasury inflation-protected security implies that investors expect inflation to average about 2.4 percent over the next 10 years.

RGM

Fed Stays the Course

Although Hurricane Katrina will cause some short-term uncertainty, the Federal Reserve Open Market Committee decided that they could continue to raise the Fed Funds rate due to the strength of the current economic expansion. At its most recent meeting on September 20, the Fed decided to raise the Fed Funds rate by 25 basis points to 3.75 percent. Many Fed watchers expect the Fed to raise the Fed Funds rate to 4.00 percent at its next meeting on November 1. Revisions to the Bureau of Economic Analysis’s deflator index shows that the Fed has been more accommodative with its monetary policy than it intended, thus the Fed is likely to continue raising rates. In fact, a recent survey by the National Association for Business Economics (NABE) predicts that the Fed will raise the Fed Funds rate to 4 percent by the end of 2005 and 4.5 percent by the end of 2006. The NABE survey predicts that long-term interest rates will rise over the next year, with the 10-year Treasury note averaging 4.45 percent in December 2005 and 5.10 percent in December 2006.

RGM

6-Month Treasury Bill
2-Year Treasury Note
30-Year Treasury Bond

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