RPT-Fitch: New Generation of Fixed Income Funds to Test Fund Manager Skills

Thu Jul 10, 2014 4:07am EDT

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July 10 (Reuters) - (The following statement was released by the rating agency)

Fitch Ratings says in a new report that a new generation of fixed income funds demands greater skills from portfolio managers to perform in a low but increasing yield and spread environment.

A growing, more sophisticated segment of the fund market consists of global benchmark unconstrained or absolute return fixed income funds, as investors move away from core fixed income benchmarked strategies. The new generation of fixed income funds implements more active, less correlated strategies to exploit market opportunities on both long and short trades, while attempting to protect capital from rising rates, spread widening or credit losses.

In Fitch's view, these strategies can be broadly segregated into flexible beta-driven and pure alpha-driven strategies. A fund's risk/returns in various markets will be influenced, in part, by where the fund fits into this bifurcated framework.

"Managing a new generation fixed income fund is more skills-based and more technical compared with traditional fixed income funds. The ability to effectively implement derivatives- based overlay or hedging strategies, as well as high-conviction directional or relative value trades will be the basis for performance differentiation between managers," says Manuel Arrive, Senior Director in Fitch's Fund and Asset Manager Rating group.

The flexibility given in tactical allocation or long/short trading, away from the constraints of traditional benchmarks to a broader investment universe, increases the fund's reliance on the portfolio manager. For instance, fixed income funds increasingly use derivatives strategies and hedging mechanisms, which require specialised expertise borrowed from the hedge fund world. In addition, the search for yield tends to lead managers to favour higher-risk, less liquid assets through barbell strategies, which demand advanced credit selection skills.

"There is a lot of focus on duration risk at the moment but our view is that credit, counterparty, liquidity and manager risk is also increasing within fixed income portfolios," adds Mr Arrive.

Fitch's fixed income unconstrained peer group and absolute return peer group show close to no correlation to interest rates and credit. While absolute return funds performed better than unconstrained funds during the June 2013 sell-off, over a three-year period, unconstrained funds performed better than absolute return funds, which had their track record tarnished in 2011.

The short track record and wide variance in funds' risk/return profiles presents a particular challenge in performance analysis and peer-group construction.

For more information, please see www.fundmanagement.fitchratings.com To receive forthcoming Fund Quality Rating research, opt in here

The report, "Managing Fixed Income in a Rising Rate Environment", is available on www.fitchratings.com or by clicking on the link above.

Link to Fitch Ratings' Report: Managing Fixed Income in a Rising Rate Environment

here

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