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An idEAL pLAYgRound foR AbSoLutE REtuRn The fund of funds managers at Ariqon Asset Management in Austria have developed their own form of unconstrained bond management, blending a systematic process with dynamic asset allocation. Stefan Ferstl and Michael Hanak explain how it works

A s an alternative to the many products investing solely in a single bond sector, we wanted to use all global bond markets such as money markets,

government bonds, corporate bonds, emerging market bonds, convertibles or high yield bonds to create a flexible portfolio benefiting from the unique behaviour and advantages of each bond sector.

The idea behind our launch in August 2004 was to create an absolute return portfolio with the possibility of acting without constraints within all global bond sectors. Simultaneously, we would use a strict risk management toolbox to keep the volatility at extremely low levels and to provide positive returns each year. The concept of unconstrained bond management is based on generating an asymmetrical risk-return profile which aims to optimise returns by avoiding draw downs of more than 3%.

The fundamental reason behind this approach is that the whole bond market, in contrast to the equity market, is heterogenous on a sustainable basis. This means that under normal circumstances the correlations of the different bond sectors remain stable and that certain bond sectors are traditionally negatively correlated. In every economic scenario there are specific bond sectors which benefit while others don’t.

An investment concept which is fully flexible and unrestricted, can – in theory at least – create positive returns in every market environment. Such unconstrained bond management can take advantage of the strength of every bond sector at a certain economic stage, without being forced to invest in unfavourable market situations.

In some market phases a broad diversification over a variety of bond sectors can be reasonable, whereas in other situations some segments are unrepresented in the portfolio and a very concentrated asset allocation is the better approach. The grade of diversification is very flexible, so the portfolio can be focused on money markets or government bonds in an environment of falling interest rates or can be concentrated in high yield bonds or convertibles during an economic boom.

A risk-adjusted view of the bond universeBefore allocating the assets of a bond portfolio it is important to evaluate the right way to analyse the heterogeneity of the bond universe. We concentrate primarily on monitoring the typical volatility of each bond sector and its correlation to others. Yet pure analysis of historical volatilities bears the risk that special events, like the Lehman crash in 2008, skew the expected characteristics of volatility. Therefore, it is key to calculate the so-called ‘natural volatility’ of each market by excluding abnormal volatility highs during a crisis as well as unusual lows. This approach leads to an adjusted volatility band for every bond sector which represents its intrinsic risk.

At the same it is important to fulfil the absolute return characteristic of our portfolio which we understand as avoiding serious drawdown periods. So, according to the natural volatility of each bond sector for all positions in our portfolio, specific stop-loss limits are set which are typically much closer to the share price than would be expected for riskier bond classes. Using this stop-loss strategy we are able to take significantly higher positions in risky fixed income sectors without increasing the overall risk of the portfolio.

This strategy successfully avoided drawdowns in the past enabling us to lose just 2% on the portfolio during the Lehman crash in 2008, for example. The entire volatility of the fund remained, at barely 2%, far below a traditional

European bond fund. So the low correlation of different bond sectors combined with a

strict stop-loss strategy results in a very conservative absolute return performance.

Vive la différence: Ariqon fund of fund managers Stefan Ferstl (left) and Michael Hanak use the low correlation in the global bond sector to their advantage

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got something to say on fund selection? call Jesús Segarra Sobral.jsobral@citywire.co.uk +44 20 7840 2175

Systematic managementWe base all our investment decisions on the quantitative analysis of prices in the various markets and funds used in our portfolios. Therefore, conventional and fundamental considerations such as credit, duration, sector or yield curve are irrelevant to our approach. In our model the only important role is the ongoing quantitative observation of prices of each bond sector or fund and their correlation to each other. Typically sectors and funds with high momentum get high positions in our portfolios but are always covered with tight stop-loss marks. The result of the systematic calculations feeds directly into the allocation of the fund. The last step in the portfolio construction is to define exit and re-entry points for every position.

Based on our monitoring, the quantitative analysis of prices works well for bond markets because typically trends last longer than on equity markets and bonds also react less sensitively on short-term changes in sentiment.

This strategy leads to very actively managed funds with generally high turnover ratios. For example, government bond funds with long duration will be under pressure in an environment of rising interest rates. Our approach is to massively reduce this bond sector (down to zero) and simultaneously build up high yield bonds quickly or even short ETFs. This could also bring the strategy to a negative duration stance. Despite a general negative market environment for government bonds it is possible to rebuild long positions in oversold markets to benefit from a temporary rebound.

In selecting sub-funds for our portfolios our main goal is a high level of diversification over a broad variety of different investment managers. The funds are selected by similar quantitative momentum parameters as with the asset allocation process.

For comparable funds, lower volatility is more important than exceptional performance. This philosophy reflects the absolute return character of our strategies. So in general, for a long-term successful approach, a balanced mixture of different managers and strategies is key.

ConclusionThe bond markets offer an ideal playground for absolute return management due to their heterogeneity and low correlations. Taking risk and avoiding risk at the same time, paired with broad diversification, offers the possibility to generate positive returns in each economic environment.

thE tEAm highLight two tYpicAL fundS to Show thAt bondS ARE LESS AffEctEd bY ShoRt-tERm SEntimEnt chAngE thAn EquitiES Source: Bloomberg

From 30-Dec-09 to 30 Jun-11

DWS European Corporate High YieldDWS European Equity

30-Dec-1030-Sep-10 30-Jun-1130-Mar-1130-Jun-1030-Mar-1030-Dec-09

100

105

110

115

120

125

130

135

140

145

25

27

29

31

33

35

S&P 500 Index Stoxx 600 IndexMScI Ac Asia Pacific Index German reX P JP Morgan eMBI

Goldman Sachs High Yield

S&P 500 Index 1 0.857 0.763 -0.404 -0.635 0.630

Stoxx 600 Index 0.857 1 0.687 -0.464 -0.671 0.604

MSCI AC Asia Pacific Index 0.763 0.687 1 -0.303 -0.626 0.641

German REX P -0.404 -0.464 -0.303 1 0.381 -0.324

JP Morgan EMBI -0.635 -0.671 -0.626 0.381 1 -0.714

Goldman Sachs High Yield 0.630 0.604 0.641 -0.324 -0.714 1

Source: Bloomberg

Low CorreLAtionS CoMpAred to equitieS underLine tHe HeterogenouS CHArACter oF tHe diFFerent bond SeCtorS