In our last piece, we described the problems associated with exposure to products that passively track the Barclays US Aggregate Index such as the I-Shares product(AGG). There is simply not a reasonable risk to reward under most circumstances and therefore we heavily favor active management.

Given the heavy weight in government debt in this index and most of the ETFs that track them, we will introduce a couple managers that similarly use the Barclays US Aggregate Index and who are heavily weighted toward Treasuries or Mortgage Backed Debt.

One of the issues with regard to fund selection in this area is the often times confusing labels. We have similar funds named, “intermediate bond”, “total return”, “core”, “core plus” etc. Even within each of these categories, there is much variance in the strategies.

The mandate can vary at a few levels that include; security type, credit quality, duration management and regional focus. To put any relative comparison in perspective, a quick review might provide some perspective.

As we mentioned in past posts on core fixed income, it is important to dig into the details to determine if the fund is truly a substitute for representation by the Barclays Aggregate Index. We found TCW to posses excellent management skills mainly within the realm of mortgage backed securities. That fund could be potentially used a strategic holding as exposure to a value added manager within a specific bond asset class. It should not be used as a broad based exposure to multiple markets to replace the I-Shares AGG due to its focused mandate.

GW&K Enhanced Core Bond Fund accomplishes outperformance vs the Barclays Aggregate Index differently than the TCW Total Return Fund. They add in a more active high yield opportunistic approach to enhance risk-adjusted returns while they maintain a solid position in AAA rated Mortgage Backed Securities. They also weigh more heavily in those areas among the investment grade world that offer more relative value.

They have done a nice job over the last few years and could have served as a reasonable substitute for the -I-Shares AGG product as they were able to adjust duration, credit quality and sector weights successfully. Their current yield stands at around 2.5%.

Another fund that has done well over the last few years on a relative and absolute basis v the Barclays Aggregate Index is the Aston TCH Fixed Income Fund. While they hold a lot of Mortgage Backed Bonds, they have achieved their numbers in part through an overweight to corporate debt below AAA as they opportunistically look for value in the BBB area of the credit spectrum. The dilemma here is that corporate and mortgage backed debt may be arguably fully valued so gains from here may be difficult to come by. They have a slightly higher duration than the AGG product and a 74 basis points yield advantage.

Thus far we have found at least one manager who may be able to fill the role of a value added manager in the mortgage backed space and two managers who have in the past been successful at beating their main benchmark.

While we support active management, it is difficult to see how theses funds will achieve the same success in the future since many fixed income classes are fully to overvalued. While we have looked at these funds it may be helpful to speak generally about various strategies and the potential benefits they possess as well as the drawbacks.

It may be difficult to find one manager who is able to be a Barclays Aggregate representative for your fixed income allocation. One reason is that it is simply difficult to find value in many spaces domestically. A US investment grade portfolio has limitations with regard to the amount of yield and capital appreciation available and a manager that tracks this will likely find it difficult although not impossible to outperform.

It strikes us at Zenith that a more unique approach is warranted. One that potentially has a wider mandate with regard to geography, security type and credit rating as well as very nimble duration management.

Here are a few strategies to begin to consider as the opportunity set that tracks the Barclays Aggregate may be limited for a while.

• Flexible Income Funds-The mandate is typically more nimble and the scope is wider.

• Global Bond Funds-The mandates vary but these managers are able to attempt to secure value domestically and to be able to search around the globe. This can involve multiple currencies and emerging markets. Each introduces their own risks but allows for a larger opportunity set.

• Unconstrained-These funds are in most cases the most nimble with regard to security selection, geographic reach and duration management. Some actually hold a negative duration. That can certainly work against the investor if rates decline.

We are convinced that a methodical move away from a core mandate around the Barclays Aggregate is one that needs to be taken over a reasonable time frame. Now would be a great time to internally assess your firms risk objective and what areas of the global bond market you are willing to explore for a portion of the bond portion of your portfolio.

We can help you through this process by taking a look at you current manager in terms of their process and if that process if conducive to future results. The high risk adjusted numbers for these managers over the last few years will likely be very difficult to achieve in the future unless their mandate and process are appropriately nimble.

Again to aid in this process we can sort through the various bond fund labels and how each may work to help or hurt your portfolio.

Thanks again for your time.

Sincerely,

Tom Koehler-CIO

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