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nstrained vs. constrained

Investing:

Co Un

Navigating a Changing Landscape

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Both constrained investment strategies (which closely follow an index) and

unconstrained strategies (which give an investment manager more flexibility) have

benefits and risks.

nstrained vs. constrained

Investing:

by | Julian M. Regan and Geoffrey Strotman

Navigating a Changing Landscape

Reproduced with permission from Benefits Magazine, Volume 52, No. 2, February 2015, pages 30-39, published by the International Foundation of Employee Benefit Plans (www.ifebp.org), Brookfield, Wis. All rights reserved. Statements or opinions expressed in this article are those of the author and do not necessarily represent the views or positions of the International Foundation, its officers, directors or staff. No further transmission or electronic distribution of this material is permitted.

M A G A Z I N E

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For multiemployer and public employee benefit funds, con-strained, benchmark-oriented investing and unconstrained, outcome-based investing offer

two very different portfolio manage-ment approaches. Both have merits and risks, and each may have a role in a well-diversified portfolio.

U.S. employer-sponsored retirement plans, with approximately $14.9 trillion in assets as of 2014,1 have predomi-nantly employed constrained active and passive (indexed) investing to po-sition their portfolios for risk-adjusted returns in the equity and debt markets. There is good reason for this. Since the Employee Retirement Income Security Act (ERISA) was enacted, constrained approaches have enabled investors to implement their asset allocation strat-egies under well-organized portfolio structures that clearly delineate invest-ment manager responsibilities for asset classes, markets and sectors.

Constrained investment strategies seek to achieve a return that meets or exceeds a benchmark index such as the S&P 500 or the Barclays Capital U.S. Aggregate index by investing in security types, sectors, markets and asset classes that are set by the index.2 By contrast, unconstrained investment strategies

seek a more abstract goal of maximiz-ing total return by accessing an array of sectors, markets and/or asset classes without limitations (“constraints”) set by a traditional benchmark index.

While constrained investing has been a staple of institutional portfolios for decades, unconstrained approaches are gaining as investors seek to ad-dress new challenges and opportunities posed by a changing market environ-ment and global economy.

A Changing LandscapeThe balance between constrained

and unconstrained investing is chang-ing. One industry consultant predicted that investment approaches based on risk factors and outcomes—a larger category that includes alternative in-vestments—will gain over $3 trillion in investor cash flows between 2013 and 2018, while traditional benchmark-based approaches will lose $1.8 tril-lion.3

In June 2014, Pensions & Invest-ments reported that assets in uncon-strained bond strategies increased from $57.5 billion to $177.4 billion between January 2010 and March 2014, an an-nualized growth rate of 32.5%.4

Interest in outcome-based invest-ment strategies increased following the

2008 financial crisis. In the wake of a meltdown that took 37% of the value of the S&P 500 index in 2008, outcome-based approaches that give wider lati-tude to investment managers to invest outside of indexes have gained.

Unconstrained approaches are be-ing driven in part by investors’ desire to access a broader array of investments and to avoid risks in traditional index-es, including the risk that a sector or market in the index may be overvalued or expose investors to a high probabil-ity of loss.

This is particularly true of outcome-based bond strategies that are designed to limit interest rate risk5 while add-ing return potential in the wake of a 30-year-plus bull market for bonds that has impacted return expectations for the Barclays Capital U.S. Aggregate Index.6

Industry marketing campaigns also are driving demand. The Wall Street Journal recently characterized mutual fund firms’ advertising campaigns as a “hard sell” on unconstrained bond funds.7

Distinctions between constrained and unconstrained approaches include differing return objectives, flexibility in portfolio construction, risk and, in the case of unconstrained approaches, returns that may vary widely over time (Table I). Unconstrained approaches may also charge higher fees, use deriva-tives8 and, in the case of bond funds, take short positions in interest rates or currencies to position the portfolio to gain from adverse movements in mar-ket factors.

Because many unconstrained strat-egies have a higher risk profile, many investors limit these approaches to modest-sized “satellite” allocations that

investments

TABlE IConstrained vs. Unconstrained CharacteristicsCharacteristic Constrained Unconstrained

Relative return objective (outperform benchmark) ■

Total return objective (maximize risk-adjusted return) ■

Well-defined controls over market and sector allocations ■

Greater flexibility in allocating assets vs. benchmark index ■

Greater expected variability in returns vs. benchmark index ■

Lower expected variability in returns vs. benchmark index ■

Provide asset class exposures ■ ■

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investments

complement larger core allocations to active and/or passive constrained strategies. The role of unconstrained equity and debt strategies in institu-tional portfolios will likely evolve as the investment industry develops new products with varying risk profiles and as outcome-based products compile longer track records.

Definitions

Constrained Investing

Constrained investment managers adhere to well-defined specialist roles investing against a specified bench-mark such as the S&P 500 or Barclays Capital U.S. Aggregate Bond Index. Constrained passive (index) managers, whose portfolios replicate the index, are expected to generate returns that match the index. Active constrained managers are expected to modestly outperform the index net of fees.

While benchmark-oriented invest-ment managers are given measured flex-ibility to add return over the index, their portfolios must stay within tolerances established by the benchmark and doc-umented in investment policy guide-

lines.9 By contrast, an unconstrained portfolio (the example to the right in Figure 1) may maintain significant non-benchmark allocations including, in the case of an unconstrained bond manager, allocations to higher yielding, riskier non-U.S. dollar and high-yield debt se-curities.

Unconstrained Investing

Unconstrained approaches give in-vestment managers the flexibility to invest across security types, markets, sectors and risk exposures with limited

restrictions. Although an unconstrained investment manager’s results may be compared with a traditional index, the manager typically invests toward a broad objective of maximizing total return. The investment manager may also shift investments dramatically over time. For example, a global unconstrained equity portfolio may theoretically increase its allocation to emerging markets Asian stocks from an indexlike weight of 7% in one period to 21% in the next period or may increase an industry sector weight to triple the index weight.

U.S.Treasury 5%

Investment-Grade Credit

26%

High-Yield 26%

Non-U.S. 21%

Convertible11%

Cash 4%

ABS/RMBS3%

Preferred/Equity 2%

Bank Loan1%

CMBS1%

Unconstrained Bond Manager

U.S. Treasury

Investment-Grade Credit27%

ABS/RMBS30% 37%

U.S. Agency 4%

CMBS2%

Barclays Capital U.S. Aggregate Index

FIgURE 1Passive vs. Unconstrained Bond Manager Sector Weightings

FIgURE 2Global Unconstrained Equity Manager Regional Weightings

0% 10% 20% 30% 40% 50% 60% 70%

North America

U.K.

Continental Europe

Japan

Asia ex-Japan

Other

Manager AManager A Manager B MSCI ACWI Index

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In addition to varying widely to an index, as shown in Figure 2, uncon-strained managers’ exposures often vary widely from one another, leading to significant variations in results.

Strategies and TermsConstrained and unconstrained

investing approaches encompass a broad expanse of strategies and terms, some of which overlap. labels such as

“benchmark-oriented,” “benchmark-aware,” “style-box investing,” “tradi-tional” and “core” are applied to con-strained approaches.

Unconstrained approaches may be described as “outcome-based,” “total return,” “opportunistic,” “benchmark-agnostic,” “multisector,” “full-discre-tion” and “go-anywhere.”

Certain investment strategies in-clude elements of both approaches. For

example, core plus fixed income strate-gies, a staple of many institutional port-folios, require the investment manager to invest the portfolio against the Bar-clays Capital U.S. Aggregate Index but provide flexibility to invest in so-called plus sectors—high-yield debt, global and emerging markets.

Constrained investment equity and debt strategies include:

• Equity and debt index funds whose holdings replicate the in-dex

• U.S. large, mid and small cap eq-uity strategies that invest against capitalization-weighted or growth, value or core equity indexes10

• International and global equity funds that invest in line with cap-italization, regional or style-based indexes

• U.S. and global bond strategies that invest against a variety of U.S. and global bond indexes.

Unconstrained investment equity and debt strategies include:

• U.S. all cap unconstrained equity strategies that provide the invest-ment manager with wide latitude to invest across sectors, sizes and styles

• Unconstrained international and global equity strategies that pos-sess broad flexibility to under- or overweight countries, re-gions, currencies and industry sectors

• global multisector and opportu-nistic bond funds that possess broad flexibility to invest across bond sectors, currencies, credits, interest rate environments and security types.

Constrained and unconstrained investing approaches involve vary-

investments

TABlE IICore Bond Managers Diversification of Equity Risk Emerging U.S. Large Core Fixed High-Yield Market

U.S. large cap equity 1.00 0.14 0.62 0.47Core fixed income 0.14 1.00 0.18 0.19High-yield fixed income 0.62 0.18 1.00 0.49Emerging market debt 0.47 0.19 0.49 1.00

TABlE IIIGlobal Outlook for Growth of Domestic Product 2010-2012 2014-2019 2020-2025 Actual Projected Trend

United States 2.4% 2.4% 1.7%Europe 1.1% 1.4% 1.3%All mature economies 2.0% 1.9% 1.4%Emerging and developing economies 6.4% 4.3% 3.2%Source: The Conference Board, May 2014.

FIgURE 3Constrained and Unconstrained Bond Strategies

Opportunistic Bond Portfolio

Core-Plus Bond Portfolio

Core Bond Portfolio

Passive Bond Portfolio

Hig

her

Less

Unc

onst

rain

ed

d

Con

stra

ined

More

Global Multisector Bond Portfolio

Flexibility

february 2015 benefits magazine 35

ing levels of decision-making authority. As illustrated in Figure 3, passive and active core bond strategies—both of which are constrained—grant limited authority, while core plus, global multisector and opportunistic bond strategies delegate progressively greater flexibility. gener-ally, greater flexibility translates into higher expected vol-atility and tracking error.11 Different trustees may settle on different approaches along this continuum based on their objectives and risk tolerances.

Potential Benefits and Risks Both constrained and unconstrained approaches provide

effective means for implementing an investor’s asset alloca-tion structure, diversifying risk and retaining highly skilled investment managers. They also provide distinct potential benefits and risks.

Potential benefits of constrained approaches include:• greater control over market, credit, currency and li-

quidity risk exposures• Ease of measuring performance• Facilitates monitoring of asset class exposures across

the portfolio• Effective, predictable means of diversifying portfolio

risks across asset classes.Potential benefits of unconstrained approaches include:• Access to a broader investable universe• Ability to change allocations as market conditions

change• Management or avoidance of risks that may be embed-

ded in a benchmark index or asset class• The ability to build a portfolio with higher expected

returns and potentially greater efficiency.

Risk Controls and Diversification BenefitsConstrained and unconstrained approaches offer dif-

fering approaches to risk management and diversification. The constraints on a core U.S. bond manager, for example, assure trustees that their portfolio includes high-quality bonds that have a lower probability of losing value or de-faulting. Although core bond managers are expected to use modest flexibility to beat the benchmark, the amount by which they may deviate in credit, interest rate and currency exposure is limited. In Figure 4, the core manager’s 85% cumulative allocation to debt rated A or better closely re-sembles the index’s 89% allocation. By contrast, the alloca-

tion of an unconstrained manager (in this case a “multisec-tor” manager) to debt rated A and above may be a fraction of the index.

As illustrated in Table II, due to their constraints, core fixed income portfolios are expected to have a low correla-tion to equities. In other words, their returns are not ex-pected to move in tandem with those of stocks. This pro-vides investors with an important diversification benefit, particularly in times of economic stress when stock prices are prone to volatility. On the other hand, high-yield debt and emerging markets debt securities, which many uncon-strained bond funds hold, exhibit higher correlations to stocks and are therefore less effective in diversifying equity risk.

A Changing Opportunity Set Economists, market researchers and investment consul-

tants have cautioned for some time that returns from core equity and fixed income strategies may be lower in the fu-ture (Table III). While well-publicized concerns of a future “low-return” environment may or may not materialize, there are reasons for the assumption. Headwinds include deceler-ating projected economic growth in many developed coun-tries, increased government debt in established markets, low yields in bond markets and as-yet-unknown impacts of an eventual exit from unprecedented accommodative monetary policy that has kept interest rates low in the aftermath of the 2008 financial crisis.12

Against this setting, many market forecasters have re-duced long-term capital market assumptions for core equity and bond returns. At the same time, a number of emerging economies have improved fundamentals, better monetary policy and improved corporate governance and regulatory

investments

TABlE IVYields, Interest Rate Risk and Credit RiskCharacteristic Unconstrained IndexAverage duration 1.93 Years 6.29 YearsAverage weighted maturity 3.56 Years 8.01 YearsYield to maturity 4.87% 2.08%Yield to worst 4.83% 2.06%Current yield 5.36% 3.16%Investment-grade bonds 56.70% 94.80%Non-investment-grade bonds 43.30% 5.10%

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frameworks. Whether they are global or not, well-executed unconstrained strategies with larger investable uni-verses merit consideration in an invest-ment program designed to meet a 7.5% or 8% long-term return assumption.

Risk ManagementRisks and potential downsides of tradi-

tional constrained investing may include:• Inflexibility in mitigating risks

embedded in a benchmark index or target market

• Distorted index weightings that unintentionally force a manager to hold overvalued sectors

• Incentives that lead some active managers to generate indexlike returns at a higher fee.

investments

FIgURE 4Credit Quality: Core vs. Multisector Fixed Income Manager

19.10%10.70% 8.30%

28.90%

6.90% 5.20%

24.10%

11.80%3.40%

One year Three years Seven years

Performance as of June 2014

Global Unconstrained Equity Manager A Global Unconstrained Equity Manager B MSCI World Index

Standard Deviation as of June 2014 Tracking ErrorManager Three Years Five Years Ten Years Three Years Five Years Ten YearsManager A 10.00 10.89 13.16 5.65 6.13 8.27Manager B 20.49 22.23 29.24 7.35 8.10 13.97MSCI World Index 15.31 15.28 19.16 NA NA NA

FIgURE 5Sample Global Unconstrained Equity Managers

AAA AA A BAA BA B CAA & Lower

Not Rated/Other

Multisector 17.9% 2.6% 13.6% 30.2% 17.0% 6.6% 3.4% 3.7%Core 61.0% 7.0% 16.7% 15.3% 0.1% 0.4%U.S. Aggregate Index 73.1% 3.5% 11.5% 12.0%

0.0%

20.0%

40.0%

60.0%

february 2015 benefits magazine 37

In addition to the potential for increased volatility, risks of unconstrained investing may include:

• A higher probability and severity of losses due to in-vestment manager decisions

• The potential for overlapping positions and risk ex-posures with other investment managers

• Newer strategies with short histories that do not show risk-adjusted results through multiple market cycles.

Risk Management Trade-Offs

Although unconstrained investing does not offer trust-ee-imposed risk controls, an outcome-based manager may have the potential to better manage or avoid risks in an in-dex. For example, unconstrained bond managers are able to avoid interest rate risk that is a product of the Barclays Capital U.S. Aggregate Index’s heavy exposure to U.S. Trea-sury and other sectors that may be highly sensitive to in-terest rate shifts. As evidenced in Table IV, the index has a relatively high average duration (one measure of interest rate risk) of 6.29 years, while the average duration of a sam-ple unconstrained manager, 1.93 years, is a fraction of that. given that interest rates and bond prices move in opposite directions, a portfolio that mirrors the higher average du-ration of the index is more susceptible to losing value in a rising interest rate environment.

The Japanese equity market in the 1990s and 2000s pro-vides another example of unconstrained investment man-agers’ potential for limiting risk inherent in a traditional index. During the 1980s and 1990s, the Japanese Nikkei Index at times represented over 50% of the MSCI EAFE In-ternational Equity Index before falling to its present level of approximately 20%. With the benefit of hindsight, uncon-strained international equity strategies had the potential to limit losses by significantly underweighting this overvalued market.

A fair criticism of unconstrained bond funds is that while they provide the potential to reduce interest rate risk, they may increase yields only by increasing credit risk and/or cur-rency risk. Table IV illustrates the trade-off between interest rate risk, yield and credit risk. The unconstrained portfolio has lower duration and higher yields than the index, which should benefit the investor. However, the portfolio’s 43% al-location to higher risk noninvestment grade bonds exceeds the index by over 35%, resulting in a higher risk portfolio that may be prone to equitylike volatility.

Risk Oversight

given the latitude they are granted, unconstrained man-agers must maintain a comprehensive risk management framework that uses key measures, governance, reporting and information technology to limit the probability and se-verity of losses. Investors overseeing constrained and uncon-strained strategies review key risk measures including the examples in Table V to assess a manager’s effectiveness in managing risk.

Historical Returns, Risk and Tracking ErrorA review of historical returns and risk provides a use-

ful, if limited, tool in assessing any investment manager’s qualifications. Predictably, unconstrained investment man-agers’ investment results evidence widely varying returns, varying volatility (as measured by standard deviation) rela-tive to the index and higher tracking error. By contrast, a typical constrained investment manager’s returns fall into a narrower band. The global unconstrained equity manager results illustrated in Figure 5 provide a partial example of widely varying volatility (in one case it is lower) and high

investments

TABlE VSample Risk Categories and Measures Market Risk Credit Risk •Standarddeviation •Creditrating •Beta •Defaultrate •Valueatrisk •Debtcoverage •Sharperatio •CapitaladequacyNote: Sample risk measures only. Not inclusive of other risk catego-ries.

learn more >>EducationInvestments InstituteMarch 9-11, Rancho Mirage, CaliforniaVisit www.ifebp.org/investments for more information.

From the BookstoreTools & Techniques of Investment PlanningStephan R. Leimberg, Robert J. Dole Jr., Thomas R. Robin-son and Robert R. Johnson. National Underwriters. 2014.Visit www.ifebp.org/books.asp?9029 for more details.

benefits magazine february 201538

tracking error relative to a traditional index that is common for many outcome-based approaches. In this sample, inves-tors’ tolerance for tracking error appears to be rewarded with outperformance relative to a traditional index from both managers over a longer period, while results are mixed over shorter time frames. Investors using unconstrained strategies should be prepared for both outcomes.

ConclusionThe story of constrained and unconstrained investing is

still unfolding. Investors who are weighing these approaches should consider the following as they position their portfo-lios for risk-adjusted returns through changing market envi-ronments:

• Well-executed constrained and unconstrained invest-ing approaches provide viable means to implement as-set allocation structures, to diversify risk and to utilize skilled investment managers.

• Traditional, constrained approaches, which have been the prevailing approach in recent decades, allow inves-tors a higher degree of control over investment man-ager decisions, while facilitating effective oversight of performance and risk.

• Unconstrained investment approaches provide invest-ment managers with a larger investable universe, broad flexibility to manage risks and the potential to generate higher expected returns.

• Demand for unconstrained investing approaches is be-ing driven in part by investors’ desire to access a wider array of investments and to avoid risks inherent in tra-ditional index weights.

• Despite lower expected returns for some strategies, constrained, benchmark-oriented approaches play a critical role in mitigating portfolio volatility in times of market distress.

• Due to many unconstrained strategies’ higher risk pro-files, many investors select outcome-based approaches for modest-sized satellite allocations that complement core equity and debt allocations.

Unconstrained investment strategies that demonstrate repeatable, well-disciplined approaches to maximizing risk-adjusted returns merit consideration for inclusion in institu-tional portfolios. looking ahead, however, investors should be wary of unconstrained strategies that have not been tested through different market environments or that are not sup-ported by highly skilled investment teams.

Investment management firms are likely to continuously improve upon existing constrained and unconstrained equi-ty and debt strategies, while continuing to develop products that include attributes of both to suit a range of risk toler-ances.

Constrained and unconstrained approaches will con-tinue to play critical, differing roles as institutional asset

Julian M. Regan is vice president/senior investment consultant for The Marco Consulting group (MCg) in Braintree, Massachusetts. In addition to advising boards and

executives of benefit plans, he serves on MCg’s fiduciary services committee. Regan previously served as executive director for the New York State Deferred Compensation Board. He also served as vice president of risk governance and strategy for Fidelity Investments and as assistant general manager and budget director for the Massachusetts Bay Transportation Authority. In 2005, the U.S. Treasury secretary appointed Regan to the IRS Advisory Committee on Tax Exempt and government Entities. Regan was a contribut-ing author to the Trustee Handbook: A Guide to Labor-Management Employee Benefit Plans, Seventh Edition, published by the Foundation in 2012. He received his M.B.A. and B.S.B.A. degrees from Suffolk University.

Geoffrey M. Strotman is director of manager research for The Marco Consulting group in Chicago, Il-linois. He has more than 20 years of experience in financial analysis

and manager research. Strotman previously was manager of traditional asset research at DiMeo Schneider & Associates. He holds a B.B.A. degree in accounting from the University of Notre Dame and an M.B.A. degree with concentrations in fi-nance, economics and international business from the University of Chicago. Strotman is a chartered financial analyst (CFA) and a member of the CFA Institute and the CFA Society of Chicago.

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bios

investments

february 2015 benefits magazine 39

allocation models evolve toward globalization, large allo-cations to alternatives and a greater focus on managing risks.

Endnotes

1. Investment Company Institute, September 25, 2014 (Retirement plan assets included $8.3 trillion in government and private defined benefit plans and $6.6 trillion in defined contribution plans). 2. Security types include corporate bonds, common stock, etc. Sectors include corporate and government bond sectors, industry sectors, etc. Asset classes include U.S. stocks, non-U.S. stocks, etc. 3. Casey, Quirk & Associates, November 2013. 4. Pensions & Investments, June 23, 2014. 5. Interest rate risk may be defined as the risk of loss in market value due to an increase in interest rates. The prices of most bonds move in the oppo-site direction of interest rates. 6. Market forecasters generally are projecting modest returns for the Barclays Capital U.S. Aggregate Index due to modest yields and higher inter-est rate risk associated with many index sectors. 7. Wall Street Journal, March 3, 2014. 8. The term derivatives generally is used to describe securities whose prices are based on the values of an underlying investment, such as stocks, bonds, commodities or currencies. Examples of derivatives include futures, options, swaps and warrants. 9. Active constrained equity managers may be subject to, among other constraints, percentage limits on investing in an industry sector, market, currency or security type. 10. Growth equity managers generally invest in stocks of companies that exhibit above-average prospects for earning growth. Value equity managers invest in companies believed to be undervalued. Active core equity managers invest in stocks that share both growth and value characteristics. 11. Tracking error is a risk statistic that quantifies the difference between

a portfolio’s return and that of the benchmark. The higher the tracking er-ror, the more a manager is deviating from the benchmark. 12. Since December 2008, the U.S. Federal Reserve has used monetary policy tools such as the Fed Funds rate and bond purchase programs to keep short-term interest rates at or near zero based on the theory that low rates (and modest inflation) will set the stage for an economic recovery.

takeaways >>• Unconstrained investing approaches—which give investment

managers more flexibility than constrained approaches—are becoming more popular because of changing market conditions and the global economy.

• With traditional index investing approaches, there is a risk that a sector or market in the index is overvalued, exposing the investor to a high probability of loss.

• Unconstrained approaches often have higher fees and may have wider variations in returns but may be worth considering by investors hoping for 7.5% or 8% returns in a future low-return environment.

• Investors often limit unconstrained approaches to modest-sized allocations in a portfolio that mainly uses constrained equity and debt strategies.

• Unconstrained managers must maintain a comprehensive risk management framework to limit the probability and severity of losses.

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