It’s a new variation on an old theme: a bond index fund that promises both safety and a potentially sweet return.
By Laurie Kaplan Singh
June 2001
Institutional Investor Magazine
It’s a new variation on an old theme: a bond index fund that promises both safety and a potentially sweet return. The product, aimed at institutional investors, guarantees a minimum return, tied to an index; the guarantee is backed by an insurance company. The fund also allows investors to share in the upside, should the fund’s portfolio managers outperform the index.
Four years ago Metropolitan Life Insurance Co. introduced a series of fixed-income products as part of the MetLife Index Track family of funds. By mid-May 2001 the series had grown to contain five funds and had attracted about $2.4 billion in assets from more than 80 pension plans. MacKay Shields, a division of New York Life Insurance Co., will be launching its own version in the next month or so.
“We are guaranteeing that the investor earns a minimum return within a few basis points of the Lehman aggregate index,” says Gary Goodenough, co-head of fixed income for MacKay Shields. New York Life will provide the fund’s guarantee; in April the team received approval from the New York State Insurance Department to sell its new product.
Says Goodenough, “New York Life is assuming all of the downside risk in return for the ability to share in the excess return it believes we will generate.”
The five MetLife Index Track funds guarantee minimum quarterly returns tied to different fixed-income indexes, including the Lehman Brothers aggregate bond index. MacKay has not yet set the pricing for its new product, but Goodenough says the fund will offer investors a guaranteed minimum quarterly return equal to the return of the Lehman Brothers aggregate bond index, plus or minus a few basis points. Investors will also share the fund’s return above the index return plus an as yet undetermined quarterly hurdle rate, which goes directly to MacKay Shields and New York Life for managing and guaranteeing the product.
For example, assuming the quarterly return on the index is 2 percent and the hurdle rate is 15 basis points, the investor would receive the guaranteed return (approximately 2 percent) plus a share of the fund’s return in excess of 2.15 percent.
As Goodenough points out, institutional bond index funds typically provide a return equal to the index return, minus a management fee - between 5 and 10 basis points on average. But for the new MacKay Shields offering, the minimum return is net of fees. “Even in a worst-case scenario, investors will earn a return very close to the return on the index,” Goodenough says.
In exchange, investors may sacrifice some liquidity. Depending on the payout terms specified in the contract documents, they may not always have immediate access to their funds.
Although MacKay Shields and New York Life will charge no up-front fees, they will of course reap a good share of excess returns. “If we don’t beat the index, we don’t get paid,” says Goodenough.
With bond index products claiming about $1.5 trillion in assets, Goodenough anticipates strong demand for the product - perhaps exceeding the available supply, which will be limited by the cost of providing the guarantee. “There’s a finite supply of insurance-company capital available for guaranteeing this type of product,” Goodenough explains.
In running the new portfolio, Goodenough will follow a “core-plus” strategy, investing at least 70 percent of the portfolio’s assets in a mix of investment-grade bonds that largely mirror the composition of the Lehman aggregate index. Goodenough will place the remaining assets in yield-enhancing instruments. The fund may invest up to 20 percent of assets in high-yield bonds and up to 10 percent in foreign bonds.
In theory, the portfolio’s moderate, opportunistically timed exposure to higher-yielding bonds should enable the fund to beat the index without increasing volatility. “Ideally, we want to produce returns above the index while keeping volatility below it,” Goodenough says. “We tend to keep the portfolio’s duration in line with the index’s or very close to it,” he says.
However, when the MacKay fixed-income team has a particularly strong view on the direction of interest rates, Goodenough will increase or decrease the fund’s interest rate exposure relative to the index.
MacKay’s other core-plus products - which the new fund will likely mirror - currently have 23.4 percent of their assets in investment-grade corporate bonds (versus 25.7 percent for the Lehman aggregate index); 16.7 percent in U.S. Treasuries (25 for the index); 16 percent in mortgage-backed securities (36.6 for the index); 16 percent in high-yield corporates (zero for the index); 7.1 percent in agency securities (10.9 for the index); 6.2 percent in asset-backed securities (1.8 for the index); and 1 percent in nondollar bonds (zero for the index). The remaining 13.6 percent of MacKay’s core-plus portfolio is in cash.
This asset allocation reflects MacKay’s expectation that the economy will slowly strengthen. “We believe that we’re now seeing the worst of the slowdown and that corporate profitability will improve within the next two quarters,” Goodenough says. Assuming the firm’s forecast proves correct, corporate bonds are likely to be the prime beneficiaries. “We are positioned for a moderate flattening of the yield curve, with short-term interest rates rising more than long-term rates,” says Goodenough.
One of his favorite core-plus holdings is Unilab Corp. 12.75 percent bonds due October 2009. The bonds are trading at a 9.1 percent yield, or 416 basis points over Treasuries. He also likes the business prospects for the $337.5 million (2000 revenues) company, which provides clinical lab testing. Recently, Unilab filed for an initial public offering, which it plans to bring to market at the end of June. Unilab says it intends to use $82.3 million of an anticipated $100 million in proceeds to pay down debt. “This will improve its financial ratios and free up cash flow to grow the business,” Goodenough says.
Investment DNA
What does it take to be a talented chief investment officer? A new study by Russell Reynolds Associates, a New York-based executive recruiting firm, attempts to answer that question. In a just-published report, “Investment DNA: Identifying the Critical Success Factors for Chief Investment Officers,” the firm identifies the management skills and personality traits - the “investment DNA” - that define successful CIOs.
At the top of that list: excellent interpersonal skills. As it happens, that’s also the trait most often missing in money managers who aspire to the job. “Many excellent money managers don’t have the people skills to become great CIOs,” says Susan Fowler, a managing director at Russell Reynolds who coauthored the study with Richard Lannamann, the head of Russell’s investment management practice.
Says Randy Merk, chief investment officer at American Century Investment Management in Los Angeles: “It’s no longer about being the smartest person or the best money manager. It’s about having the right communication and problem-solving skills and the interest in developing other people.”
Fowler and Lannamann teamed up with Lynne Rosansky, a psychologist and CEO of the Boston-based management consulting firm LHR International. Rosansky conducted in-depth “behavioral” interviews with seven CIOs, selected because they are highly regarded by their peers and subordinates and because they lead organizations that have produced strong investment returns during their tenure.
The team chose behavioral interviews, Fowler explains, because they are designed to elicit stories about past performance and to reveal not only what someone did but also why he did it. “We were trying to determine what makes great chief investment officers tick and to develop a prototype, or a model, that would be useful in identifying candidates with the potential to become outstanding CIOs,” Fowler says.
Not surprisingly, successful CIOs captain the investment process by establishing a philosophy and a framework for investing. “A good CIO clearly articulates core investment tenets, requires consistency in the application of the investment discipline, establishes meaningful performance metrics, and sets high standards,” the study concludes.
Says Merk: “One of the CIO’s chief responsibilities is to look out for style drift. You have to make sure that value funds remain value funds and growth funds remain growth funds.”
Good CIOs also foster a culture of intellectual curiosity, in part by promoting a meritocracy in which good ideas prevail. “Successful CIOs are approachable,” Lannamann says.
Most effective CIOs, the study concludes, act as good mentors. “He or she can look at an individual portfolio manager or analyst and determine how to help them grow and develop,” Fowler says. Adds American Century’s Merk, “Once you get to this point, it’s all about developing the next generation of money managers.”
