Gentlemen Prefer Bonds discusses factors to consider when allocating fixed-income assets. It recommends an actively managed portfolio using multiple investment firms with complementary philosophies to balance risk and returns. The document contrasts active versus passive management, advantages of multiple advisors, and importance of manager experience, philosophy and ability to generate alpha. It emphasizes maximizing portfolio performance within regulatory constraints by allowing managers flexibility and discretion tailored to their expertise.

1. Gentlemen Prefer Bonds
In Consideration of Fixed-Income Investment Strategies
Prepared by Andrew Biggane
Yield by any characterization is paramount to most discussions involving the
performance of your asset manager, however the potential for enhanced returns to the
portfolio should not be the sole arbiter in the deployment of funds. Far from a fungible
commodity, fixed-income investment managers, while frequently constrained by both
regulatory issues and market conditions, can add value through contrasting investment
methodologies. While yield remains a primary consideration, it is also important to
consider the ancillary factors of investment philosophy, market perspective, sector
diversification and management tenure. It is through discussion of the relative merits of
these points that this paper will attempt to define the ideal solution to the question of
asset allocation, through the review of several significant fixed-income investment firms,
while attempting to isolate those characteristics that prove inherently successful.
1. Active v. Passive Portfolio Management
An industry-wide index is the most common benchmark in measuring performance and
provides a metric that is both visible and discrete to the client, while holding the manager
to a standard of performance with implicit ties to the fixed-income marketplace. In this
respect, it is important to distinguish between actively and passively managed portfolios
and the role of an index in both. An actively managed portfolio seeks to add value from
opportunistic trading while avoiding market anomalies. This type of portfolio may be
structured to meet specific client requirements, while remaining representative of the
broader market. To this end, an index may be employed as a tool to aid in asset
allocation. While adherence to an established benchmark (i.e. Lehman indices) typically
ensures a return consistent with the aggregate fixed-income market, it can be argued that
the mandate to replicate this market in some manner will artificially handicap the
portfolio manager’s ability to trade the portfolio and may result in periodic
underperformance to the benchmark. Passively managed portfolios are pegged to a
particular index and returns fluctuate with the cyclical operations of the market. Holdings
in this type of portfolio are particularly exposed to events peripheral to the market,
remain fully invested with little cash reserves to alleviate potential downturns and as a
result, might not be best positioned to succeed in times of economic uncertainty.
Additionally, concerns of cost are legitimate, as fee schedules for actively managed
portfolios can be linked to trading activity, while passive portfolios are frequently
assessed a flat fee that is a function of assets under management. In order to justify the
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2. considerable expense of maintaining an outside investment firm it should be reasonable
to expect returns supplemental to that of the benchmark. This expectation should be
incorporated into the discussion of investment manager compensation, as the
conventional payment arrangement centered around the market value of the portfolio
appears bound to induce an indifferent result, absent this provision for performance.
Further, it would seem counter-intuitive to augment a portfolio in which every additional
dollar invested is first devalued by the established fee structure without some assurance
of superior returns. Contractual stipulations that allow actively traded portfolios to
mitigate expenses through a progressive fee structure with a contingency for performance
may offer the best combination of portfolio agility and cost certainty, while properly
incenting the portfolio manager.
2. Multiple v. Single Advisors
To move forward under the notion that, budgetary constraints aside, an actively managed
portfolio represents the most efficient utilization of a company’s financial resources, an
appropriate investment management firm must now be identified. It would be folly to
assume that there is a complete correlation between the amount of assets under
management and the ultimate success of a portfolio manager. One must only look to
recent financial headlines for verification. Bear Stearns Companies, with over $350
billion under management and one of the largest financial services companies in the
world, recently suffered the first loss in it’s 83 year history and was forced to write down
over a billion dollars in mortgage-related securities.
As such, it is important to recognize not only the innate risk of the markets, but also the
structural risks associated with committing significant capital to a single firm to manage.
Depending on the aversion to risk, it may be prudent to designate the balance of the
portfolio to multiple money managers. In order to perform this allocation it is first
necessary to determine an investment strategy suitable to the individual company’s long-
term financial goals, taken together with any immediate liquidity requirements. As stated
previously the yield on the portfolio is of primary concern. However, when taken by
itself, yield is a relatively poor gauge of performance. Due diligence demands that we
investigate the means by which an investment firm generates it’s returns, with the
eventual goal of isolating market dynamics (i.e. typical levels of activity) from the
implementation of a successful investment strategy, therefore ascertaining true levels of
performance by an asset manager.
Upon determination of a suitable investment policy it is necessary to understand the basis
by which a prospective firm conducts itself. In this regard, the 3-P’s of investment
management may be used to gauge an asset manager’s capabilities and ability to
implement a successful fixed-income investment strategy. While themes of philosophy
and process must first be considered, the people responsible for executing the objectives
and managing the results are fundamental to any discussion involving potential asset
deployment. In reviewing management tenures at successful institutional bond funds, the
average asset manager has 13 years of experience in their present position. In light of
this, it’s debatable whether an investment firm’s historical performance should be given
any significant weight, absent this continuity in their management team. So, while it can
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3. be stated that stability does not assuredly forecast success, it appears innately
characteristic of it.
source: http://en.wikipedia.org/wiki/Investment_Management (adaptation)
In the current economic environment it may be appealing to retain a certain level of
redundancy in the portfolio. Multiple investment firms with complementary styles of
money management may serve to mitigate risk systematic to the marketplace, but one
must also consider if having this level of potential security outweighs the intrinsic benefit
of contrasting management philosophies.
3. Contrasting v. Complementary Investment Philosophies
At this point, it may be helpful to understand exactly how challenging it can be to extract
additional yield from an investment portfolio, and in relation, the importance of selecting
an investment firm with the ability to do so. Unable to avail itself of equity driven
investment vehicles of any significance, insurance company portfolios have traditionally
relied on the structured finance marketplace and the process of securitization to generate
returns. By definition, securitization is identified as the “creation and issuance of new
fixed-income securities, whose payments of principal and interest are derived from cash
flows generated by pools of assets acting as collateral for the aforementioned securities.”1
Further limitations arise from state statutes that may limit the kind and quality of fixed
income investments available for inclusion. It is from within these relatively narrow
constructs that the contents of an insurance company’s investment portfolio are drawn. In
order to maximize the potential for return, it is therefore a necessity that the investment
1
“Structured Investment Vehicle (SIV) The new yield curve arbitraging engine”, Pradeep K. Singh,
<http://www .ibsaf.org/nl/nl12/articles/article3.asp>
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4. firm be allowed to trade to the limits of the established investment policy, exercising
discretion and maximizing it’s value to the client.
At the risk of oversimplification, a review of the investment objectives of successful
institutional bond funds it is apparent that, in an effort to augment yield, fund managers
will weight allocations in accordance with their capacity for positive returns. It can be
argued that an investment manager with knowledge unique to certain segments of the
market and allowed to invest as such, is better equipped to obtain these higher yields.
Efforts should be made to mirror this practice, within regulatory guidelines, of allowing
portfolio managers to trade to their strengths. Companies that stray entirely from this
practice may unwittingly peg their investments to an artificial index, inviting the
problems that a passively managed portfolio entails, namely underperformance to the
established benchmark. Far from advocating an extreme overweighting of a particular
segment, an actively managed portfolio of this type seems ideally suited to alpha
generation and could potentially minimize market aberrations that would have otherwise
adversely affected the portfolio.
4. Absolute v. Relative Performance
The framework to establish the investment policy is moot without the mechanism to
monitor it’s performance and an investment company’s ability to consistently
manufacture superior returns will ultimately decide it’s fate. These two investment
axioms aside, it is of critical importance to determine a metric by which results will be
quantified and to make this value as transparent as possible. The use of an industry-
accepted benchmark is the most expeditious means of creating this tracking method and
can be useful in facilitating a generic evaluation of the results. However, this philosophy
may have the unintended consequence of establishing a performance ceiling, as the
portfolio manager alters their investment style to suit existing portfolio constraints and
meet a goal not necessarily congruent to that of their holdings. A more appropriate ideal
for an actively managed portfolio may be to encourage asset managers to achieve the
greatest possible yields, respective of statutory restrictions and internal compliance
controls, but the solution may ultimately reside in a blend of these strategies. Segmenting
the portfolio in this manner would entail a bespoke result, compromising neither return
nor quality and allowing a investment management firm to make full use of its
intellectual capital.
As one moves forward with considering alternatives to fixed-income asset allocation it is
imperative to consider a prospective asset manager as a partner in crafting a
comprehensive investment policy. In an environment rife with economic uncertainty, an
ideal portfolio should be optimally positioned to take advantage of inefficiencies in the
market and can require providing a fund manager with the latitude to do so. When taken
in the aggregate, it should be apparent that diversification and specialization need not be
mutually exclusive terms and that the benefits of an actively managed portfolio,
administered by multiple investment firms, each with their own particular strengths, are
evident.
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