Benefits of Sovereign's Active Asset Management

Sovereign believes that actively managed bond portfolios, particularly over the longer-term, should provide pre-tax and after-tax returns in excess of passively managed portfolios, such as laddered maturities and market index funds.

Sovereign’s approach is a prudent, active management approach which overlays our longer-term views with a disciplined and consistent process for the evaluation of value-added opportunities.  Our value-added strategies consist of numerous, incremental departures from the market. However, given their incremental nature, the risk profiles of our portfolios are only marginally different from the corresponding market.

Sovereign has identified  three key factors which suggest that actively managed portfolios are likely to produce greater returns relative to  passive strategies, with only modest differentials in the portfolio’s overall risk profile relative to the market:

• Market Inefficiencies:  Inefficiencies in the bond market provide opportunities to generate returns in excess of passive portfolios.  These inefficiencies result in opportunities for active managers to capture certain attractive premiums in the market: maturity premiums, liquidity premiums, and credit premiums.

• Diversity and Depth of Strategies:  Active managers, with dedicated resources and expertise across various sectors of the market, are able to identify incremental and diverse sources of added value.  These strategies include sector rotation, controlled duration management, credit research and tactical trading opportunities.  Over time, these incremental strategies and opportunities  should enhance returns on a consistent basis, without significantly altering risk profiles.

• Passive Limitations:  Passive strategies sacrifice returns given general restrictions on permissible maturities, securities and sectors in which they can invest.  Active managers seek value across all maturities, as they search diligently for those new and alternative security types and sectors which can add significant incremental return.

Inefficiencies  = Opportunities for Capturing Market Premiums
The fixed income market includes a wide variety of  sectors and securities from which to choose: US Treasury, Federal Agency, investment-grade and high-yield corporate issues, emerging markets, mortgage-backed securities, asset-backed securities, preferred stocks, and the list goes on.  The degree of inefficiency, whether structural or tactical, varies from sector to sector as well as from security to security, resulting in each with unique risk and reward characteristics.  Active managers, with ready access to the full spectrum of fixed-income alternatives, have a much broader opportunity set and therefore a greater opportunity to exploit these inefficiencies and to add value over passive strategies.

Within the bond market, Sovereign has identified three specific structural aspects, which consistently provide active managers the opportunity to generate incremental returns over those of passively managed portfolios.

Maturity Premiums
The front-end of the yield curve (defined as maturities ranging from three months to three years) provides a number of opportunities to capture structural maturity  premiums.  This is a result of  its generally upward sloping configuration and the excess yield provided by the longer maturities, i.e., three-year securities yield more than two-year securities, which in turn, yield more than one-year securities, and so on.  Under normal market conditions, the excess yield provided by these longer-dated securities amply compensates investors for extending maturities slightly beyond the three-to-six month range.  Empirical evidence and market returns clearly demonstrate that those portfolios, which slightly extend maturities at the front-end of the yield curve, particularly a systematic reduction in cash holdings, have historically generated higher returns, without materially increasing risk.

Liquidity Premiums
Passive strategies, particularly those seeking to mirror the return of a specified index, often purchase only the largest, most actively traded and liquid securities.  By limiting themselves to these “benchmark issues”, they are forced to pay a premium (higher price and lower yield) for high levels of liquidity that are often unnecessary.  Active managers, however, have the discretion to invest a portion of their portfolio in securities which may have slightly less liquidity but which earn higher yields relative to liquid, benchmark issues.  Capturing these attractive yield premiums (or liquidity premiums) results in a portfolio with higher average yields relative to passive portfolios.  Over time, this incremental yield advantage will translate into higher returns, without materially increasing risk. 

Credit Premiums
Passively managed portfolios generally limit themselves to only the highest-rated credits.  For example, most will not buy issues rated at the lower end of the investment-grade rating scales, resulting in an unnecessary loss of yield and potential return.  As an active manager, Sovereign does invest a portion of the portfolio in such securities when we believe sufficient compensation (an attractive credit premium) is provided for taking the additional credit risk.  Our portfolio management and trading staff couple in-house analysis with unbiased and independent credit research to identify attractive credits with sufficient yield premiums.  The application of this strategy is focused in the short-to-intermediate maturity sectors.  Portfolios, therefore, assume only a modestly higher credit risk profile, which is further diversified by limiting exposures to any particular sector or credit.  Investors are well rewarded for implementing this strategy on a consistent basis. 

 

Diversity, Depth, Discipline  = The Sovereign Advantage              
While these active management strategies provide unique opportunities to earn excess returns, reduce risk and improve portfolio diversification, not all fixed-income managers are equally capable of exploiting the potential benefits.  The following characteristics distinguish Sovereign as an effective fixed-income manager:

Breadth and Depth of Scope

Many market inefficiencies are subtle and transitory in nature.  Those firms which are most likely to produce attractive excess returns are ones in which the managers have a broad, multi-sector approach, coupled with the flexibility to rotate across market segments in order to exploit anomalies as they arise.

Sovereign, with dedicated resources and expertise across various sectors of the market, can easily identify numerous incremental and diverse sources of added value.  These strategies include sector rotation, controlled duration management, credit research and tactical trading opportunities. Over time, these incremental strategies and opportunities should enhance returns on a consistent basis, without significantly altering risk profiles.

Sovereign’s expertise in the fixed-income markets allows us to systematically evaluate competing investment opportunities identified by our managers and traders.  Sovereign then efficiently shifts portfolio exposures across sectors in order to capture these opportunities.  By contrast, firms with fewer resources and which are more narrow in their approach are at a disadvantage, given the more limited range of opportunities from which they can choose.

Investment Philosophy, Process and Execution

Another key aspect of an effective manager is a disciplined and broad approach to the identification and execution of value-added strategies.  Sovereign’s general approach is strategic in nature, focusing on a long-term, top-down view of market trends.  These top-down views are coupled with our bottom-up analysis regarding sectors, credits and security structures.  Together, these investment decisions are determined within a consistent and disciplined process focusing on the analysis of fundamentals and momentum, with a particular emphasis on valuations.  Next, we leverage the experience and negotiating powers of our traders with our market presence to ensure our strategies are implemented in a consistent, disciplined and cost-effective manner.

Risk Management and Controls

Successful active management also requires the ability to systematically identify measure and actively manage the risk profile of each portfolio.  To this end, Sovereign applies both quantitative and qualitative methods.  Quantitative methods include multifactor risk analysis, scenario analysis and performance attribution.  Qualitative methods include the diversification of strategies, an emphasis on quality and liquidity both coupled with rigorous review procedures.  This disciplined system of qualitative and quantitative measures is not common, but Sovereign believes it is essential in order to ensure that risk profiles and realized returns are consistent with portfolio risk parameters and client expectations.

Limitations of Passive Strategies = Laddered Portfolios       
Laddered bond portfolios are a rather common, passive investment strategy in fixed income.  This strategy invests in equal amounts of bonds at staggered maturities.  Most investors assume such a strategy is inherently less risky than active strategies.  On the contrary, laddered portfolios have several limitations which introduce certain risks in the form of lost opportunities. 

First, laddered portfolios commit to interest rates and yield curve structures on the day the ladder is invested, with periodic rebalancing as bonds mature.  Although yield curves change frequently, a ladder does not adjust during periods of significant volatility and curve reshaping, thereby potentially missing opportunities to enhance returns.

Second, laddering results in a loss of yield and therefore potential return.  Laddered  structures are buy-and-hold strategies that usually invest in liquid, high-quality and lower-yielding securities such as U.S. Treasury bonds or AAA-rated insured municipal bonds.  Over time, this loss of yield compounds into potentially significant sacrificed returns. 

Third, ladders suffer from a general lack of sector and security diversification.  Typically, there are restrictions on the sector and type of securities allowed to be purchased.  Over time, the relative attractiveness of various sectors and securities change. Laddered portfolios are unable to take advantage of such opportunities, again sacrificing potential returns

Conclusion – Active Management Adds Value

Active managers can potentially generate greater excess returns and thus higher pre-tax and after-tax returns relative to passive strategies.  This is due to their ability to exploit opportunities not available to passively managed portfolios.

(1) Active managers exploit a number of inefficiencies in the market place in order to capture excess returns.  Inefficiencies in maturity structures, liquidity and credit selection create attractive market premiums which active managers can capture.

(2) Active managers apply a diverse number of strategies in an incremental fashion in order to capture excess returns, but without materially altering risk profiles.  These strategies include duration management, sector rotation, credit selection and tactical trading opportunities.

(3)  Active managers assist in the efficient application of tax-management strategies in order to enhance after-tax returns.  Generally, these strategies are developed in concert with a client’s financial planner or tax-consultant.