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Three Fixed-Income Alternatives With an International Flavor

Finding credit opportunities in less-tapped markets.

Mallory Horejs, 05/10/2012

It's no secret that the typical investor is probably overallocated to fixed income. Looking at flows over the past decade, investors have allocated record amounts to bond funds over the past few years (over $360 billion in 2009, $230 billion in 2010, and just over $120 billion last year). For comparison, investors have pulled money out of stock funds each of the past five years. These massive inflows may be subsiding, but it's clear many investors are faced with bond-heavy portfolios.

Fortunately, several long/short credit products are available for investors seeking to diversify this part of their portfolio, a small subset of which also invests internationally. This broader geographic focus not only provides additional diversification benefits, but also introduces new sources of alpha to the portfolio. Foreign credit markets, particularly those in emerging-markets countries, tend to be less efficient and therefore offer more mispricing opportunities and greater growth potential. Investing internationally also allows managers to profit from currency movements (depending on their currency-hedging decisions). For those seeking to give their bond portfolio a more worldly view, these three young offerings might be worth a look.

Driehaus International Credit Opportunities DRCIX
No stranger to nontraditional-bond strategies, Driehaus launched its third alternative mutual fund on March 1, 2012. The youngest of the bunch, this new fund invests in sovereign and corporate debt across both international developed and emerging markets. Manager Adam Weiner uses quantitative models to identify disparities or inefficiencies within these foreign credit markets and takes long and short positions accordingly.

This opportunistic, bottom-up fund has a broad mandate, and Weiner can employ any of the following trading strategies: capital structure arbitrage, convertible arbitrage, directional trading, event-driven, or pairs trading. He may also take views on currency and use foreign exchange trades to generate alpha. The fund strives to produce absolute returns within a 10% volatility limit and to maintain low correlation to traditional equity and credit indexes.

Weiner and his team have been ramping up the fund's portfolio over the past two months. Given the ongoing solvency problems in peripheral Europe and weak growth prospects of the region, they have taken net short positions in Italy and Spain. They do have a net long position in Portuguese credit, however, which they perceive to be trading at close to recovery value. Management also remains bullish on Russian and Venezuelan credits given its expectation that oil exporters will outperform.

Forward Global Credit Long/Short FGCVX
Subadvised by SW Asset Management LLC, this fund also seeks to capitalize on inefficiencies in the international bond market, particularly within the emerging-markets space. Portfolio manager David Hinman uses a combination of top-down and bottom-up fundamental analysis to construct his portfolio of corporate credits.

Macroeconomic themes help frame the fund's industry and country allocations, and then Hinman and comanager Ray Zucaro use qualitative and quantitative research to select individual issues. To hedge the fund's long positions, they may invest in options and credit default swaps. To reduce the risk of fluctuating exchange rates, the fund may also enter into forward foreign currency exchange contracts.

This fund may be young (launched in September 2011), but management certainly isn't new to the strategy. Hinman and Zucaro have run a long/short emerging- markets corporate-debt hedge fund, SW Global Credit Opportunity Fund LLC, since January 2010. Prior to that, the duo ran their flagship long/short global credit strategy at hedge fund firm Drake Management from 2006 to 2009. (The 34-month track record belongs to SW Asset Management.)

Columbia Absolute Return Emerging Markets Macro CMMAX 
Unlike the previous two offerings, 100% of this fund's portfolio is invested in emerging-markets countries. The fund is subadvised by London-based firm Threadneedle International, and Nicholas Pifer and Jim Carlen are responsible for its day-to-day management. Pifer and Carlen invest long and short in sovereign debt obligations, corporate credits, currencies, and interest rates of emerging-markets countries.

When constructing the portfolio, the duo relies on a combination of top-down fundamental research, economic policy, and political assessments, as well as quantitative and technical analysis. To execute their views, Pifer and Carlen take varying exposures through directional, relative value, or basket trades. As of February 2012, the fund's three largest country exposures were to Venezuela (12.4% of portfolio assets), Malaysia (12.1%), and Chile (8.9%).

Although manager ownership in this fund does not meet the industry's highest standards, these two portfolio managers are still more invested than those of the other two offerings. Pifer invests between $10,001 and $50,000 in the strategy, while Carlen invests under $100,000. Weiner, Himan, and Zucaro do not own any shares in the nontraditional-bond funds that they run.

Looking Abroad for Diversification
These three young funds all promise to enhance portfolio diversification while providing access to credit opportunities in less-tapped foreign markets. This comes at a high price, though: Driehaus International Credit Opportunities DRCIX, Forward Global Credit Long/Short FGCVX, and Columbia Absolute Return Emerging Markets Macro CMMAX charge prospectus net expense ratios of 2.00%, 2.99%, and 1.47%, respectively.

These fees are all well above the 1.40% nontraditional-bond category average, as well as the cost of most long-only fixed-income funds. Expenses may go down somewhat as assets in these young funds grow. (With only $5.2 million assets under management, Forward Global Credit Long/Short FGCVX, for example, is the smallest fund in the category by far.) But these niche credit strategies will always come with a higher price tag.

It's too early to judge whether these managers will generate the excess returns necessary to justify their hefty fees. However, it's safe to say that many of today's bond-heavy portfolios could benefit from the diversifying element these three strategies bring to the table.

Mallory Horejs is an alternative investments analyst with Morningstar.

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