Fixed-income manager welcomes opportunities to pounce on good deals.
This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Throughout his career, Mark Egan has done things differently.
To begin with, Egan--the manager of Scout Core Plus Bond
In the early 1980s, after he graduated from Marquette University in Milwaukee, the industry was more heavily concentrated in New York than it is today. Egan heard about an investment course at the University of Wisconsin’s business school. Its graduates had good success breaking into the industry.
“At the time, that was kind of hard to do if you were from the Midwest,” he recalls. “Most people who thought about the investment industry had to go to an elite business school at Harvard or Yale or maybe Northwestern. Then you would try to get into Goldman Sachs or Credit Suisse, one of those firms.”
After getting his MBA from Wisconsin, Egan did a stint with registered investment advisor National Investment Services in Milwaukee. Before that, he was an accountant with Arthur Young & Co. (now Ernst & Young). He received his CPA in 1982 and his CFA charter in 1989.
Then, in 1990, a headhunter contacted him about a position with Reams Asset Management--a small, unique fixed-income shop south of Indianapolis.
Egan recalls his first impression of Reams as “a strange and unusual little firm in Columbus, Ind., that had a good track record and did some unusual things in fixed income.” He was leery about a move to southern Indiana, but was intrigued by Reams’ approach to fixed income. The firm, headed by Robert Crider, was an early arrival to the high-yield market. Reams was also investing in currencies and long-duration bonds at a time when few others were.
“It was ‘core-plus’ investing back when nobody knew what to call it,” Egan says. In addition to a core of investment-grade bonds, the strategy allows managers to use high-yield debt and other higher-risk instruments that could bring higher return.
This approach to fixed-income appealed to Egan’s desire to invest differently. Having come from a background of more traditional fixed-income investments, such as Treasuries and investment-grade corporate bonds, he welcomed the chance to try something new. He began managing Reams’ Frontegra Core Plus Fund at its inception in 1996. Kansas City-based Scout Investments acquired Reams in 2010 and renamed the fund Scout Core Plus Bond.
Morningstar fixed-income analyst Miriam Sjoblom, who covers the fund, says that with around $544 million in assets under management, the offering is small enough to allow fast moves in response to market volatility.
“When the market gets volatile, they use that as a signal to take on more risk. When risky sectors are selling off, they tend to make pretty sizeable moves quickly, which I think is a pretty unique approach. They’ve been really good at timing those moves generally,” Sjoblom says.
Egan welcomes volatility because of the opportunities it presents. “Volatility is a great thing. People should embrace it and hope for it. We hope for it every day, and we’ve used it to our success over long periods of time,” he says. “Volatility, especially in this low-rate environment, is one of the only friends you are going to have. It’s going to give you the opportunity to buy a lot more Bank of America 10-years like you could a year ago at 8%, instead of today at 3%.”
Core Plus Bond has a 10-year annualized return of 8.74%, and a five-year annualized return of 10.23%. The fund got smacked hard in 2008, which Sjoblom attributes to a move into corporates and commercial mortgages ahead of the Lehman Brothers collapse in September of that year.
Sjoblom adds that the fund rebounded in 2009 and has been in an uptrend since then.
Egan acknowledges that the fund’s approach toward volatility--accepting more of it to gain higher returns going forward--can result in short-term declines.
"Our approach is a bit different from others, and that sometimes gets us into trouble over the volatility. In 2008, we underperformed the market, but we told people at the time that they would look back on that period of time and early 2009 as an opportunity lost if they didn’t take advantage of it,” he says.
While plenty of pundits and portfolio managers have become skittish about fixed income, Egan believes their fears are misplaced.
“There’s always a place for bonds in people’s portfolios, and we understand that and we would hope to garner our fair share of that,” he says. But he adds that investors will need to become more selective in how they incorporate debt instruments into portfolios.
Two New Funds
Toward that end, Reams opened Scout Low Duration Bond
Low Duration Fund, which is less volatile than a longer-term bond fund, is intended for use in capital-preservation strategies. Egan expects the fund to return about 1% to 2%, a higher yield than money market funds.
“We think investors will gravitate toward a lower duration profile, knowing they will give up tens of basis points, to what they might get in a longer portfolio,” Egan says. “But should rates rise ultimately, as people expect they will one day, you’ll make that back.
So we think low duration will be an area of increasing interest.”
Scout Unconstrained Bond, as the name suggests, seeks value throughout the fixed-income market. Explaining the fund’s approach, Egan quips, “There’s nothing wrong with bonds per se, except the possibility of negative returns should interest rates rise. But in an unconstrained mandate, the only thing that’s different is you don’t have the artificial construct of the [Barclays Capital] Aggregate Bond Index; about 80% of that index is Treasuries, agencies, and agency mortgage-backed securities, with significantly long durations, so significantly negative return profiles should interest rates increase.”
The fund’s unconstrained mandate allows it to take advantage of corporates, high-yield bonds, currencies, and emerging markets and other foreign securities. In other words, there is ample room to find compelling returns as interest rates rise, Egan says.
“The returns there could be significantly larger than in an aggregate-based mandate; I think the downside protection, because of our ability to hedge out positive duration with respect to changing Treasury interest rates, is pretty significant,” he says.
Egan also manages Scout Core Bond
The selection process within the funds is carried out by Reams investment committee, which consists of Egan, Crider, and managing director Thomas Fink. Egan says that the investment process begins with the need to avoid permanent impairment in any of the funds.
“Our record’s not perfect, of course, nobody’s is, but over time, the one thing we are most proud of is that we’ve had very few instances where we got into trouble and lost principal for our investors,” he says.
Despite the drawdown in 2007 and 2008, the Scout fixed-income funds had no exposure to subprime. “It wasn’t because we were so good at seeing the problems that would transpire in the housing market, but when we looked at subprime, those kinds of assets to us just didn’t pass the first test. The possibility of permanent impairment in those securities is always really large to us.”
He notes that the investment committee will often forgo current yield in the interest of greater downside protection. However, they don’t shy away from opportunities to be compensated for taking some risk, when it makes sense. That’s where the acceptance of volatility factors in.
“When you’re being massively compensated to take credit risk, liquidity risk, what have you, we’ll take volatility if we think the return is worth it. But we won’t take permanent impairment just to get a little extra yield,” Egan says.
Christopher Abbruzzese, chief investment officer at Rain Capital Management in Portland, Ore., uses the Scout Core Plus and Unconstrained Bond Funds in client portfolios.
“We like Scout, particularly the Unconstrained Fund, because we are able to use it in a part of a defensive portfolio that needs to be less sensitive to interest rates and credit spreads,” he says.
Like Morningstar’s Sjoblom, Abbruzzese praises the Scout managers’ nimbleness and agility when it comes to sidestepping interest-rate and credit risk. He also likes their ability to capitalize on volatility in the fixed-income markets. He says that boutique funds, such as those in the Scout family, are better than bigger funds at limiting what instruments they own.
Also in Oregon, Lantz Stringham of Hillsboro-based Chinook Capital Management uses the Scout Core Plus Fund in about half of the firm’s client portfolios.
“Within fixed income, we don’t have a separate allocation for high-yield bonds, so we’re basically allowing the managers of this fund the latitude to have some exposure to that area,” Stringham says.
Stringham said that the lengthy tenure of the Scout fixed-income team also plays a role in his firm’s decision to use the fund. In total, the investment committee members have logged 65 years with the firm and have even longer track records within the investment industry.
Sjoblom also says her confidence in the Scout fixed-income funds is partly due to the talent of Egan and his colleagues.
“Their strategy of making big sweeping moves in a portfolio is not something we would recommend for a less skilled manager,” she says. “It’s not an approach we recommend that everyone do.”
But she notes that as with any fund family, the Scout fixed-income offerings could face choppy waters ahead. “I don’t believe these guys will be insulated from a bond bear market, but they do have a strategy that might be a bit better for taking advantage of a low-return environment,” she says.
When it comes to managerial skill, Egan maintains that it’s most evident in the fixed-income, rather than equity universe.
“I think evidence will back me up on this, not just at this firm, but at other firms: In the fixed-income space, for a variety of reasons, you’ll find that good managers, unlike in the equity space, have a propensity to outperform significantly over time. So to just go passive, using indexes, ETFs, you are leaving a lot of return on the table,” he says.
That brings him back to a key tenet of his investment philosophy: The desire to take advantage of market volatility. “We are different because we are willing to accept some volatility. A lot of managers say they like it, but they really don’t.”
Egan believes investors need to understand that markets will be unsettled for the foreseeable future, due to a confluence of factors such as central bank actions and the European debt crisis.
“You need to anticipate and accept a little more volatility if you don’t want to experience catastrophic investment results over, say, a three- to five-year horizon,” he says.
Kate Stalter is a freelance financial journalist.