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Actively Managing Risk in Fixed Income

Jeremy Glaser

Note: This video is part of Morningstar's November 2014 Risk Management Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Laird Landmann. He is the co-director of fixed income at TCW. We'll talk about how he manages risks in his portfolio.

Laird, thanks for joining me today.

Laird Landmann: Thank you, Jeremy.

Glaser: So, we hear a lot about risks in fixed income these days, from credit risk to interest-rate risk. When you're managing your portfolio at that level, what kinds of risks are you really thinking about and how do you manage those risks?

Landmann: For us, it really all boils down to how we're going to do versus the benchmark at the end of the day. I know investors would love us to think about absolute return risk combined with tracking error risk. It's nearly impossible to have multiple objectives for your risk management in that form. So, we really focus on building a portfolio that can outperform the benchmark with a reasonable risk profile versus the benchmark.

So, we're focused on obviously our positions versus the benchmark, how diversified we are, and how risk is being priced in general in the marketplace at a given point in time. So, we think a little bit differently than, I think, hedge funds and lot of shorter-term investors. And to us, risk is most profound when prices are high and rising and correlations are low--that's when the models are disguising risk for you. And we believe that when prices are lower and there is opportunity in the market, you shouldn't be afraid of risk at that point.

We've been trained in this market that you're supposed to have a certain type of tracking error, and I think that too little tracking error is a bad thing. If you look through the Morningstar Intermediate Bond universe, you observe that managers with tracking errors of less than 150 basis points generally have provided no alpha for the fee that they are charging, whereas managers that are sort of in the 200 to 250 range seem to be in the sweet spot.

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Glaser: How, then, do you think about risk on the individual security level? Is it the same kinds of issues you're thinking of at the portfolio level or is it a slightly different calculation?

Landmann: You have to do both. It all has to add up to something that's understandable and relative to the benchmark at the portfolio level. But if you don't get the parsimonious risk measures correct on each and every security in the portfolio, you sort of end up with the old "garbage in, garbage out" problem.

So, I think you have to look quite carefully at the individual securities and how you are measuring risk in those securities, and then making sure that these securities fit the fundamental risk framework that you want to put into place. There are certain securities that our philosophy and process will just never allow us to put into portfolio. And obviously, a part of risk management is making sure that you adhere to that discipline.

Glaser: So, what kinds of risks, then, wouldn't you take? What kinds of securities would just not fit into your portfolio?

Landmann: I think that the first type is what we'd describe as a black box security--a security that you don't really have the ability to measure all the risk factors that would affect its pricing and understand how its price might evolve in different scenarios. So, you are taking a risk that you don't really understand, and our claim as an active manager is, of course, that we understand how these risks should be priced and that we're buying securities that are mispriced or underpriced for the risks that we're taking. Obviously, if you're buying a black box, you can't understand that.

I think the second type of risk is similar in that it's what I've describe as a binomial security. These are securities that, if an event occurs, they could pay off at zero very easily, and you're just speculating on the probability of that single event. Those are securities that we don't think fit the fixed-income risk management framework.

Glaser: How does your thinking about risk really impact your weightings of individual securities? If you see something that maybe is riskier, are you likely to underweight that some more? How does that play into the whole process?

Landmann: Well, risk always plays a role in position sizing. You have to fit the position sizing into acceptable levels of both systemic risk for the portfolio--that is your duration, your yield curve, your credit exposure overall--as well as the idiosyncratic risk profile. And I think it is important to understand that you need to vary this with the environment. If you're in an environment like today, where risk is very expensive and securities have very high prices associated with them, you should really seek out higher diversification in your portfolio. You should try to control your idiosyncratic risk because you're not being paid for it. And clearly, when the environment changes, you could have all sorts of shocks to the portfolio that you don't want to have.

Likewise, when you have periods like late 2008 or 2002, I think you want to be open to the idea of increasing the position sizes somewhat because you should have more conviction in that environment. So, we try to blend together the position sizing--that is the active management component--with the risk management component at TCW.

Glaser: Do you worry about any macroeconomic factors, things like geopolitical issues or other kinds of headlines? Does that play into your process at all?

Landmann: Well, I certainly think we all worry about them. I know I do personally. But in terms of our process, we really have always strived to basically make issue selection the forefront of what we do. And to do that, you have to put good risk control around the systemic risk factors, which are what are really impacted by those macroeconomic and those geopolitical factors that you referenced.

So, for us, it's very important that we keep the duration of the portfolio, the yield-curve positioning, the overall sector exposure well controlled, so that we're not worried, day to day, about where retail sales is going to come out, what's going to happen in Russia. Obviously, those can affect our longer-term positioning and thinking, but we want to make sure that the portfolio is better insulated than most of our peers in the universe versus those types of factors.

Glaser: Laird, I appreciate your thoughts on risk today.

Landmann: I've very much appreciated joining you, Jeremy. Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.