Constraints are often good to have. It’s best to constrain your workday to within reasonable bounds and to constrain your child to eating only half their loot on Halloween night. Investors need constraints, too. Asset allocation, for example, is built entirely around constraints: You are constraining the amount of stocks and bonds you own to within certain thresholds so that you don’t end up taking on too much or too little risk. And you definitely want constraints on your fund managers, otherwise they could invest in anything, which would be bad. Wouldn’t it?
Practitioners of unconstrained investing, which does not hold fund or portfolio managers to a specific benchmark, geography or sector, would tell you otherwise. When you constrain managers, you essentially handicap your portfolio potential by limiting the manager’s ability to make tactical adjustments.
To learn more about unconstrained investing and why it makes sense in today’s environment, we spoke with Rick Rieder, chief investment officer of Global Fixed Income at BlackRock and portfolio manager of the BlackRock Strategic Income Opportunities Fund (ticker: BSIIX), a five-star unconstrained fund recently featured on U.S. News & World Report’s “8 Great Fixed-Income Funds to Buy Now.” Here are edited excerpts from that interview:
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What are the advantages of unconstrained investing?
Unconstrained investing sounds like higher-risk investing since it isn’t bounded by, or benchmarked to, any specific index. That is simply not the case, and therein lies the beauty of being unconstrained. Environmental conditions and investment regimes can change radically throughout the economic cycle these days, which can occur over weeks, months or years. Over those time periods, however, the investment opportunities available and the sets of risks can be incredibly different.
Consider the past three to four years when Federal Reserve policy went from tight conditions in 2018 to easier conditions in 2019, and then both monetary and fiscal policy had to ride to the rescue during the start of the COVID crisis in 2020. Ultimately, the Fed maintained quantitative easing policy for too long in 2021, and then started to radically tighten in 2022. Interest rates and risk assets moved in wildly different manners during these periods, allowing an unconstrained approach to pivot aggressively from a standard benchmark and to not just outperform from a return perspective, but to actually take on dramatically lower levels of risk, in contrast to what many believe “unconstrained” may suggest. In fact, unconstrained can very often be termed as unconstrained active management to avoid excessive market-driven risk.
Unconstrained active management also allows the manager to avoid those assets in an index that are almost definitionally overpriced due to inclusion in an index of fixed income assets; as with capitalization-weighted indices, the greater the debt an entity takes on, the more exposure one would have to it in an index. Further, and almost more importantly, many of the assets that are not in the index, or included in minor size in some indexes, should be owned, or overweighted, due to their relative attractiveness at any point in time.
Advisors are looking for portfolio managers that can maintain flexibility in their approach, while mitigating risk, to create long-term wealth for their clients. Being unconstrained in our approach provides us that flexibility to adapt assertively to changing economic or market regimes, act upon idiosyncratic relative value opportunities and avoid large concentrations of unwanted risk. We often say that risk-aware active management in this way can make a little money a lot of times versus being tethered to any one benchmark-driven risk, in order to create higher returns with more stable levels of volatility throughout most, if not all, periods or market cycles.
[READ: Q&A: Diversification and Portfolio Risk Mitigation.]
Why does an unconstrained investment approach to fixed income make sense in today’s environment?
Advisors and their clients today are facing an investing landscape that has a higher level of uncertainty, coupled with dramatically changing environmental conditions, than virtually any other period before. Inflation is excessively high, and in some ways structurally so, due to an unexpected war’s influence on major price-shock drivers, such as energy and food. Additionally, the influence of deglobalization alongside this, which we haven’t seen in generations, married to the unaffordability of housing driving up shelter prices and demographic and economic conditions, have all led to historically low unemployment and persistently high wages.
That is making inflation very difficult to bring down, and central banks are trying to fight a historically challenging inflation condition while simultaneously trying not to devastate growth alongside it. Advisors are looking for portfolio managers that can maintain a steady hand in the management of risks, and particularly interest rate risk, in this type of environment. Changing risk-tolerance and liquidity conditions are providing opportunities and risk-mitigation dynamics that require attentive and dynamic portfolio response on a nearly continual basis.
Where are you seeing opportunity today in fixed-income markets?
My how the world has changed here! Short-term interest rates were close to zero merely a few short months ago. Now, they’re greater than 4.1%, with inflationary expectations well below that. This means that today one can buy high-quality assets, such as U.S. Treasuries, corporate credit and well-collateralized secured assets off one of the highest front-end interest rates in a decade or so. Thus, you can get great yield today and take extremely low levels of interest rate, credit or structure risk. This means you can run a much less risky portfolio than would have been possible over the past few years, with a much lower inherent volatility to it, making it a unique point in time for fixed income investors, the likes of which we haven’t seen for years.
We also think layering in some credit risk today makes sense, due to recent risk pressure that provides for more attractive yields in the context of low expected default rates for companies over an extended period of time, while nominal GDP and corporate revenues stay at comfortable levels and should remain there despite anticipated softening. Yet, many credit assets are giving you plenty of buffer at these levels to absorb this type of slowdown.
How are you positioning your BlackRock Strategic Income Opportunities Fund?
Alongside those points we discussed previously, we have shifted a good deal of our positioning from lower-rated securitized assets, which served us well over the past few years, and some of our longer-dated duration, to shorter-term rate expressions given their high-quality nature, attractive risk-adjusted return, and downside break-evens. Simultaneously, we hold some modest levels of U.S. high-yield bonds and are long investment-grade credit risk at the front end of the yield curve, while reducing some European credit risk and staying longer dollar assets in an environment of greater certainty in the U.S. than in regions such as Europe and China for the next few months. Finally, our securitized asset holdings tend to be focused on high-quality segments of that market, and given that we’re cautious about the negative impact higher interest rates can have on the residential and commercial real estate markets, are centered on very high quality — AAA rated — parts of the financing market.
Where would the BlackRock Strategic Income Opportunities Fund fit into client portfolios?
The fund is delivering a very nice yield today relative to traditional fixed income benchmarks, while not holding nearly as much interest rate risk. The Fund has some hedges and opportunistic higher-yielding assets barbelled with shorter-duration high-quality assets. That combination should create a nice income stream for clients with a presumably stable nature to it, while not being subject to major moves in longer-dated interest rates, which would in this environment hurt risk assets such as equities. Hence, BSIIX can be a great income supplement, with a lower volatility to it and a lower correlation to pure interest rate movements and/or equity, or alternatives risk, held in client portfolios today.
In the current market and monetary policy climate, the ability for an investment manager to actively adjust duration exposure is extremely attractive, but equally important is the ability to support an investor’s yield and total return targets and preserve their principal as well. There is so much uncertainty in markets today that perhaps an investor’s goal of capital appreciation needs to be balanced with that of capital preservation, at least until more data provides better clarity on the direction of inflation, policy, growth and risk markets. Adding BSIIX to a traditional fixed income portfolio could help advisors support both their goals of generating return and mitigating volatility.
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Q&A: Why You Need to be Unconstrained in Investing originally appeared on usnews.com
