1. Fixed Income Management Evolution or Revolution
Fixed Income Management Evolution or Revolution? June 2008 Susan Buckley, Managing Director, Active Management Division

2. Discussion Agenda The Traditional Approach to Fixed Interest
Evolution or Revolution? – The separation of Alpha and Beta
Accessing Fixed Interest Beta Risk and Return
Meaningful Fixed Interest Alpha

3. The Heritage of Fixed Interest…..
Traditional Approach was based on the concept of Strategic Asset Allocation (SAA)
Fixed Income was mainly used as a risk reduction allocation within diversified portfolios
Active returns were low, and the weighted contribution of the assets to the total portfolio return was negligible.
Downweighting of the asset class, within portfolios, in order to search for alternatives that added more meaningful return.
This encouraged fixed interest managers to evolve and remain meaningful.

4. Traditional Fixed Interest Management
Fixed income portfolios were historically managed relative to a specific benchmark. Eg. UBS Composite Bond Index, Lehman’s Global Aggregate
BUT, these benchmarks embody a number of complex issues.
The 2 major inefficiencies relate to:
Duration problem – duration of benchmark comes from issuer preferences and is not necessarily duration that a given investor should hold.
“Bums” problem – the biggest debtors have the largest weight in the benchmark.
The recent growth in size of the credit market has also caused a number of issues.

5. Bond returns have disappointed Australian Investors…..
Fixed Interest market (beta) returns have disappointed in recent years
Australian Fixed Interest underperforming cash returns

6. Weaknesses of the Traditional Approach
Pre-occupation with benchmarks and a reluctance to hold significant allocations to assets which fall outside the benchmark.
Strategic asset allocations tend to be static for long periods, even in the face of significant changes in market valuations.
Active mandates are allocated in accordance with SAA weights – possibility of insignificant contributions.
Active managers tend to be analysed by investors on an unweighted basis

7. Evolution or Revolution? – The Separation of Alpha and Beta
Fixed Income portfolios can provide significantly different risk and return outcomes, depending on composition and construction.
Beta Policy
Developed to provide market return stream from risk premia
Allocations include sector exposures, country allocations, credit limits, inflation exposure and overall duration.
Structure of Beta portfolio should reflect investment objective and risk preference of client
Alpha Policy
Aimed at construction of absolute return portfolio that provides:
Diversification (multiple alpha sources)
Consistent return stream
Outcome not tied to changes in Beta portfolio

8. Accessing Fixed Interest Beta Risk and Return
Sources of Fixed Interest asset return are driven by four fundamental factors:
Real Interest rate risk - Credit Risk
Inflation uncertainty - Illiquidity Risk
Exposure of traditional beta sources to conceptual risk premiums:
Some asset classes are more effective in accessing risk premia

9. Methods of Beta Replication
Physical Index Replication
Full replication is the lowest risk - but is highly complex.
For example Lehman Global Aggregate Portfolio contains over 12,000 issues
Enhanced indexing – investing in large sample of bonds such that portfolio risk factors match index risk factors
Synthetic Beta Replication
Shown to be effective – achieved by utilising market inovations
Instruments used include:
Bond Futures
Interest Rate Futures
Interest Rate Swaps
Mortgage Futures
Credit Default Swaps / Indexes

10. Achieving Meaningful Alpha
Reasons why fixed income alpha can be meaningful
Improved diversification of alpha sources with switch to absolute return from fixed interest benchmarks
Flexibility to adjust underlying betas without disrupting alpha sources
Low correlation to Beta
Greater capital capacity with use of derivatives and overlays
Alpha becomes more scaleable

11. Breadth – Improving the Opportunity Set
Fixed interest provides a BROAD opportunity set
Global
Access to the entire capital structure
Access to the entire risk curve

12. What Does Diversified Fixed Interest Alpha Look Like?

13. Scaleable – Largest Global Markets - Currency and Fixed Interest
Fixed interest provides SCALEABILITY due to its broad opportunity set
Availability of fixed interest derivatives markets
Highly liquid
Economies of scale
QIC is using less than 2.0% of capital to generate 25bpts of fixed interest alpha over $50bn ie. $125m pa target
Achieved via derivatives for strategy implementation and beta hedging

14. Sourcing Alpha from Breadth of Opportunity Set

15. Uncorrelated to Other Sources of Return
Fixed interest alpha can provide UNCORRELATED returns
The fixed interest alpha used in measuring correlation is taken from QIC Global Fixed Interest overlays and the GFI Alpha Fund. The correlations are based on over four years of data.

16. What’s So Good About Low Correlation?
The fixed interest alpha used in measuring correlation is taken from QIC Global Fixed Interest overlays and the GFI Alpha Fund. The correlations are based on over four years of data.

17. Achieving Meaningful Alpha Returns
To access fixed interest alpha successfully requires:
Global capability
Flexible mandates that allow derivatives
Strong risk systems and governance
Robust investment process
Absolute return focus

18. Derivatives and Risk Control
Global derivative capabilities requires:
Experienced fixed interest staff
Wide selection of counterparty contacts and ISDA agreements
Global coverage across the major financial centre (London, New York, Tokyo, Hong Kong & Sydney).
Risk Control:
Understanding the risk factors attached to the derivative instruments
This is particularly important for new instruments such as credit derivatives and inflation swaps
Stress testing, VAR analysis is crucial

19. Packaging Fixed Interest to be More Meaningful – Going Forward
Explicit focus on Client’s total portfolio objectives
Think about risk and adding value at fund level
Get away from irrational capitalisation weighted debt indices
Target fixed interest betas that meet client objectives
Make fixed interest alpha meaningful
Improve capital efficiency
What is the key theme?
If you have skill alpha is alpha and fixed interest alpha can present some great opportunities for investors.
It is a fast moving market with rapid developments in high yield, structured credit and the availability of market, index, single name derivatives is improving exponentially.

20. Separating Fixed Income Beta and Alpha for Improved Client Outcomes…
To achieve clients’ overall objectives