Portfolio Manager Perspectives

Jeff Benjamin

Low volatility on a high-yield bond fund? Swaps are the secret sauce

CDSs have helped Iron Strategic Income Fund steel itself against market gyrations

Oct 26, 2012 @ 12:20 pm

Turning a high-yield-bond fund into a low-volatility total-return strategy is as easy as sprinkling in some credit default swaps.

Of course, that assumes the portfolio manager is sufficiently skilled in the application of the hedging strategy, which appears to be the case with the $490 million Iron Strategic Income Fund Ticker:(IRNIX).

In the most basic sense, credit default swaps — swaps in which a seller agrees to compensate a buyer in case of a loan default — act as insurance on the underlying portfolio to help limit losses. But, unlike some hedging strategies that might keep the insurance on all the time, portfolio manager Aaron Izenstark applies a dynamic strategy to create a net long exposure that will range up to 100%, depending on market conditions.

“We're looking for indicators that affect high-yield bonds, and our work involves coming in and varying the exposure over time,” he said. “We believe that the biggest driver of returns is adjusting the exposure to the market.”

Mr. Izenstark, who has managed the fund since it was launched in October 2006, is chief investment officer of Iron Financial LLC, a $1.6 billion asset management firm.

For the high-yield-bond exposure, Mr. Izenstark invests in mutual funds, exchange-traded funds and individual bonds to create a broadly diversified portfolio. The fine tuning comes with the use of the credit default swaps derivative instruments, which enable him to tweak the portfolio net market exposure.

The fund is currently 80% net long, which is a relatively bullish stance. That doesn't mean, however, that Mr. Izenstark is afraid to pull back when appropriate.

During the 2008 financial crisis, for example, he applied the derivatives to reduce the net long exposure to around 3%. “What we're trying to do is only own the insurance when it makes sense to own the insurance,” Mr. Izenstark said. “What you see in some alternative funds is that they look great when the market is down, but [because they keep the insurance in place] they don't do so well when the market is up.”

From inception through the end of September, about a month shy of six years, the fund generated an 8.3% annualized return, compares with 3.3% for the S&P 500 over the same period.

More notable, however, is that the fund's volatility over the period, as measured by standard deviation, was 6.7%. The volatility for the S&P 500 during that same time frame was 17.8%.

In 2008, when the fund was about 3% net long, its return declined by 8.3%, while the S&P 500 fell 37%. In 2009, when the market snapped back, the fund gained 35.5%, while the index gained 26.5%.

Since the start of the year, the fund has gained 7.2%, compared with 14.4% for the S&P 500 and 3.7% for the Barclays U.S. Aggregate Bond Index.

While Mr. Izenstark is a big believer in hedging for downside protection, he is adamantly opposed to the use of leverage to enhance performance on the upside. “I would never use leverage in this fund,” he said. “I find that leverage can mask a bad strategy.”

Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. For more information, please visit InvestmentNews.com/pmperspectives.

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