Absolute Return Fixed Income: Taking A Different Approach

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Cleopatra Quinn
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1 August 2015 Absolute Return Fixed Income: Taking A Different Approach Executive Summary Historically low global fixed income yield levels present a conundrum for today s fixed income investors. Increasing income through longer duration or increased credit exposure now comes with minimal downside protection from the absolute yield. With the Fed facing a possible tightening, they are now avoiding the risk of higher income from extending duration. Having heavily exploited the credit spectrum, with its rising liquidity concerns, assuming more credit risk has also become less attractive. As a result, institutional and individual investors alike are actively seeking new strategies that manage these combined risks going forward. Dix Hills Partners offer investors a time tested approach that seeks to manage both of these risks. Our strategy seeks to avoid the traditional fixed income strategy s long only interest rate bias, taking a decidedly shorter term horizon over which to consider the direction of interest rates. To generate our excess return, we assess whether interest rates are likely to rise or fall during this period, and take the corresponding long or short duration exposure, calibrated by our conviction. Credit and liquidity concerns are mitigated through the use of exchange traded futures in the four most liquid global sovereign debt markets (10 yr. note futures in US, Japan, Germany and United Kingdom). The resulting strategy provides the investor the potential for excess return, imbedding interest rate exposure management and credit mitigation in one strategy. As a true liquid alternatives strategy, the alpha is also easily included as part of a mutual fund vehicle. Our 12 year track record of uncorrelated excess return stands as a validation of the opportunity and our investment process. And while past performance is no guarantee of future results, we believe our actual experience offer investors insight into its potential for the sustainability of returns. We would argue those investors seeking such new approaches should seriously consider the merits of including Dix Hills Partners as one of the multiple strategies within their fixed income strategy portfolio. Managing Interest Rate Risk: Taking a Different Approach As the market anticipates the Federal Reserve s timing in raising short term interest rates, many investors and market participants assume that long term rates will in fact rise in tandem. While a continued tightening cycle would likely bring higher long term rates, such a result does not necessarily have to occur immediately. In fact, the anticipation of higher rates can build in

expectations that, in fact, may not occur over the short term. Looking at the last Fed tightening cycle (on the chart below) demonstrates this phenomenon.

2 expectations that, in fact, may not occur over the short term. Looking at the last Fed tightening cycle (on the chart below) demonstrates this phenomenon. Even during the entire period of the last episode of Fed tightening shown below, long term interest rates were declining over 50% of the time on a monthly basis, suggesting the market s tendency to overshoot in both directions. Yields During Last Federal Reserve Tightening In fact, much of the move to higher yields took place prior to the actual Fed tightening in mid 2004, with yields actually declining or stabilizing for almost two years before achieving new highs in mid This short term volatility creates pricing opportunities for Dix Hills Partners, enabling us to take advantage of short term mis pricings that arise. Many of these opportunities may be missed by those investors or managers with a longer term horizon, leaving us able to capture these short term inefficiencies as excess return, or alpha for our investors. Five Decades of Interest Rate Movements: Making the Case for Flexibility In fact, when we analyze over 50 years of yield on the 10 year US Treasury note, shown below, we see a similar pattern of short term volatility. While interest rates had been declining for over 30 years, the distribution of rate changes on a month to month basis is much more balanced 2

3 (50/50). This demonstrates how a flexible and opportunistic trading approach to extracting alpha (excess return) from the fixed income markets can be both successful and sustainable. 10 Yr. Treasury Note Yield (%) Example: Monthly Tactical Analysis of US market. 10 year Constant Maturity US Treasury yields based on yields published in Federal Reserve Statistical Release H.15. At Dix Hills Partners, we see this as an opportunity to take advantage of these shorter term trading opportunities in either direction, seeking to capture them in the form of an alpha stream. We assess these opportunities through an integrated approach answering three questions with the associated factors used to gauge the answers: Question What Should the Market Do? What Can the Market Do? What Does the Market Want to Do? Factors Macroeconomics Valuation Momentum While we would argue that the global sovereign debt markets are efficient, we believe there are short term pricing inefficiencies that can be prudently exploited for the benefit of investors. While past performance is no guarantee of future results, our research suggests, and we believe our track record has demonstrated, that these opportunities may offer an attractive return for the associated risk. At Dix Hills Partners, our expertise is in opportunistically capturing these short term opportunities and transforming them into an alpha stream with several attractive attributes for investors, large or small. Among these attributes is the lack of correlation to both traditional 3

and alternative benchmarks, including those based in fixed income. This uncorrelated alpha may improve portfolio diversification, with the possibility of improved return with reduced overall risk.

4 and alternative benchmarks, including those based in fixed income. This uncorrelated alpha may improve portfolio diversification, with the possibility of improved return with reduced overall risk. A Short-Term Investment Horizon: Additional Advantages Looking at the world in these monthly intervals offers us several advantages. First, similar to the Federal Reserve, we are data dependent, approaching the decision to be long or short interest rate exposure multiple times during a calendar year. This offers us the opportunity to be flexible to changes in the economic environment. Our systematic process is designed to immediately respond to new, relevant economic information, anticipating that the rest of the market s decision making may be somewhat lagged, and therefore offering us an advantage. Our flexible non directional approach, going either long or short, enables us to reduce the one sided bias to interest rate exposure associated with long only fixed income strategies. Second, and just as important, a short term horizon may significantly increase the opportunity set for generating excess return from interest rate anticipation versus the more traditional longer term view. Using 2004 as an example, as can be seen in the chart below, where rates were virtually unchanged over the calendar year, yet yields moved an absolute cumulative 227 basis points measured month to month. Taking the shorter term view presented a much greater opportunity to generate excess return through correctly assessing monthly interest rate direction. MONTH TO MONTH CHANGE OF 10Y TREASURY YIELD (2004) Yr. US Treasury Yield Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec * Tactical Opportunity assumes full active duration adjustment each month. ** Cumulative average annual rolling basis points calculated based on data from 1988 through Duration Opportunity is calculated based on a 5 year duration exposure for both the period and the 2004 year rate changes. 227 basis points is the absolute movement in yield of the US 10 Year Treasury Note in basis points is the change in yield of the 10 year US Treasury note in

5 Using Futures Helps to Create a Cost-Effective, Liquid Alternative While Dix Hills Partners has always felt that liquidity was of paramount importance, it has only become a key concern to most investors since We have always preferred using exchangetraded futures to maintain high liquidity and low execution costs. We select only the largest global sovereign markets to avoid unwanted credit risk and facilitate maximum scalability. This makes our strategy suitable even for the largest investors. Finally, when creating long and short exposures as we do, the use of exchange traded futures helps to mitigate counterparty risk, helping to avoid single credit counterparty exposure. Disclosures: Past performance is no guarantee of future results. All information is provided for informational purposes only and should not be deemed as a recommendation to buy any investments mentioned. The content of this document should not be construed as, and is not, legal, tax, or financial advice, nor shall it constitute an offer to sell or the solicitation of an offer to invest in programs managed by Dix Hills Partners, LLC in any jurisdiction. Dix Hills Partners, LLC 425 N. Broadway #458 Jericho, New York

Beginning Date: January 2016 End Date: June Managers in Zephyr: Benchmark: Morningstar Short-Term Bond

Beginning Date: January 2016 End Date: June 2018 Managers in Zephyr: Benchmark: Manager Performance January 2016 - June 2018 (Single Computation) 11200 11000 10800 10600 10400 10200 10000 9800 Dec 2015