|Share Class||Class I||Class N|
|Min. Initial Investment||$500,000||$2,500|
|Availability*||S, A, F||SO, AN, FN|
|Managers||Christopher T. Vincent and Paul J. Sularz|
|*Certain restrictions apply. Please check with your broker/dealer for details.|
We recently spent six hours with Chris Vincent and Paul Sularz, co-portfolio managers of William Blair Bond, in their Chicago offices. The visit reinforced our confidence. The fund remains Recommended in the Intermediate-Term Bond category, reflecting our belief that the team can outperform the Bloomberg Barclays U.S. Aggregate Bond Index over a credit cycle.
After our time with the team, we went through an exercise of distilling their investment approach. We think this helps us solidify our understanding of their process, the crux of our thesis, and areas for deeper investigation.
The team has essentially devised a “divide-and-conquer” strategy around the notion that several smaller wins can lead to a bigger success. The process starts with the decision that the fund’s duration will approximate that of the benchmark—within 10%. At year-end 2016, fund duration was 5.45 years, slightly shorter than the index’s 5.81 years. To achieve that duration target, the team segments the benchmark into various duration buckets (e.g., less than one year, one to three years, three to five years, five to seven years, seven to 10 years, 10 to 15 years, and longer than 15 years), then attempts to outperform within each segment.
The team starts by assessing what they are up against (i.e., understanding the composition of the Aggregate Bond index within each duration bucket). From there they evaluate the tradeoff between their directional expectations for the credit cycle and interest rates, and their bottom-up, fundamental assessment of security-level risk and reward. Since interest-rate expectations, company fundamentals, relative-value assessments, etc., are moving targets, the team is continually re-evaluating their positioning. Typically, the portfolio’s exposures to the duration buckets approximate the benchmark’s, although investors can expect modest over- and underweights.
Using the longest-duration bucket (15 years and longer) as an example, the portfolio’s duration is neutral to the benchmark. The underlying composition is quite different though. The team believes interest rates will rise over time, so they have avoided the benchmark’s low-yielding, long-term, interest-rate sensitive Treasury exposure in favor of long-term investment-grade corporate bonds. At the security level, the team seeks industry-leading companies with a competitive advantage, multinational operations, consistent cash flows, and, importantly, strong management teams with a track record of making sound capital allocation decisions. Currently, the team owns higher-yielding, less rate-sensitive bonds such as Apple’s 2046 maturity yielding 4.65%, Microsoft’s 2055 maturity yielding 4.75%, and AT&T’s 2046 maturity yielding 4.75%.
The tradeoff in this long-duration example is that should there be a flight to quality, that segment of the portfolio would underperform the benchmark’s Treasury exposure. The team is willing to accept short-term volatility and underperformance in exchange for longer-term results that are consistent with their goal of outperforming the benchmark by 75–100 basis points, net of fees, annualized. Looking back at 2016, the fund underperformed the benchmark by 176 bps during the sharp market decline through the middle of February. During the remainder of the year, as corporate credit spreads narrowed, the fund outperformed, finishing 189 basis points ahead of the benchmark.
Agency mortgages account for a large allocation in the short- to intermediate-term buckets. When evaluating mortgage-backed securities (MBS), the team’s goal is to own specified mortgage pools they believe will outperform the mortgage-backed component of the Aggregate Bond index. The team invests in highly liquid TBA (to-be-announced) eligible pools with coupons that tend to yield 100 bps or more than the prevailing mortgage market rate, which is consistent with the team’s spread-based approach.
Currently, the fund is meaningfully underweight U.S. Treasury and agency securities, preferring exposure to TIPS, which the team typically uses as a hedge against unexpected inflation, and agency MBS. Exposure to both TIPS and agency MBS provided a boost to relative returns in 2016.
The portfolio is also overweight to credit sectors, favoring investment-grade industrials and financials, as well as select positions within emerging markets and high-yield. Emerging-market names meet the team’s “global leaders” requirements. They are multinationals, hold a market leadership position, and have superior management teams. High-yield holdings are, as expected, at the upper-end of the below-investment-grade ratings spectrum. The relatively higher yields offer a potential cushion against a rising-rate environment. (The portfolio can own up to 10% in high-yield securities.) Credit sector positioning also had a favorable effect on fund performance in 2016.
Our confidence in William Blair Bond rests on two dimensions. One is the team’s ability to outperform based on investment approach and skill. The second dimension is our ability to identify when our thesis is breaking down, due to the team’s execution of the process or because of firm- or team-related issues, among others. We have a high degree of confidence in both aspects. However, in this report, we focus on the team’s investment approach and why we think their framework will help the team win as well as simplify our task of identifying a breakdown.
The team’s portfolio construction process involves a number of self-imposed parameters we view as positive. One limits the number of corporate bonds to 100; the number typically ranges between 75 and 100. There will be investment environments during which the team finds credit unattractive, such as 2007–2008. The fund may hold fewer corporate bonds during those times. Constraining holdings to this relatively low number narrows the team’s focus, helping maintain their deep knowledge of each security, understand the associated risks, and determine whether they are being appropriately compensated for those risks. They own few enough securities that they can steer clear of complex and/or speculative investments. We like that the limit on holdings imposes forced displacement, requiring the team to continually determine the most attractive relative-value investments by comparing potential holdings to those in the portfolio. Theoretically, this process should result in a constant improvement of the portfolio’s risk/reward.
We believe their security-level analysis of both corporate and mortgage securities will drive the team’s longer-term outperformance. (They are not big users of derivatives, options, currencies, futures, etc.) It’s difficult for us to see this advantage eroding over time given the team’s intention to always run a relatively concentrated portfolio. While taking risks is unavoidable, the team consistently attempts to stack the deck in their favor via bottom-up credit selection within their areas of expertise.
Another parameter is issuer diversification, which provides a measure of risk control. At the issuer level, position size limits ensure one issuer or issue does not have a material impact on performance. Investment-grade credits have a 1% maximum overweight limit relative to the benchmark, while “riskier” issuers such as high-yield and emerging-market positions are limited to a 0.75% overweight. Actual position size is influenced by qualitative factors such as liquidity, credit rating, market cap, total issuance, issue size, and volatility assumptions.
A third parameter is the team’s emphasis on liquidity, which, in combination with limiting the number of names, dictates the strategy’s capacity. The team views ample liquidity as essential; they pay close attention to the size of the issuer, level of issuance, frequency of issuance, the other owners of the credit (e.g., mutual funds, exchange-traded funds, insurance companies, or managers facing outflows), and the bankers bringing the deal. The team looks to limit assets per position to $25 million. That is a level which they believe, based on experience, they can trade without substantial price deterioration, even in environments of limited liquidity. Assuming a maximum of 100 corporate credit positions, all of which are investment-grade and held at their maximum 1% weight, results in $2.5 billion in assets. Assuming credit comprises roughly one-half of the portfolio, on average, this results in a strategy capacity of $5 billion. We applaud the team for planning to limit assets to such a low level. Doing so should allow them to continue executing the process effectively. The team’s mortgage holdings are very liquid and could accommodate more assets. However, credit holdings dictate the portfolio’s overall capacity.
At the end of the day, the team’s strategy is somewhat straightforward in terms of how they attempt to beat the market. Our impression is the team knows what they are good at, what their goal is, and how to execute. The team has demonstrated consistency in philosophy as well as decision-making frameworks throughout the investment process, all geared toward the goal of outperforming the benchmark. Given the team’s portfolio construction parameters and clarity regarding the types of corporate and mortgage securities in which they invest, we are confident will we be able to quickly identify a deviation from their process.
We continue to view the fund as a true core bond holding and expect it to provide some ballast to a balanced portfolio should the stock market suffer a material decline. Moreover, we believe the fund will meet the team’s goal of outperforming the Bloomberg Barclays U.S. Aggregate Bond Index benchmark by 75–100 bps, annualized, over a three- to five-year period.
—Jack Chee and Alistair Savides, CFA
|Calendar Year Returns||Trailing Returns*|
|William Blair Bond||4.54%||-0.03%||5.35%||-1.28%||8.56%||7.62%||4.54%||3.26%||3.36%||5.03%|
|Vanguard Total Bond Market Index||2.50%||0.30%||5.76%||-2.26%||4.05%||7.56%||2.50%||2.83%||2.03%||4.12%|
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