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Global SovereignQ
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Overview
Since 1997, Western Asset’s Tokyo investment management team has sub-advised on what is now Japan's largest retail mutual fund with assets under management of $49.6 billion, as of June 30, 2009. Leveraging the same philosophy and proprietary, model-driven investment process, the Tokyo office has developed a new product for institutions, Global SovereignQ. The investment process is unique to the Tokyo investment management team and is a departure from the investment process used for Western Asset’s traditional fundamental value driven approach.
Product Summary
The Global SovereignQ strategy is a pure relative alpha strategy that aims to minimize explicit beta exposure and that implements long/short strategies through the use of derivatives.
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Tokyo Investment Management Team
Western Asset’s Global SovereignQ portfolios are managed by a team of investment professionals who have been working together for over 10 years. This Tokyo based team is led by Kazuto Doi, who is responsible for the day-to-day strategic oversight of the portfolio’s investments. Kazuto Doi is the Head of Asia Pacific Investment Management, overseeing Western Asset’s investment management teams in Tokyo, Singapore and Australia and reporting to Stephen Walsh, Western Asset's Chief Investment Officer.
Contact your Client Service Executive or
your local office for more information:

Western Asset Management Company Limited
10 Exchange Square
Primrose Street
London EC2A 2EN
Phone: +44 (0)20 7422 3000

Western Asset’s approach is to construct a diversified portfolio using all major global markets. The Firms seeks to add value primarily through country and currency allocation as well as duration positioning and yield curve positioning. Alpha sources are independent and rigorous analyses of market data are performed using proprietary quantitative models. Their output combines with qualitative insights of the portfolio management team to determine the relative value positions that seek to provide optimal risk/return characteristics. The information ratio of each strategy is less than one but, due to the independence and low correlation amongst the strategies, the portfolio as a whole has an information ratio greater than one.

The investment management team aims to thoroughly understand the ‘fair value’ of interest rates based upon the macro economies as well as to capture the ‘momentum’ of the fixed income markets as these are driven by changes in macro economic conditions and financial market environments.

The investment process for Global SovereignQ is comprised of the following components:
  1. Alpha/forecast generation process
       a. Currency Strategy
       b. Country Strategy
       c. Global Duration Strategy
       d. Yield Curve Strategy
  2. Risk budget process
  3. Model portfolio construction process
  4. Client portfolio construction process
  5. Risk management and monitoring process
Click a box to learn more about each strategic component.
     
The Global SovereignQ Currency Strategy rigorously analyzes, discusses, and monitors the following model factors:
  • Momentum: What is the short-term trend of the economy?
  • Economic strength: How strong is the country’s economy?
  • Potential GDP: What is the potential GDP of the country?
  • Carry consideration: What is the difference between the interest rates of each country?
  • Equity valuation: What is the valuation of the equity market?
Exchange rates are currency prices that reflect the differences of expected rate of return on local assets (i.e. interest rates, equities, real economy). Local assets’ intrinsic values are largely determined by economic fundamentals. Since currency markets are highly episodic, it is important to understand the current state of the global economy and the economic regime of each country.

The five factors above are analyzed by a model that gives the investment team information about the strength or weakness of a country’s currency and its relative attractiveness. An analysis of momentum, economic strength and potential GDP provides information about the direct investments in each country. Carry analysis provides information about the potential demand for each country’s currency. Higher carry normally results in higher demand. Equity analysis provides information about the potential cash flows into the currency market of each country. Strong equity returns in a particular country will likely lead to a stronger currency. Each factor provides information about the expected cash flow associated with each currency which aids in the valuation of the currency relative to other currencies.

Currency markets are highly inefficient since participants (e.g. central banks, corporations, tourists) in the markets do not necessarily buy and sell currency seeking to maximize returns. Western Asset believes that investors can exploit inefficiencies in currency markets with a well-considered model-driven investment discipline.

Western Asset believes there are two key success factors in alpha generation using the currency markets:

  1. Thoroughly understanding the current state of the global economic cycle and;
  2. Utilizing a model-driven investment discipline to analyze and monitor currency behavior and to guide investment management decisions.
When actively managing currencies, Western Asset also believes that a quantitative discipline is superior to a purely judgmental approach, as it is extremely challenging and complex to assess ‘true’ relative value. For example, bilateral currency rates are not only influenced by two countries, but also by other factors at work within each country.

Western Asset believes a quantitative discipline is paramount when actively managing currencies for the following reasons:

  • It provides the investment management team with a sensible framework within which to assess broad relative values (and not just currency pairs).
  • It enables the investment management team to focus on and adhere to a set of predetermined fundamental factors and, later, review the decisions objectively with a scientific and empirical attitude.
  • It enables the investment management team to seek diversification. Diversification is an important method of risk control, particularly in currency markets, since the risk structure is relatively unstable when compared to other asset classes.
For the Currency Allocation strategy as well as the other strategies described, Western Asset combines model results with the qualitative insights of the portfolio management team to determine the relative value positions that seek to provide optimal risk/return characteristics. This fundamental value overlay, or judgmental input, takes into account certain items that the models don’t adequately address, such as risk scenarios, market themes and the evolution of volatility and correlations.
The Global SovereignQ Country Allocation Strategy rigorously analyzes, discusses and monitors the following factors:

For the Momentum Model:

  • Business cycle: Where are we in the business cycle?
  • Term premium: What’s the difference between long and short term interest rates?
  • FX: Is the currency strengthening or weakening?
  • Reversal: Do we need to consider reversion to the mean relative to other countries?
For the Valuation Model:
  • Expected policy changes: What is the output gap or the gap between forward-looking GDP versus potential GDP? What is the inflation gap or the gap between forward-looking inflation versus target inflation?
  • Market implied policy changes: What is the market’s expectation for future policy rates?
  • The Valuation Model factor gives us information regarding the potential change in policy rates.
Similar to the Currency Strategy, each factor in the models that support the Country Allocation strategy provides us with information about the momentum and valuation of rates.
For the Global Duration Strategy within the portfolio, the following model factors are rigorously analyzed, discussed and monitored:

For the Momentum Model:

  • Commodity prices
  • Leading economic indicators
  • Bonds vs. Equities
For the Valuation Model:
  • Expected policy changes (output and inflation gaps)
  • Market implied policy changes
For the Yield Curve Strategy within the portfolio, the following model factors are rigorously analyzed, discussed and monitored:

For the Momentum Model:

  • Business cycle
  • Market volatility
  • Inflationary environments
  • Yield volatility
For the Valuation Model:
  • Expected policy changes (output and inflation gaps)
  • Market implied policy changes
Taking into consideration the client’s risk/return profile, guidelines and selected benchmark, a risk budgeting process is applied to ensure the risk in each of the strategies is acceptable. The risk budget ranges for each of the strategies discussed above are as follows:
  • Currency Allocation Strategy: 0% to 90%
  • Country Allocation Strategy: 0% to 70%
  • Global Duration Strategy: 0% to 20%
  • Yield Curve Strategy: 0% to 20%
Alpha Strategy Target Risk Target Tracking Error Target Excess Return
Currency Allocation 45% 1.3% 1.0%
Country Allocation 35% 1.2% 0.7%
Global Duration 10% 0.6% 0.2%
Yield Curve 10% 0.6% 0.2%
Total 100% 2.0% 2.1%
- Target Risk is the targeted risk budget allocated to each strategy.
- Target Tracking Error is the risk (as measured by standard deviation) targeted for each strategy.
- Target Excess Return is the targeted excess return or alpha for each strategy.

Each strategy is allocated a risk budget and theoretically generates returns consistent with the risk allocated. Strategies that are allocated relatively higher risk budgets should theoretically contribute corresponding levels of excess return. For example, as presented above, 80% of the overall excess return for this product should be derived from the Currency and Country Allocation Strategies consistent with the target risk allocated to these strategies.

Allocations are subject to change without notice.

Q:  What is the investment philosophy for the Global SovereignQ strategy?
A:  Western Asset’s investment approach for the Global SovereignQ strategy is to employ a proprietary model-driven discipline combined with the professional insights and experience of portfolio managers. This approach focuses on seeking to add value through global relative value analysis and constructing diversified portfolios of independent alpha engines using all major global markets. Relative value analysis is performed using a model to determine ranking, direction (long or short) and the magnitude of positions implemented within a portfolio. Robust and consistent analyses of the economic and market situations drive our decision-making process. Value is primarily added using country and currency allocations but duration and yield curve positioning also contribute to performance.
Q:  What is the investment objective of the Global SovereignQ strategy?
A:  Excess return objectives are customizable based on investors’ risk tolerance. Targeted excess returns range from 100 to 400 basis points on an annualized basis over 3- to 5-year periods with corresponding 100 to 400 basis points tracking error targets.
Q:  What is the recommended benchmark for the Global SovereignQ strategy?
A:  The benchmark is flexible. Western Asset’s recommended benchmarks are:
a) Citigroup World Government Bond Index (WGBI);
b) A cash equivalent benchmark
Q:  How is the model portfolio constructed?
A:  The portfolio management team determines the model portfolio at each monthly meeting based on market forecasts. During this stage, risk levels are rigorously and thoroughly assessed, discussed and managed using proprietary risk models. Risk levels are then set appropriately for the model portfolio. The evolution of correlations and volatility are also analyzed and taken into account when setting risk levels. Factor sensitivity analyses are also performed and discussion ensues about possible outcomes due to varying risk levels. Since these steps are taken before any transactions are completed, the model portfolio provides the portfolio management team with further insights as to how the portfolio might perform under the various conditions that are studied. As a result, the opportunity exists to make adjustments before trades are performed. Western Asset believes this creates a tightly controlled risk framework to assess, monitor and manage risk.
Q:  What other aspects are there to the model portfolio construction process?
A:  Portfolio managers are responsible for the construction of the model portfolio as well as for the construction of the client portfolio.
Analysts play an integral role in the process. For example, analysts review portfolios on a daily basis and assist the portfolio management team in rebalancing portfolios after the final strategy has been determined.
Portfolio managers’ market outlook and investment decisions are reflected in the model portfolio through a well-defined process. Once the strategy is determined, client portfolios are rebalanced (if necessary) as soon as is feasibly possible under the current market conditions.
The discussions and analyses that take place include but are not limited to the consideration of the following risk factors:
  • Portfolio’s overall risks
  • Risk factor weighting among currency allocation strategy, duration strategy and country allocation strategy (major countries’ duration positioning)
  • Risk factor weighting between the mid- to long-term interest rate forecast and the short-term forecast
  • Currency allocation risks
  • Bond risks (global rate volatility risk, relative rate volatility risk)
  • Beta and duration
Q:  What additional optimization takes place after the market outlook has been considered?
A:  Subsequent to the optimization based on the market outlook, the model portfolio is constructed as a specific investment strategy. The following are determined:
  • Weight of currency allocation
  • Weight of country/region allocation or active duration positioning by country
  • Portfolio’s overall duration
Q:  How is the client portfolio constructed?
A:  Risk assessment and management analyses applied during the model portfolio construction process are again applied in the same rigorous fashion when constructing the client portfolio to ensure each portfolio is constructed with the appropriate level of risk.
Q:  What risk management & monitoring takes place?
A:  Risk levels are rigorously and thoroughly assessed, discussed and managed during the model portfolio construction process as well as during the client portfolio construction process. Risk levels are then set appropriately for the model portfolio and client portfolios. Risk management and monitoring activities are continuous and dynamic and are an integral part of the investment management process on a regular basis.
Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence. Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority (ref: 145930). This material may not be reproduced or used in any form or medium without express written permission.