The Scientific Approach to Fixed Income Management

That led me to understand that I didn't have a firm grasp of the financial markets and investing. I decided to transition to an economics major, which is what I ended up graduating with. For a short time, I was a financial advisor immediately out of college. I was good at it, but what I realized is that it didn't speak to my passion of understanding the engine of the markets. That meant getting better at investment research as well as asset management.

I was born and raised in Phoenix. I spent about 17 years of my career after that initial stint as a financial advisor with Charles Schwab. I did most of that work in the context of asset management and investment research. About 10 years ago, I moved to Chicago, the land of asset management and investment research, and took on a role as a quantitative equity analyst, which I thoroughly enjoyed. It allowed me to get my hands dirty and to exercise my passion, to be more creative and intellectually curious about exploring ideas and finding out exactly what that means as it relates to what drives markets. I did that and I was very good at it.

I also had a knack for discussing very complicated matters of financial markets in much more intuitive terms. I was tapped and transitioned over to a role in wholesaling with Charles Schwab and worked in that unit for about six years, discussing our separately managed accounts and different strategies ranging from dividend growth, dividend income growth, to a global tactical asset allocation model. I did great work, had wonderful relationships and worked with wonderful people there.

After some time, you find yourself looking for the next challenge. You've done a lot in terms of what you can do in a certain place, and that intellectual curiosity never goes away. When you're thinking about asset management, that leads to a firm that perhaps has a very forward-thinking vision about where the industry is headed and how they're going to position themselves to be successful.

I found that home at Harbor. Earlier this year, as a lot of people did during this pandemic, I made a transition that allowed me to exercise and explore the intellectual curiosity that drives us to find those sources of return. It's been a short but very wonderful experience so far here at Harbor. I've enjoyed my new colleagues and the new strategies, two of which of course I'm here to talk about today.

Why did Harbor enter the ETF market? What was the opportunity you saw? What was the problem you were trying to solve?

That's a fair question and I'm sure it will not be the last time that it's asked. Harbor has been historically rooted in mutual funds, and we're headed from the age of mutual funds into an era of ETFs. ETFs have some clear structural advantages that are not afforded to mutual funds, and investors' preferences are indeed changing.

The creation of exchange traded funds was a watershed moment, one that has continued to gain steam. We're going through a period of rapid adoption, with the appeal to the next generation of investors, and it's an area we're very excited to be a part of.

That's the reason for selecting the ETF vehicle. Why active and why fixed income?

There's a lot going on at fixed income these days. The need for high-quality income has never been greater. Driven in part by demographics, the ability to get yield from the market has never been more difficult. There is an interest rate cycle that is presenting a great challenge to investors. Generally, yield and spread compressions that we've seen across the world have made this a space that demands attention. There's a lot of uncertainty as it relates to the pandemic environment, what the recovery will look like and the inflation picture, which continues to grab headlines.

Putting that all together, clients need high-quality income solutions. Now is the time to take an active approach to help navigate the uncertainty investors are faced with as they invest in fixed income.

Your approach is called “scientific investing.” What is scientific investing? How is it different from traditional active or quantitative investing?

This is something we will talk about a lot going forward. It's going to take education to bring everybody up to speed in terms of what exactly that is. You couched the question correctly; historically, there have been two approaches to fixed income investing. There has been the fully passive, low-cost approach, which continues to grow market share, and the discretionary or fundamental approach, with analysts attempting to produce a superior outcome.

There is a space for third approach in the middle, which will be filled by scientific investing. There are elements of the process that are quantitative, but taking this approach means being objective, using technology and data to be un-emotive about making decisions. By navigating the market with a scientific approach, we hope to provide corollary benefits to both the low-cost index investing and fully active approaches that are traditionally used. For our clients building out their diversified portfolios with fixed income, that's highly attractive in a risk-adjusted return and corollary benefit way.

Our investment process is grounded in the scientific method and subject to continual refinement. The process engages in systematic observation, gathering of information, formulation of a hypothesis, experimentation, drawing a conclusion, and most importantly, the continual modification of that hypothesis. This is a distinctly different approach from what many investors would consider traditional active or passive investing.

How are advisors using your products? What allocations are they typically committing to it and where does that allocation come from?

This is where we have to figure out which slice of the pie the scientific piece fits. We understand that the advice must be delivered in the context of a broader portfolio.

We're tilting away from duration risk. That means we underweight interest-rate sensitivity and overweight credit – not all credit – but selective credit through an active manager. But being tilted towards areas like high yield and steering clear of emerging market debt are the positions that we want to take.

As it relates to how much of this is an appropriate allocation for an investor, it's always going to fall back to the broader financial plan or risk tolerance that investor has in their portfolio. But these strategies provide benefits that are not correlated with traditional fixed income strategies. You can look at this as a great addition or complement to virtually any allocation that one might have in the space.

You mentioned that ETFs have historically been recognized as great vehicles, especially for passive investors. Why then should an investor embrace active ETFs and particularly your fixed income active ETF?

The innovation of the ETF was a watershed moment for investors in every category. But the passive market for this is saturated with both equity and fixed income products seeking data exposure, or more simply put, market returns. Specific to passive fixed income ETFs, the risks are well documented. Two of the largest potential risks are worth noting.

First, using fixed income ETFs means that you're over weighting the most indebted companies. Typically, the defense for this is rooted in the argument that those companies – such as JPMorgan Chase, Bank of America, and Goldman Sachs – are the largest weightings in those indices, but they have substantial asset bases and revenue profiles, which is why the market is willing to extend that financing to those firms in the first place.

The flip side of this argument is that company-specific risk becomes a larger part of the picture whenever the credit markets tighten up. We all have a very vivid memory of when that last happened and the severity of that impact on the fixed income allocations of investors' portfolios.

Secondly, when volatility hits markets, there's nobody with their hands on the steering wheel to change lanes when there's an avoidable collision ahead. With interest rate volatility increasing and the effects of the pandemic still unfolding, there's a clear need for unemotional and robust credit analysis expertise to navigate the challenging environment this asset class finds itself in. Those are a sampling of the reasons Harbor partnered with BlueCove on these two strategies.

But I've interviewed numerous active managers and asked them whether they would consider offering a version of their mutual fund product in an ETF. The response has been that they don't want to provide daily full disclosure. It would allow traders to front run their trades. It would allow competitors to steal their “secret sauce.” As an active manager, why has Harbor Capital chosen transparent ETFs over a semi- or non-transparent product?

It's a great question and one that active managers have been hesitant to take a step into for many years. One of the big decisions Harbor made a while back was to embrace active transparent management.

We abbreviate active nontransparent as “ANT.” ANT ETS were flawed from the beginning. They were designed around solving for active managers' paranoia around copycats rather than a real client concern.

Any solution that doesn't start and end with the client at front and center is inherently flawed. Clients are very perceptive and will spot flaws immediately, which will impede adoption. The structure has never had enough escape velocity and will collapse into itself and be consigned to history. We joke around in the office and say, "The ANTs have been squashed." They're complicated to understand, confusing for buyers, and extremely restrictive in terms of strategies you can offer. For instance, they support only U.S. stocks at this stage of the game.

ANTs put additional barriers in front of clients. At Harbor, we're all about removing friction for our clients. Active transparent ETFs do that nicely. The Harbor Scientific Alpha Income ETFs are the latest editions to our ETF roster. Both strategies are actively managed, employ the scientific method and are very transparent. We're bullish on the prospects for high-quality alpha delivered through fully transparent active ETFs.

You mentioned that you have a partnership with a company called BlueCove. What is its role in this product offering?

I should first share a core belief at Harbor. One of our best bets is on technology, particularly disruptive technology. Technology is eating the world and changing how we live our lives, how we interact and how we work. Technology is revolutionizing everything, including investing. We're deploying strategic technology investments across our firm. We use technology to produce alpha investing with managers that can identify technology disruption, using technology to understand markets and managers better than ever. We also invest in technology to drive our distribution approach.

Technology is in every conversation and thought we have. We looked at areas of the market where taking a technological approach to investing was under penetrated. We've been investing in systematic approaches within equities for years and we feel the time is right to do the same thing in fixed income. Fixed income is a more heterogeneous asset class and systematic approaches could add even more alpha than for equities.

There is an engineering challenge. It takes a huge amount of human capital, technology and know-how to do scientific investing well, and there are very few people with this skill set or experience to be able to pull it off. We're delighted to partner with BlueCove, who is well-positioned to be a long-term winner in this space. The firm has a near monopoly for talented entrepreneurs who have proven track records of taking a scientific approach to products and producing better outcomes for clients.

Building a scientific approach to understanding fundamental valuation and sentiment indicators and applying that instantaneously across thousands of bonds is extremely powerful. It’s a clear demonstration of a competitive edge that will result in better outcomes for our clients. It's repeatable, scalable, and means that we can create cost-effective solutions. Additionally, from a portfolio construction perspective, it fits into a core-satellite model.

BlueCove's approach is so different; it's not just their alpha profile we're attracted to, it's the journey it took to get there. Because its starting point is so different, it will be less correlated to more traditional discretionary based approaches. In other words, we're going to zig when others likely zag. Bringing this corollary benefit to our clients was a huge part of the attraction that helped BlueCove build better portfolios with better risk-adjusted returns, which is what we're all striving for in one way or another.

It's an exciting time to be in the early innings of a new industry. In an industry where the playbook is always the same, the shift starts with the innovators and disruptors before moving to the early-stage adopters. Then you'll see a broadening out of adoption as the new technology reaches acceptance by the market before you finally hit maturity. What's exciting is that we're firmly in that first inning of innovators and disrupters, but we'll shift to the early-stage adopters very soon. Then we’ll have a very long runway of growth.

Is Harbor going to be launching any other ETFs?

We're just getting started. We're excited to launch with a world class up and comer like BlueCove, but we're not stopping there. We're challenging ourselves to build the best actively managed ETF platform in the world. Why not? It's the wave of the future and it's something where we'll be a leader as we continue to bring these solutions to the markets.

What else can you tell us about your plans and what we can look for in the future?

I advise anyone with an allocation to fixed income to take a serious look at us. Harbor is a 35-plus-year old asset management firm that believes in active management and providing innovative, institutional-caliber investment solutions for our clients. We've successfully employed a sub-advised business model, where we seek out and partner with elite managers across the globe in a wide range of asset classes and investment styles. We maintain 20 sub-advisory partnerships that span across 26 commingled products, 17 asset classes and investment styles, and we have approximately $68 billion in assets under management and growing.

We also recently launched an in-house multi-asset capability. We're offering model portfolio solutions to clients based on a wide range of different risk profiles. This combination of internal and external investment capabilities puts us at a unique position to harvest a wide range of insights on financial markets that we can synthesize and share with our clients. We do that through what we call the Harbor Lens, which is available for reading via our website.

You mentioned that you consider yourself an innovator and a disruptor. When people read this, there's some who are going to look at this with skepticism. If there's one key takeaway that you would like to leave with them about the due diligence they should perform on a new product from an innovative firm like yours, what would that be?

I compliment those who look at new products with the skeptical eye, as they should. The best investors are always going to take an extra second, an extra minute, an extra day to do their due diligence and rightfully so. I would say that to anybody who is looking at a new product or strategy, you have to start with the people, and you also have to look at the process. When we talk about the people, the professionals at BlueCove are seasoned the veterans of the fixed income investing space.

They hail from a number of the global leaders in the industry and banded together to create a firm and build this strategy from the ground up. Given that technology and human capital, it would take years for the competition to catch up. For a firm that was established back in 2018 and didn't take any outside financing, it has grown to over $1 billion in assets under management in that short period of time. That's a great feather in their cap – a validation of what it is that they've built in a very short period of time and its success.

Second is the process. Take a good, hard look. We have documentation, which advisors can access, that will detail what that scientific process looks like including a firm-level process from BlueCove, which is proven and robust.

Harbor has a very well-known and successful track record in partnering with niche boutique firms. I can think of a few small names which might ring a bell, one being Jennison, who is a well-known, successful advisor that we've partnered with for 50 years.

We have done our homework with all advisors that we bring into our sub-advising partnership program and with whom we launch products.

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