Lifecycle of an SMA: Kirk Barneby and Interest Rate Risk Investing

Rydex/SGI's Long Short Interest Rate Strategy Fund, a ’40 Act mutual fund, is a total return, actively managed fund designed to “exploit changes in the interest rate outlook, and to deliver positive price performance even in rising rate environments.” The fund invests in short-term Treasury bills, and government and agency bonds, using Treasury futures.

The fund follows a rigorous rules-based methodology that is designed to capture both the fundamentals of interest rate cycles along with monthly forecasts on the direction of rates. The methodology is delivered by the fund’s subadvisor, American Independence Funds and its chief strategist for taxable fixed income, Kirk Barneby.

kirk barneby But long before now, the process behind the fund’s investing strategy was being explored by Barneby (left), and first saw light as a separately managed account. Beginning in the 1970s, Barneby said in an interview on Friday, he started his research into the behavior of interest rates, which became the basis for a SMA bond discipline at Paine Webber. Barneby points out that the period from 1973 into the present has been a “great lab for this strategy," lisiting the three serious recessions in the period, with accelerating inflation followed by a period of decelerating inflation. How has the strategy done over that time? “It’s performed well,” responds Barneby.

What was the impetus behind the new Rydex fund? “Since the 1980s, investors have looked at bonds as their ‘safe’ money,” he says, but because the prior recessions weren’t serious, “earnings risk never factored” into investors’ thinking. “We learned in 2008-2009,” however, that “earnings risk can dominate the return profile of fixed income.” While Treasuries rose, other fixed income was affected by both credit risk and earnings risk. Now, he says, investors are concerned about rising interest rates, which can impose a loss on the value of their bond portfolio, especially if those investors are stuck in longer-duration bonds. “If rates rise by 2%,” he points out, “and your duration is five years, you lose 10%” of the value of your fixed income holdings.

The strategy is designed to manage interest rate risk by quantitatively determining a monthly interest rate forecast—based on measures of the economy, inflationary expectations, and investor psychology using market indicators—and then using Treasury futures to short, or go long, interest rates based on that outlook. (The rate outlook is released on the first Friday of the month coincident with the release of the government’s employment situation report.)

The process, Barneby says, allows him to “capture general cyclical trends, but also deviations from the trend.” If the process indicates a fully bullish sentiment on bond prices, expecting rates to fall, the portfolio can double duration out to 11 years in a long position. If the process suggests a bearish sentiment, that rates will rise, then duration can be shortened and go as far as -11 years in duration in a short position.

What is the role of the fund in an investor’s portfolio? “We play the role of risk mitigator,” says Barneby, and “more often than not, we’re seen as a compliment to the overall bond portfolio.” Investors, he says, can retain most of their present fixed longer-duration income portfolio to get income from the coupon, while the strategy ameliorates the danger of those longer-duration bonds reducing the value of the overall portfolio.

So what’s the forecast for April 2011? “This month we’re fully bearish,” Barneby reports, based on “our measures of the economy, with inflationary concerns higher,” and the investor psychology reading agrees with the other two major data inputs.

If this SMA-turned-alternative-mutual-fund is such a great risk mitigator, does Barneby himself invest in the strategy? “The bulk of my personal net worth,” Barneby says, is in the strategy.