High-yield bonds are simply too risky to buy and hold, according to Aaron Izenstark, portfolio manager of the Iron Strategic Income Fund, so he uses a hedging strategy designed to produce steadier total returns from the asset class.
“If you want to be in the [high-yield] space and clip coupons, we feel that is a mistake,” he said. “High yield is really good when it's good — but really bad when it's bad.”
By mitigating risk, Mr. Izenstark aims to stay invested when junk bonds get hammered, and then capture some of the upside when the sector turns.
His hedging strategy clearly helped in the financial crisis.
“Some [high-yield] funds drew down over 30% in 2008 [when] we were down about 8%,” he said.
Over the five-year period ended May 30, the Iron Strategic Income Fund gained an average 7.91% per year, according to Morningstar Inc. That was 1.36 percentage points better than the Barclays Capital U.S. Aggregate Bond Index and 5.08 points better than Morningstar's nontraditional-bond category.
In fact, Mr. Izenstark pitches the $520 million asset fund as the “alternative to alternatives.”
“We probably have one of the only true alternative [mutual] funds with longer than five years' performance record,” Mr. Izenstark said.
Newer absolute-return products are performing poorly and hedge fund fees are out of line, never mind the illiquidity, he said.
By the Iron fund's own measure, from its launch in October 2006 through the end of last year, its annualized total return of 8.17% was double the 4.14% return of the Dow Jones Credit Suisse Hedge Fund Index.
Mr. Izenstark, 47, co-founded the fund's adviser, Iron Financial LLC, in 1994 after developing his proprietary hedging strategy while working as a derivatives trader on the Chicago Board of Trade and the Chicago Mercantile Exchange.
He co-founded the firm with managing director Howard Nixon, 52, also a former member of the Chicago Board of Trade.
Mr. Izenstark shares portfolio management duties with co-portfolio manager Daniel Sternberg.
“What we're trying to do is monitor banks, bank credits and loans, because the high-yield market is the first thing that gets affected” when banks get shaky, Mr. Izenstark said.
The fund hedges by using a high-yield credit default swap index. The process is like buying a put option, paying for coverage and limiting risk to the cost of the hedge, Mr. Izenstark said.
Other funds take the opposite — and riskier — tack, he said, selling insurance (by shorting volatility) rather than buying protection.
Iron Strategic Income can adjust its exposure from 0% to 100% in high-yield bonds, but does not leverage either way, Mr. Izenstark said.
Due to the costs and timing of its hedges, the fund typically lags on the upside. Last year, it gained 0.7%, compared with a 7.84% return for the BarCap aggregate index, and 4.38% for the BofA Merrill Lynch U.S. High Yield Master II Total Return Index.
The fund also yields less than unhedged-junk portfolios. It was recently distributing less than 4%, while unhedged funds yielded about double that.
“When we're 100% invested, we're yielding what the high-yield market yields,” Mr. Izenstark said. “When we're 50% hedged, the yield is half.”
He said the portfolio is in a “conservative mode” right now. The situation in Europe “looks worse than before. It's affecting other countries, and spreads have widened a bit,” Mr. Izenstark said. “It starts to create liquidity issues with bank loans and high yield.”
He likes it just fine that few people have ever heard of his fund.
“We're asset managers, not marketers,” Mr. Izenstark said, projecting a decidedly Midwestern attitude toward minimizing risk. On the coasts, “there is more of a focus on marketing, and less on substance,” he said.
Wall Street “is filled with people who don't trade their own money,” Mr. Izenstark added. “If I didn't make money [as a derivatives trader], I didn't get paid. That's the difference between [Chicago's] LaSalle Street and Wall Street.”
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