Over the past several years, many investors have moved from active to passive fixed-income strategies, believing these markets offer fewer idiosyncratic risks to exploit than equities and are too efficient for active managers to generate alpha.1 Yet passive approaches have frequently underperformed active strategies across many segments of the fixed-income market and may expose investors to several forms of unintended risk. Active fixed-income management not only offers potential for enhanced returns, but can also add value by aligning an investor’s objectives with risks in several key areas—market structure, credit deterioration, dislocations, and divergence—where index-tracking approaches may fall short.2
Reason #1: Performance potential
Advocates of index-replicating fixed-income strategies argue that active managers cannot consistently outperform the Bloomberg Barclays US Aggregate Bond Index (the “Agg”), net of management fees. Yet active core-plus fixed-income approaches have historically fared well against the index over most time frames during the past 20 years, even after excluding a “survivorship bias” (Figure 1).
Active managers have often outperformed the Agg
Annualized total returns of US-based, active core-plus mutual funds, net of fees, as of March 31, 2019. Sources: Morningstar, Wellington Management. Universe has been filtered to: 1) include those funds benchmarked to the The Bloomberg Barclays US Aggregate Bond Index (the “Agg”), a widely used measure of the US fixed-income market, and exclude index funds; 2) mitigate survivorship bias, which occurs when the performance results of a group of managers are calculated using only the survivors at the end of the period and excluding those that no longer exist. Survivorship bias can result in the overestimation of historical performance by assuming that only funds currently in existence were available in the past. These results mitigate survivorship bias by including now obsolete funds that were active historically, but have since closed. Past performance is not a guarantee of future results. Indices are unmanaged and not available for direct investment.
Indices are designed to be market proxies, not investment strategies
The capitalization-weighted indices that passive fixed-income approaches typically seek to track, such as the Agg, are designed to be transparent, objective, and replicable sets of securities that represent opportunity sets and summarize market information. That said, the standard fixed-income market indices—or more precisely, the passive approaches that seek to closely mirror them—have several shortcomings as investment strategies, including:
- Performance: By definition, generally cannot outperform the indices tracked
- Duration: Expose investors to substantial interest-rate risk
- Downgrades: Cost investors return due to mechanical rules on downgrades
- Dislocations: Cannot take advantage of pricing dislocations or inefficiencies
- Divergence: Can fail to accurately mirror the target index
We think investors’ circumstances and goals should drive the composition of their portfolios, not an index provider’s efforts to replicate a given market. Any weighting scheme that excludes consideration of a market’s credit quality, duration, volatility, and liquidity exposure is too narrowly based, in our view.
Much of active core-plus outperformance versus the Agg has stemmed from the dramatic narrowing of credit spreads since the global financial crisis (GFC). Managers of investment-grade corporate debt have also benefited from a narrowing credit curve, as they tend to overweight lower-rated issuers, which have typically outperformed higher-quality issuers when spreads3 tightened.
Active outperformance over such a lengthy period, spanning turns in the credit cycle, suggests factors at play beyond an emphasis on credit. Indeed, active managers have many other levers for seeking to generate alpha, such as sector rotation, out-of-benchmark allocations, duration4 positioning, security selection, and (in the case of global strategies) country and currency selection. These noncredit levers may also mitigate drawdowns during credit-adverse environments.
Active outperformance over such a lengthy period, spanning turns in the credit cycle, suggests factors at play beyond an emphasis on credit.
That said, credit overweights have clearly helped boost excess returns delivered by active managers over most periods—the great exception in the past decade being the GFC. Narrowing spreads since then have compensated for active managers’ shortfalls versus index returns in 2008.
While the median active manager’s performance versus the index have tended to be positively correlated to credit spreads—outpacing the index when spreads narrowed and lagging when spreads widened—periods of underperformance have often been short-lived and typically outweighed by longer stretches of outperformance.
In high yield, active management has historically not fared as well. Active high-yield managers tend to be defensively positioned versus the index; perhaps as a result, they have trailed the index when spreads remain unchanged or narrow. However, the top quartile of high-yield managers has produced net-of-fees alpha in 15 of the past 20 years,5 demonstrating that this sector is ripe with opportunities for skilled managers.
Reason #2: Market structure
Fixed-income markets tend to be fragmented and opaque, prone to experiencing volatile liquidity. However, these features may benefit thoughtful investors by increasing the premia that can be earned through portfolio implementation and active management (Figure 2).
Fragmented: Unlike equity markets, there is no “central” fixed-income exchange. Instead, securities are still traded “over-the-counter” (OTC). This often requires a trading desk to strategically plan how it will either buy or sell a bond, allowing the implementation aspect of investing to potentially add value. Moreover, issuers may have different bonds in various parts of their capital structure or in varying currencies and maturities. A single corporate or government issuer may have numerous individual bonds, each with different terms and conditions. That can mean the risks and rewards differ as well. A passive exposure does very little to distinguish among those individual bonds.
Noneconomic actors: Some key participants in fixed-income markets are looking to achieve objectives other than a rate of return. These include central banks and the US Treasury, along with banks and insurance companies that may be subject to investment constraints imposed by the regulatory framework. Hence, these counterparties are often not trading based on valuations, leaving room for active investors to purchase or sell bonds at opportune times.
Liquidity and balance sheet: Reductions in dealer balance sheets following the GFC have made liquidity more variable across fixed-income markets. Given that there is no central fixed-income venue, investors rely on dealers to serve as counterparties for trades and to hold inventories of bonds. The reduced ability of a dealer to “intermediate” or serve as a place to store inventory means bond prices can be influenced by the noneconomic actors, providing the opportunity for an active investor to supply liquidity when traditional intermediaries cannot and to do so more effectively than passive investing.
Implementation: Fixed-income markets provide a number of ways for skilled practitioners to add value through implementation, many of which are not replicable in passive terms. Issuer, CUSIP, and maturity are all important facets of a decision. In addition, active investors can decide whether the exposure looks better in cash (“funded”) format or through derivatives such as futures (“unfunded”) and can seek to exploit differentials between the two. Similar dynamics exist for currency markets, where lending dollars via the cross-currency basis market may deliver robust risk-adjusted returns. Over time, these and other tactics have often translated into superior results versus passive exposure.
The structure of fixed-income markets can work to investors’ advantage
Source: Wellington Management
Reason #3: Credit deterioration
An important feature of credit is its asymmetric risk profile: The market value of a bond can fall much more than it is likely to rise. (In other words, credit yield spreads can widen much more than they can narrow.) An active portfolio manager can play an important role in anticipating turns in the credit cycle and avoiding downside risk. In particular, fundamental research can help managers identify deterioration or improvement in a credit before the rating agencies do, and even before the shift is priced in by markets.
An active portfolio manager can play an important role in anticipating turns in the credit cycle and avoiding downside risk.
A prominent concern among investors is that lower-rated credits now comprise a larger share of the investment-grade credit universe than in the past, while issuer leverage has been rising (Figure 3). Deeper analysis of a company’s leverage ratios is essential to understanding whether or not the company’s ability to service its debt is negatively impacted by higher debt levels. At the very least, higher leverage should be a clear warning sign for credit teams to investigate a company’s earnings and free cash flow, its plans for asset sales and dividends, and how committed its senior management is to investment-grade ratings. An experienced portfolio management team that can go beyond the headlines may be able to identify opportunities and risks.
Investment-grade corporate leverage has been steadily rising
US investment-grade corporate credit metrics
As of December 31, 2018 | Source: Capital IQ. Net leverage is a measure of how much of a company’s capital is in the form of debt and is used to evaluate the company’s ability to meet its financial obligations. Interest coverage is a measure of a company’s ability to meet its interest payments.
Index providers’ rules for credit downgrades can also cause passive strategies to trail active ones. In the Bloomberg Barclays Investment Grade Corporate Index, securities downgraded by at least two of the three main credit-rating agencies (Standard and Poor’s, Moody’s, and Fitch) must exit the index by the end of the month in which they are downgraded. But deteriorating credits often sell off before they are downgraded as investors anticipate the downgrade. Consequently, the indices are often forced to sell such bonds after they have fallen in price.
Index providers’ rules for credit downgrades can also cause passive strategies to trail active ones.
Reason #4: Dislocations
Lack of liquidity, merger and acquisition (M&A) activity, and market segmentation can cause market dislocations and create opportunities for active managers, as can responses by government policymakers to such dislocations.
- It is particularly in credit sectors that post-crisis regulations have made secondary bond markets less liquid. Figure 4 shows that when spreads widen, the liquidity premium between new and older issues widens, and vice versa. As noted earlier, active managers can seek to benefit from this by acting as liquidity providers, purchasing higher-yielding corporates at steep discounts when others wish to sell them.
Market liquidity conditions create opportunities for active managers
Observed liquidity cost scores and option-adjusted spreads for investment-grade corporates: January 2007 – March 2019
Liquidity cost score (LCS) is an objective, quantitative bond-level liquidity metric. It is expressed as a percentage of the bond’s price and measures the cost of an immediate, institutional-size, round-trip transaction. Observed LCS are aggregated across the US investment-grade corporate bond universe as proxied by the Bloomberg Barclays US Corporate Index. Option-adjusted spread is a measurement tool for evaluating yield differences between similar-maturity fixed-income products with different embedded options. | Monthly observations through March 2019 | Sources: Bloomberg/Barclays, Wellington Management
M&A activity has accelerated in recent years, generating idiosyncratic risk that active managers can seek to exploit
- M&A activity has accelerated in recent years, generating idiosyncratic risk that active managers can seek to exploit. Some combinations represent strategic transactions from which synergies may accrue, while others may be done to enhance shareholder value. Active managers can assess companies’ deleveraging intentions and commitments to investment-grade ratings. There may be opportunities for investors to profit from M&A, particularly if the announcement triggers indiscriminate spread widening. Conversely, some debt-funded M&A transactions have pushed the investment-grade limit. If active managers are skeptical of management’s commitment to bondholders, they can choose to avoid/underweight the issuer.
- Finally, active managers can exploit market inefficiencies caused by market segmentation. For example, BB-rated securities can’t be included in mandates that require investment-grade credits. Without a natural buyer, their spreads may be high relative to their credit risk, handing savvy active managers another potential path to outperformance.
Reason #5: Divergence
Although many investors assume that an index fund will closely track its target index, this is not always the case. The challenges of index replication are most evident among high-yield, index-tracking exchange-traded funds (ETFs).
Although many investors assume that an index fund will closely track its target index, this is not always the case.
Two funds have had dominant market shares in the US ETF high-yield market since their launches in 2007. As of March 2019, these two funds together held 40% of total US ETF high-yield assets. Almost since their inception, the funds have shown significant tracking risk6 versus the Bloomberg Barclays High Yield Index. They have also meaningfully underperformed the index, as reported by Morningstar (Figure 5). These funds may lag the index because their benchmarks are more liquid than the index and, therefore, can’t benefit as much from today’s hefty liquidity premiums; however, we think it is appropriate to measure their returns versus the Bloomberg Barclays High Yield Index because it is commonly used as a yardstick for the performance of high-yield portfolios.
Returns of two major high-yield ETFs vary considerably from a widely used high-yield benchmark
November 30, 20077 – March 31, 2019
Sources: Morningstar, Bloomberg/Barclays
To summarize, we believe actively managed fixed-income portfolios have several distinct advantages over passive approaches:
- Active core-plus and investment-grade corporate managers have demonstrated the ability to outperform their benchmarks across numerous time frames.
- Fixed-income markets tend to be fragmented and opaque with volatile liquidity—features that may benefit thoughtful investors.
- The fixed-income indices commonly used as portfolio benchmarks expose investors to potentially costly index rules that “force sell” issues falling below investment grade. Active managers have more flexibility on the timing of such trades and can often stay ahead of these situations.
- Some so-called “passive” strategies can deviate meaningfully from the broad-market indices they purport to track in ways that cause them to underperform; high-yield ETFs are a prime example.
- Greater dispersion among sectors, issuers, and individual securities provides more opportunities for active managers to potentially add value.
- Finally, active managers are able to use market dislocations and inefficiencies to their advantage, whereas passive approaches must simply “ride them out” and endure the volatility.
1 The measure of the performance of a portfolio after adjusting for risk. Alpha is calculated by comparing the volatility of the portfolio and comparing it to some benchmark. The alpha is the excess return of the portfolio over the benchmark.
2 We recognize that passive investing is not exactly the same as index-tracking. Passive investing features low turnover of portfolio securities compared to active approaches, resulting in relatively lower transaction costs. A low-turnover approach may be perfectly consistent with an investor’s objectives. However, to simplify terminology, this paper uses “passive” and “index-tracking” interchangeably.
3 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.
4 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.
5 As measured by three-year monthly rolling returns; active returns stated net of fees. As of March 31, 2019.
6 Tracking risk is the difference between a portfolio’s price behavior and its benchmark’s price behavior
7 Earliest date that monthly data is available for both ETFs. Returns are net of fees.
Bloomberg Barclays US Aggregate Bond Index is composed of securities from the Bloomberg Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.
Bloomberg Barclays US Corporate Investment Grade Bond Index covers all publicly issued, fixed rate, nonconvertible, investment grade debt.
Bloomberg Barclays High Yield Index is an unmanaged broad-based market-value weighted index that tracks the total return performance of non-investment grade, fixed-rate publicly placed, dollar-denominated and nonconvertible debt registered with the Securities and Exchange Commission.
Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Risk assets have a significant degree of price volatility.
Additional Information Regarding Bloomberg Barclays Indices Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
The views expressed herein are those of Wellington Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.