The writer is a bond portfolio manager at Barksdale Investment Management and co-author of ‘Undiversified: The Big Gender Short in Investment Management’
Equity investors have been shifting away from actively managed funds to passive strategies for decades. Passification, if that is a word, has been slower to take off in fixed-income strategies, though.
There are several reasons for this — but perhaps the most significant is that the case for active bond management is supported by its outperformance, net of fees, versus indices and passive strategies.
This might be different from what you’ve commonly heard and read. However, the case against active management typically focuses on mutual funds and exchange traded funds. The performance of institutional fixed income — that is, separately managed accounts (SMAs) for pensions, endowments, foundations, etc — is better.
The focus on mutual funds and ETFs is for two reasons. First, data are easier to come by thanks to Morningstar, the largest provider of ratings for funds. Second, funds are the main exposure for retail investors. But with a substantial amount of bonds held outside fund structures, it’s important to analyse returns for this category.
Take data from PSN, a widely used database of manager returns used by consultants, and compare the performances against the Bloomberg Aggregate index — the most commonly used benchmark for investment- grade fixed-income portfolios and known as the Agg.
The Agg’s performances would rank in the fourth quartile for the 150 core bond managers in the PSN database over three- and five-year rolling time periods as of September 30 and are barely in the third quartile over the past year. For the avoidance of doubt, that means more than 75 per cent of those 150 core bond managers — a large and representative sample — outperformed the index over the past five years, net of fees.
Why is that the case? First, true indexation — that is, investing in all the securities in an index — is impossible in fixed income. It’s not just that the Agg contains more than 12,000 bond issues. It is also the challenges of trading corporate bonds privately between counterparties, or “over the counter”. The average corporate bond trades infrequently a month after issuance, resulting in potentially large spreads between bids and offers, a cost that the indices don’t incur. With that backdrop, it’s remarkable that the two largest passive vehicles have managed to generate (albeit lacklustre) results in line with the Agg.
Second, by definition, the index overweights issuers with the most debt — which suggests a bias towards lower-quality companies. Take two examples in the same industry, Oracle (rated Baa2/BBB+ by Moody’s and S&P, respectively) and Microsoft (a AAA-rated “unicorn”). Since Oracle is a larger component of the index than Microsoft, a passive strategy must own more of the former, while active managers might choose to avoid it given its negative credit rating trajectory.
The index has also experienced an increase in BBBs, the lowest rating rung of the investment-grade corporate universe, over the past decade. Passive strategies have no choice but to follow the ratings trajectory downwards.
Third, a meaningful component of alpha in investment grade comes from asset allocation decisions among the three primary sectors of the index — Treasury bonds, mortgage-backed securities and corporate bonds.
A common criticism of active fixed-income investing is that managers blindly overweight higher-yielding, riskier MBS and corporates to juice returns (and subsequently blow up when risk appetite declines sharply). But the reality is more nuanced. According to JPMorgan data, the level of average risk-adjusted returns — the Sharpe ratio — in MBS and corporates is higher than in Treasuries, over virtually all time periods. Most active managers overweight these sectors accordingly — a decision not available to passive strategies.
A fourth reason is that in periods of dislocation, fixed-income index funds can be whipsawed by outflows, whereas SMAs are by and large static pools of capital. While an institution might redeploy cash from bonds to stocks in a downturn, institutional behaviour tends to be less herd-like than retail.
Index funds in fixed income can make sense for smaller institutions underserved by investment managers and individual investors lacking the critical mass to achieve liquidity or diversification. But larger institutions would be wise to embrace the adage of “you get what you pay for”. Active fixed-income strategies are worth the fees they charge.