Investors face a difficult choice when deciding between active and passive investment management. The decision is a complicated one, as both approaches have merits as well as disadvantages. Passive strategies offer low-cost and tax-efficient management, but sacrifice the ability to outperform the market. Active managers have the ability to capitalize on market opportunities, but picking winners can be challenging. The debate grows more complex when applied to fixed income investing. In this piece, we outline the pros and cons of each strategy, before exploring some of the nuances that uniquely impact bond market investing.
Active Investing: An active fixed income investment strategy involves positioning the portfolio to capitalize on market conditions. Goal is to produce results that are better than that of the index.
Passive Investing: A passive fixed income investment strategy involves mimicking the index and limiting trading activity. Goal is to produce results that are similar to that of the index.
Pros and Cons
Passive Investing Adoption in Equity Markets
- Passive equity strategies track easily-understood and widely-used benchmarks
- Stocks trade on liquid exchanges where the efficient market hypothesis largely holds true
- The universe of available investments is well-researched and similar in structure
- The emergence of mutual funds and exchange-traded funds (ETFs) has made it easier for investors to implement passive equity strategies
- Low-cost indexing reduces the complexity of constructing an equity portfolio, which appeals to retail investors
While passive investing has been very popular in the equity space, adoption has been slower in fixed income. We delve into why this may be next.
Passive Fixed Income Management Considerations
- The vast number of securities (9,000+) makes it nearly impossible to truly replicate bond indices with a passive strategy2
- Passive managers can get close to replicating an index with a subset of holdings; however, not all risks can be mitigated
- Most bond indices, including the widely used Barclays US Aggregate Index, are market-weighted, meaning the issuers with the most outstanding debt carry the largest weights
- Passive funds are forced to invest in issuers with the most debt; these companies could be increasing leverage and risk
- 65% of the Barclays US Aggregate Index is comprised of US Government exposure through Treasuries and Agency mortgage-backed securities (MBS)2
- Passive strategies force investors to hold these securities, which are at historically low yields
Security Selection Opportunities
- The most widely used fixed income indices exclude many bonds with attractive return profiles
- For instance, the Barclays US Aggregate Index excludes privately-placed securities (144A’s) and issues that do not meet the Index’s minimum size or maturity requirements
- Securities with embedded options or unique structures can be more bondholder friendly relative to straight debt
- The new-issue market for corporate bonds, which totaled over $1 trillion in 2015, introduces many complexities3
- New deals may come with sizable concessions, and funds that wait until index inclusion often sacrifice performance
- Bonds are traded over-the-counter (meaning that all bonds are traded through a negotiated process) rather than by a formal exchange, which reduces pricing transparency
Approaches to Active Fixed Income Investing
Fixed income managers can introduce a number of risk factors to generate alpha. Active approaches may exploit any one of these strategies individually or in combination. Typically, as more risk exposures are introduced, the more the strategy performance might deviate from the index. Some of the most common approaches are explained.
- Unlike a bond portfolio of similar quality, plan liabilities are immune to the effects of downgrades
- In an LDI context, this necessitates active investment in the portfolio to avoid downgrades and keep pace with the plan liabilities
- Active security selection enables managers to assess the relative attractiveness of fixed income sectors to identify securities that may outperform the broad market
- Managers can identify attractive issuers based on credit research
- Managers can seek bonds with favorable structural characteristics
- Duration management aims to reduce interest rate risk relative to the benchmark
- When expecting rising rates, active managers can shorten duration to help preserve market value
- When expecting falling rates, active managers can lengthen the portfolio to help achieve outperformance
Key Rate Management
- Key rate management aims to reduce interest rate risk by taking advantage of non-parallel shifts in the yield curve
- For instance, the 5-year rate is most sensitive to changes in monetary policy; managers may reduce exposure to this key rate if predicting less Fed accommodation
- Managers may use leverage in an attempt to enhance portfolio returns
- Managers can borrow funds to create a position larger than available through direct cash outlay
- A levered portfolio magnifies both gains and losses, increasing the client’s risk
At IR+M, we believe active security selection can generate positive excess returns over the long-term. Unlike other active managers that rely on market timing or leverage, we strive to add value through careful, bottom-up security selection. While the lower fees associated with passive management can be appealing, investors sacrifice the tailored approach and available customization that active managers utilize to help clients meet their investment objectives. We believe that our relative value-oriented approach, dedicated team of experienced investment professionals, and proactive client service will continue to enable us to add value for our clients for many years to come.
1Source: Bloomberg and Barclays as of 11/30/15
2Source: Barclays as of 11/30/15
3Source: JPMorgan as of 11/30/15
The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.