Jigsaw Puzzles, LEGOs…. and Bond Portfolios?

By: Tucker Rothmann
April 14, 2021

It was just about a year ago when quarantine-fueled demand made it increasingly difficult to source at-home entertainment like jigsaw puzzles and LEGOs. I was one of the lucky ones, buying a few of each as my wife and I hunkered down for what we thought would be a few short weeks of quarantine. 

Approaching the finish line of my first puzzle, I realized that I was missing a piece. To this day, the puzzle remains incomplete; it’s not like puzzles are sold with extra pieces.  In contrast, with a LEGO set, you can find a piece from a different set that is close enough. The color could be a bit off, but it’s the same shape. Structurally, no difference.  Are bond portfolios more like jigsaw puzzles or LEGOs? It depends! 

Fixed income portfolio managers frequently run into similar challenges – the solution varies widely depending on considerations such as the type of investment strategy and client-specific objectives, as well as guidelines and regulatory restrictions, to name a few.  For example, if you are trying to line up bonds to mature on specific dates in a cash match strategy, you may not be able to find a certain maturity.  So, you need to live with a substitute and a bit of mismatch with your incoming cash flows.   

Cash match and passive strategies are more like jigsaw puzzles. The goal of a passive portfolio is to mimic the index, so if a piece is missing, it leads to dispersion (tracking error).  Most passive strategies use replication; some pieces are missing, but there are enough that you can see what the overall picture is supposed to look like.  Active strategies, on the other hand, are more like LEGOs. There are numerous opportunities to substitute one security for another, or invest out-of-index, enhancing a manager’s ability to add value. 

Managing an active bond portfolio is like building a never-ending LEGO masterpiece where incremental changes and additions are made over time. The new issue market offers new bonds to choose from virtually every day, and as relative value shifts between sectors, active managers can react accordingly.  The manager can look beyond a given set to find the most appropriate and attractive replacement. 

LEGO Masters and Active Managers 

If you’ve ever seen the show LEGO Masters, then you know the astounding creativity of its artists. On the show, contestants are given a theme to work within, and then use their skills and creativity to produce true masterpieces. 

Active managers are the “masters” of the bond world, using security selection skills, sector rotation prowess, and creativity to build fixed income portfolio masterpieces.  If a specific sector or issuer exposure is difficult to source, the portfolio manager can work with research analysts and traders to determine the best alternative. If the resulting portfolio has the risk and return characteristics desired, the substitution likely has little effect.  Maybe Utilities are trading rich, but Telecom is cheap. Or maybe the analyst thinks that a specific name is an upgrade candidate, providing some upside. 

 The Space Between 

Sometimes, an investment mandate lies at the intersection of jigsaw puzzles and LEGOs.  In bond portfolios, guidelines can vary, from strict index-oriented mandates to those with quality and sector restrictions, or ESG objectives and SRI exclusions. 

With these strategies, the index and client objectives/constraints are like the ‘theme’ for the portfolio. Working within the bounds of the theme, our goal remains the same: construct the most attractive portfolios for our clients. There is no ‘right answer,’ and there are often rules and restrictions to what types of bonds can and cannot be used.  With the rising prominence of ESG, improving pension funded statuses, and strong equity markets, clients are considering more customized solutions.   

Maximizing portfolio utility given a set of constraints and objectives is truly an art form. As the opportunity set is limited, security selection becomes even more important.  At IR+M, we believe that a bottom-up, flexible approach to constructing portfolios allows us to be nimble and respond to ever-changing market dynamics.  We take what the market gives us.  We are benchmark aware, but not beholden. The opportunity set that we’ll consider is more than double the size of the traditional passive universe. We look beyond the index and turn over every rock in the pursuit of adding value to our clients’ portfolios. Given our bond-by-bond approach, we’re able to construct investment portfolios just as LEGO artists produce masterpieces, brick-by-brick. 



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.