A healthy allocation within fixed income is a strategic mix of active and passive management.
The number of sub-sectors with different liquidity, efficiency and credit-quality characteristics means fixed income provides a range of opportunities to generate alpha. And these distinctions are key to choosing whether an active or passive product should be used to gain exposure.
Unlike in equities, where passive strategies have generally outperformed active managers, active fixed-income managers have generally outperformed passive strategies.
The fundamental problem is that fixed income simply does not lend itself easily to passive investment.
Most fixed income indices are comprised in such a way that the companies with the most debt make up the largest component of the market index.
This leaves them more exposed to unfavourable changes in creditworthiness than active investors, who can ‘vote with their feet’.
Risk mitigation is the key advantage of active management. The opportunity set of investments outside of the fixed-income benchmark index, and the ability of managers to dial up or dial down risk, are not options for a passive strategy.
For example, the impact of rate and yield curve changes on long-duration assets can be managed with active decisions around portfolio duration positioning.
With fixed income the risk and return are asymmetric. In the best-case scenario (no bonds default) the total return is the coupon plus the principal.
The upside is limited, but the downside can be more significant as credit quality deteriorates.
The objective is to generate stable returns by delivering what famed investor Charles Ellis termed “a loser’s game”, in which one wins by avoiding defaults, rather than chasing returns.
Active a no-brainer for fixed income? Not so fast
It can be argued that alpha generated by active managers has been, at least to a great degree, due to a long-term overweight to credit.
If we account for fixed income managers’ credit exposure, fees and other factor exposures (eg volatility) there may not be much alpha left. Not only this, but credit is inherently more correlated to equities, so analysis on the impact to the wider portfolio is crucial.
The main argument for index solutions is not just the low fees (though they usually are on the low end), but the transparency, daily reporting and a systematic approach to managing risk.
For example, government bond markets are highly efficient and large institutional ownership dictates limited alpha potential, offering limited opportunity for active management.
Having exposure to passive strategies can add to portfolio liquidity. For example, US treasuries can be held as a satellite position in the fixed income allocation, with the capability to deploy to riskier, less liquid assets when the opportunity presents itself.
Exchange traded funds have traded continuously and orderly in stressed markets, a potential advantage compared with investors holding individual bonds and mutual funds.
Never judge a book by its cover. Larger debt issuance does not inherently reflect higher issuer risk.
