Active fixed income strategies may offer investors numerous advantages over passive index strategies, providing enhanced risk-adjusted performance potential.
As the U.S. Federal Reserve (Fed) continues to raise interest rates and unwind its balance sheet, investors are re-evaluating their fixed income investment allocations. They still seek returns in this relatively lower yield, low-inflation environment, yet many have made a move to passive investing.
We believe active management for fixed income can better help investors realize their goals. The advantages become more significant as we consider the flawed nature of issuance-based fixed income indexes and the long-standing segmentation of indexed markets.
Active management can be used in any environment
We believe actively managed bond strategies can help manage portfolio risk while enhancing returns. Active sector rotation, bottom-up security selection and interest rate (duration) management can create opportunities for investors to add value that are simply not available in passively managed strategies.
It might be logical to assume that index mutual funds or index exchange-traded funds (ETFs) would match the risk and return characteristics of their benchmarks, but on average these products have exhibited lower returns and higher volatility as shown in Exhibit 1. On the other hand, actively managed mutual funds have historically outperformed their benchmarks while maintaining a similar risk profile, on average.
The return profile of active versus passive is even more pronounced when considering only those mutual funds with fees in the bottom half of the universe—which are the lower-cost share classes many investors own today.
Exhibit 1: Actively managed bond funds have offered better risk-adjusted returns
5 years ending 30 Jun 2018
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Chart does not represent the past performance of any Nuveen Fund. For fund performance visit nuveen.com.
Data source: Morningstar Direct, 30 June 2018. Past performance is no guarantee of future results. Risk is measured by 5-year standard deviation and return by 5-year total return. The Aggregate Index is represented by the Bloomberg Barclays U.S. Aggregate Index. Active mutual funds include all share classes of non-index open-end funds in the Morningstar Intermediate Term Bond Fund category with a primary prospectus benchmark of the Bloomberg Barclays U.S. Aggregate Index. Lower Fee Active Mutual Funds include the funds in the Active Mutual Fund category with fees lower than the average fund. Index mutual funds are open-end funds benchmarked to the Bloomberg Barclays U.S. Aggregate Index. Index ETFs are index ETFs benchmarked to the Bloomberg Barclays U.S. Aggregate Index.
Why is it difficult for index funds to keep up?
Fixed income index strategies may often have difficulty matching their benchmarks' performance due to the complexities of bond indexes. The global fixed income market is nearly 50% larger than the global stock market.
1 The most common stock market index, the S&P 500® Index, contains approximately 500 liquid stocks. In contrast, the most widely quoted bond index, the Bloomberg Barclays U.S. Aggregate Index (Aggregate Index), contains 10,000+ securities.
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It is impossible to buy all of those bonds, so an index manager must use statistical analysis and sampling in an attempt to replicate the characteristics and performance of the benchmark using fewer securities. And the gross return must outperform the benchmark to cover the management fees.
How can active managers add value?
The most commonly used benchmark, the Aggregate Index, suffers from many drawbacks that provide active managers with more opportunities to generate excess returns and manage risk. These shortfalls include limited sector exposure, increasing credit risk due to market value weighting and duration that fluctuates with issuance. Active managers may add value to fixed income portfolios by taking advantage of these limitations. Let's look at each in turn:
Expanding the investment universe
By their very nature, bond indexes are exclusionary. For example, the Aggregate Index contains thousands of holdings with a market value of more than $20 trillion.
1 But it essentially excludes non-dollar denominated bonds (non-USD), emerging markets debt, global high yield corporate bonds and senior loans.
The index also has minimal exposure to select securitized sectors, such as asset-backed and commercial mortgage-backed securities and non-agency residential mortgages. Thus, the Aggregate Index overlooks trillions of dollars' worth of bond issues.
In contrast, active managers have the ability to strategically allocate away from potentially lower yielding government bonds. They can often supplement index-eligible bonds with off-benchmark investments that may offer higher yield, greater diversification and less sensitivity to rate increases.
Exhibit 3: Off-benchmark sectors have offered potential for higher yield, greater diversification and less interest rate sensitivity
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Data sources: Bloomberg, L.P., JPMorgan, Credit Suisse, 30 Sep 2018. Past performance is no guarantee of future results. Representative indexes: Aggregate Index Bloomberg Barclays U.S. Aggregate Index; Non-USD bonds: Bloomberg Barclays Global Aggregate ex USD Index; Emerging markets debt: Bloomberg Barclays Emerging Markets USD Aggregate Index; Global high yield corporates: Bloomberg Barclays Global High Yield Index; Senior loans: Credit Suisse Leveraged Loan Index. Indexes are unmanaged and unavailable for direct investment.
Enhancing risk-adjusted returns
In fixed income indexes, securities are weighted by the market value of the outstanding debt, so the most indebted issuers make up more of the index. To be sure, some of the world's most successful institutions (including the U.S. government) carry large debt loads. But passive investing may increase exposure to issuers with higher leverage, declining credit quality or substantial interest rate risk. Active managers, using rigorous credit research processes, can focus on the most compelling opportunities.
Actively managing interest rate risk
Not only is the typical bond index limited in its sector composition, but the sector weights may also change over time. This means the risk factors are not constant, even for an index strategy.
The U.S. Treasury issued more debt in part to finance growing deficits following the financial crisis, and as a result, Treasury exposure in the Aggregate Index increased massively from 25% to 38% from 31 Dec 2008 to 30 Jun 2018.
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The index's duration has also increased over time due to the higher weighting of Treasuries, along with the increased issuance of long-term corporate debt. Longer duration means the bonds tend to be more sensitive to rising interest rates. Active managers can reduce portfolio sensitivity to changing interest rates in two ways:
1)
Manage overall portfolio duration. As rates rise, a portfolio with a shorter duration will generally experience a smaller price decline than one with a longer duration. Portfolio managers can actively lengthen or shorten duration as rates rise and fall throughout the cycle.
2) Position portfolios along the yield curve. Interest rates do not typically rise uniformly along the yield curve. For example, if long-term rates rise more, the yield curve steepens. In this environment, an active manager has the flexibility to emphasize intermediate-term securities.
Active fixed income management offers opportunity
We believe actively managed fixed income strategies will continue to add value going forward. Actively managed portfolios have provided better returns with less risk than passive portfolios. Active managers can adjust their sector allocation, benefit from bottom-up security selection and position portfolios to minimize the impact from rising rates. Together, these levers make active fixed income an attractive management strategy.
1 Bank of International Settlement.
2 Data source: Bloomberg, L.P. The Bloomberg Barclays U.S. Aggregate Index contained 9,959 securities with a market capitalization of $20.135 trillion as of 30 Jun 2018.
3 Barclays Live, Bloomberg, 29 Jun 2018.
