By Rob Glownia and Tim Anderson, RiverFront Investment Group
As we look into 2018, we believe one of the biggest risks to the market is the pace at which the Federal Reserve unwinds their balance sheet. The implications of this process are broad, having the potential to affect both global equity and fixed income securities. In our opinion, an active approach is necessary to navigate such an environment, especially within the fixed income segment of a portfolio. This week, we’d like to outline some of the reasons we believe active management has an edge over a passive fixed income strategy.
Popular Passive Benchmarks Employ Questionable Weighting Methodologies and Lack Broad Representation
One of the most prominent fixed income benchmarks is the Bloomberg Barclays US Aggregate Bond Index (the AGG), which has been in existence since 1986. Despite its wide-use and popularity, however, there are a couple peculiarities about this index and most other fixed income indices. First, the AGG index is weighted by debt issuance, which means that as an entity’s debt burden grows it has a larger representation in the index. We view this weighting methodology as counterintuitive, since growing debt burdens can also signify escalating risk. Second, the AGG index excludes a significant percentage of the investable fixed income market. Specifically, the index only includes investment grade bonds with fixed rate coupons, which means that high yield bonds, emerging market debt, and floating rate notes are all excluded. Because of the inherent biases in many of the popular fixed income indices, we believe an active manager has multiple opportunities to add value to a fixed income portfolio. For example, as an entity takes on more debt, an active manager does not blindly have to increase that constituent’s weighting in their portfolio. Another example would be the opportunity to rotate into non-traditional sectors of the bond market (where the yields tend to be higher).
Popular Passive Benchmarks Can be Yield Constrained if Low Inflation Environment Persists
A passive strategy tracking the AGG index will have about 2/3 of its portfolio tied to US Treasury Bonds and agency mortgage-backed securities. With both of these sectors having coupon payments near historic lows, investors should expect returns in-line with yields and since there are few signs of inflation, rates may remain lower for longer. Low interest rates benefit borrowers but create a difficult environment for someone who expects to generate income from their investment portfolio.
Popular Passive Benchmarks can Reflect Irrational Purchasing Behaviors of Large Investors
Unlike equity markets, fixed income markets have a meaningful number of market participants who make purchase and sale decisions where higher portfolio returns may be a secondary objective. For example, many companies and governments pensions have long term obligations. Therefore, they have an incentive to buy bonds maturing in the same year as that obligation, regardless of their view on future interest rate movements, in order to reduce their risk. This is called asset-liability matching (ALM) and is an important factor for many banks and insurance companies.
Another recent example involves the activities of central banks around the world as they carry out their quantitative easing programs. For these central banks, their growth and inflation mandates take priority over portfolio returns. Passive products and benchmark sensitive fund managers can be most susceptible to this potentially irrational behavior given that their investment process is driven by minimizing tracking error with little if any consideration of valuations. Because of these differences in investment objectives, we believe active managers have the potential to find opportunities where other market participants aren’t looking.
The Hidden Costs of Passive Investing
The proliferation of ETFs has made it easier and cheaper to invest. However, there are more costs incurred by the investor than simply an expense ratio. Specifically, we are talking about the costs incurred through trading and rebalancing, which are most prevalent in high turnover products.
According to Bloomberg, turnover in the AGG index has been about 35% over the past three years. To put that in perspective the S&P 500 index turnover has been about 5% over that same time period. With interest rates so low, companies have issued more debt to capitalize on lower financing costs. As new bonds are issued, they are added to the index. Likewise, as bonds cross inside one year to maturity or are called, they leave the index. A passive product has to sell bonds before they mature and buy the new issues coming to market, creating trading costs for the end investor.
More concerning, is that most investors that buy and hold a passive FI product may not realize all of the trading happening below the surface. The chart below illustrates the changes in the AGG’s duration since 2008.
*Source: Bloomberg Finance L.P., RiverFront. Past performance is no guarantee of future results. Shown for illustrative purposes only.
As you can see, the income (solid-line) generated from an AGG index like strategy has decreased, while the interest rate risk, as measured by duration (dotted-line), has substantially increased. We believe an active manager can help mitigate these risks.
Conclusion
For all the reasons discussed above, we believe active FI managers have a fertile field to deliver outperformance relative to passive products and that there are structural reasons to favor active over passive investing for your fixed income allocation.
This article was written by Rob Glownia, CFA, CFP, Assistant Portfolio Manager, and Tim Anderson, CFA, Chief Fixed Income Officer, at RiverFront Investment Group, a participant in the ETF Strategist Channel.
Important Disclosure Information
The comments above refer to generally to financial markets and not RiverFront portfolios or any related performance.
RiverFront Investment Group, LLC, is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). RiverFront also serves as sub-advisor to a series of mutual funds and ETFs. Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations.
RiverFront is owned primarily by its employees through RiverFront Investment Holding Group, LLC, the holding company for RiverFront. Baird Financial Corporation (BFC) is a minority owner of RiverFront Investment Holding Group, LLC and therefore an indirect owner of RiverFront. BFC is the parent company of Robert W. Baird & Co. Incorporated (“Baird”), a registered broker/dealer and investment adviser.