Three Challenges Facing Passive Fixed Income Funds

    Ahmed Farooq, CFP, CIMA®

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    We are on the tail end of a 30-year bull market for bonds. This unusual period of sustained growth was facilitated by both a low interest rate and low inflationary environment. Today, changes in monetary, fiscal and trade policies, as well as higher asset correlations present threatening new challenges for fixed income investors. These emerging dynamics underlying the market mean that investors need to be more cautious and meticulous when selecting which fund is right for their portfolio.

    Three challenges with passive indexed funds

    The average investor may not be aware of the risks and potential unintended consequences that are built into fixed income indices. I believe the following three major challenges faced by fixed income indexing can be resolved by investing with active managers that are working to mitigate these risks.

    Challenge #1 - Indexes are weighted towards big debtors

    A typical equity index is weighted by market capitalization, typically a measure of company size, if not company health. While this may come with its own set of flaws, bond indexes are issuance-weighted. This means that fixed income indexes place larger relative weight with those companies or governments that issue the most debt.

    A case in point is the Citi World Government Bond Index (WGBI): 78% of the index is made up of just five countries, and their average debt-to-GDP ratio, or government borrowings less repayments, is over 126%. Paradoxically, the remaining 17 countries in the index combined make up only 22% of the index, and their average debt-to-GDP ratio is 65%!1

    Fixed Income Indexes

    So the holdings of many passive fixed income funds have become disproportionately represented by issuers with the highest debt loads. Makes you wonder whether it is wise for these funds to boost their holdings simply because the company or country exhibits extensive financial leverage. Furthermore, would investors make that same decision themselves if the funds they are invested in didn’t force their hand?

    Challenge #2 – Index composition is “passively” driven by market forces

    A passive product must follow index reconstitution, irrespective of investment merit or market insight. For example, the Canadian bond market is dominated by government bonds On the other hand, an active manager can work to mitigate the shifts that may drive or change the risk/reward profile of a portfolio based on their research.

    Passive Products Must Mimic the Index

    1 Source: FactSet 12/31/2018 Average debt-to-GDP ratio is a 2018 estimate. IMF WEO October 2018.

    Challenge #3 – Indexes may not align with investors’ goals

    Bond markets have many different participants who have many different reasons for buying. Almost 50% of the $100 trillion in global fixed income assets is held by central banks and those trying to influence foreign exchange rates and adjust money supply. The goals of these market participants may not always align with the goals of Canadian investors seeking diversification, income and/or total returns. As a result, bond indexes can be shaped by many disparate forces, many of which are not relevant to the average investor.

    A case in point is that, as of December 31, 2018, almost 15% of the Bloomberg Barclays Global Aggregate Bond Index is comprised of negative interest rate bonds . This means that instead of receiving interest, the investor is essentially paying the issuer interest for the right to lend them their money. How many investors would choose to purchase bonds with negative yields? Not many, yet frequently managers of index funds must also own those bonds simply because they are held by the indexes they track.

    Actively managed fixed income has outperformed recently

    Knowing the perils of today’s market environment along with the flaws inherent in fixed income indexing, active managers have leveraged their experience and expertise with success. The capability to seek out the best opportunities and be flexible in order to meet investor needs is what makes them different. By aligning goals, having personal relationships with issuers and, most importantly, using a variety of strategies to implement their market views and position their portfolios to add value, active fixed income ETFs have actually performed better than their passive counterparts.

    Data compiled by Franklin Templeton shows that rolling 1-year returns of all actively managed ETFs within the Canadian fixed income categories outperformed 83% of the time against the FTSE Canada Universe Bond Index over the 24-month period ending December 31, 2018.

    Passive Products Must Mimic the Index

    Investors can rely on fixed income experts

    The senior investment professionals and fund managers at Franklin Templeton base their decisions on each investment’s inherent potential for strong risk-adjusted returns. They aren’t constrained to the size limitations of the specific index weightings. As active managers, they have the flexibility to decide to invest outside the benchmark as well as over/underweight positions relative to the benchmark if their bottom-up analysis dictates it’s a better position. Simply put, investors who rely on the expertise of active managers can rest easy knowing that their portfolios are positioned for changing market conditions.

    Source: Bloomberg