Portfolio Construction Perspective: Active Fixed IncomeFeb 22, 2019

The Active vs. Passive Debate

Throughout the history of investing, there is probably not a more hotly contested or emotional topic than the debate of “Active versus Passive”. In my role as a Portfolio Construction Consultant, I spend a large portion of my day thinking about how this debate plays out in constructing portfolio effectively. In this article I want to provide context around why we see an opportunity right now to go active with the fixed income portion of your investment portfolios.

For the past 20 years, investors have been fully indoctrinated by the mantra that active mangers do not consistently outperform their passive indexing peers. But that isn’t necessarily true – particularly in the fixed income space. While the allure of low-cost exposure to a lower risk asset class like bonds may seem attractive, what many investors may not realize is that active bond managers have a much higher likelihood of outperforming passive benchmarks. Moreover, active management can help steer clear of several unintended risks that stem from how the passive indexes are constructed in the first place.

Passive performance during the Quantitative Easing Era

From the March 2009 market bottom right up until the end of 2018, hindsight tells us that a long only, low-cost beta strategy (for both stocks & bonds) would have generated exceptional returns with a below-average level of risk. Also, with the gift of hindsight, we can see the passive index strategies have been fully supported by the favourable price distortions caused by the massive quantitative easing program.

Although Quantitative Easing (QE) provided a nice tailwind to asset prices over the last decade, it appears the winds may now be shifting as QE is withdrawn and higher interest rates are implemented. In October 2018, we witnessed concurrent declines in stocks and bonds as interest rates increased and the Fed shrunk its balance sheet. With the QE program now being put into reverse (quantitative tightening), we believe equity and bond markets will remain susceptible to further valuation corrections and some portfolios may not be exposed to unintended risk.

When it comes to equities, investors generally brace for significant price fluctuations and the real potential for loss. However, they don’t feel the same when it comes to their fixed income. Fixed income is often employed as a volatility dampener, but this approach only works if stocks and bonds maintain a low level of correlation. The past 10 years have been an exceptional period with both equity and bond prices simultaneously benefitting from the combination of low interest rates and low inflation. With inflation now beginning to stir and interest rates poised to move higher, both equity and bond prices may be equally vulnerable as QE is unwound.

Active fixed income outperforms

Morningstar’s research team has found that over a 10-year period more than half (56%) of active Canadian fixed income managers were able to beat their benchmarks. Moreover, they also found that 70% of high yield managers (where discerning credit research is paramount) were able to beat their benchmark over all short, medium, and long time periods.1

So active bond managers have a track record of outperformance relative to many of the indexes that those managers are using as their benchmarks. In addition, the further we look beyond performance in core fixed income—in other sectors like high yield, global bonds and bank loans—the higher the probability of beating their benchmark.

Why is active fixed income different?

There are several reasons or “factors” that help explain the outperformance. The biggest factor comes from the credit research work that active fixed income managers engage in. Fundamental research helps them identify attractive valuation and opportunities that may not be reflected in the price of the bond Over time, this differentiation has usually been rewarded with higher returns than the market.

In addition to credit, some active managers manage interest rate risk via their duration calls and yield curve positioning. Yield curve positioning management has been a much more elusive factor to capture consistently, but managers getting it right have performed exceptionally well relative to their benchmarks. Momentum and Value are other factors that some active managers can take advantage of, but credit and duration management are the big two.

The problem with passive indexes

It’s also worth noting that sometimes active outperformance comes from the poor design of the passive indexes themselves. Most indexes weight securities based on market capitalization, and for fixed income indexes this means passive investors must hold more exposure to companies that are the biggest issuers of debt. Having higher (not lower) exposures to the most debt-laden businesses is generally a poor overall strategy that active managers can work to avoid. In Canada, the bond universe is concentrated with over 80% in debt issued by Government and Financials. Active management can avoid that sensitivity based on manager conviction.

Some experienced bond managers can actively take advantage of the non-homogenous nature of the various bond market participants. Unlike equity markets where there is one shared desire to generate the best risk adjusted returns, bond market participants can have different objectives. For example, some large insurance and pension funds are limited to certain maturities or credit qualities as they seek to immunize their liabilities. Additionally, as central banks rolled out their quantitative easing programs they effectively became market participants willing to “buy at any price”.

Active bond managers can gain an advantage by knowing there are both buyers and sellers with less price sensitivity. Incrementally, this advantage can help them outperform a passive benchmark. In the past 5 years, international flows into the Canadian bond market have more than doubled. Capital has come to Canada from low or negative yield jurisdictions in Europe and Japan seeking higher returns. Active managers took advantage of this inflow and they ought to be able to take advantage when the flows begin to reverse in the future.

Putting it all together

The first step in constructing a client's fixed income portfolio is to have a well-defined view of the macroeconomic environment, in addition to an accurate assessment of the client's own goals and their tolerance for risk. Constructing and optimizing any model portfolio requires that you fully understand how different products perform within different market and economic environments.

Deciding between active or passive is not a simple either/or type question for fixed income. We believe active security selection is appropriate for some sectors where the probability of relative outperformance is high and/or where specific risk tolerances need to be met. A combination of both active and passive approaches in fixed income can result in better outcomes for all of your models.

Lastly, we believe the portfolio construction process requires the implementation of a disciplined optimization routine. This framework enables you to properly assess the risk of the portfolio in a disciplined manner. Experience has taught our Portfolio Management team that employing a well-structured risk management discipline together with a security selection process based on broad practical experience will provide the client with the best potential of receiving above market long-term investment returns.

1Have Cdn Bond Managers Earned Their Keep? Morningstar Research 2015