When it comes to equity markets, it appears active US large cap managers in particular seem to struggle to outperform comparative passive strategies after fees.
Are the fixed income folks smarter and better at what they do than their equity counterparts? As a fixed income person it would be nice to think that, but unfortunately it’s not the case. In our estimation there are six key drivers of outperformance in this sector:
As the old joke goes, “What’s the difference between a bond and a bond trader? A bond eventually matures”. Funnily enough it’s the ongoing bond maturities and subsequent issuance of new bonds that help make a compelling argument for active bond portfolio management.
Most bonds are issued with a final maturity date which means new bonds have to be issued as those older bonds mature. Issuers usually sell those bonds at a discount (higher yield) in order to attract demand.
Active managers tend to drive this process. Pure passive managers by contrast will often buy the new bonds only once they enter their relevant index at higher prices (lower yields) than where the active managers purchased them. This process is repeated many times a year and contributes to active manager outperformance.
By some estimates, new issuance makes up about 20 per cent of bond market capitalisation annually as compared to about 1 per cent in equity markets. Its easy to see how this can contribute to outperformance over a pure passive strategy.
Another major driver of relative outperformance is a larger potential investment universe. There are many pockets of fixed income securities that simply do not appear in actively followed indices. By one estimate, approximately two-thirds of the investable universe in the US is not covered by a major index.
In Australia for instance, there is no widely recognised index for residential mortgage backed securities, despite the market being very large and widely followed by active fixed income managers. Any passive manager only following the major indices would miss out on the asset class entirely.
More Credit Risk
Another reason we believe many active managers outperform is by taking more credit risk. Indices are constructed with specific rules that only look at a portion of the universe. One common rule is a minimum credit rating of the securities that make it into the index.
Active managers will frequently allow their portfolio to take more risk than the index through time by overweighting riskier securities. Assuming the issuers don’t default, higher risk/higher yielding securities are guaranteed to outperform lower risk/lower yielding securities given the contractual obligations to pay higher coupons.
This is a simple way for active managers to systematically outperform an index over time. It also means when evaluating active managers investors should be very mindful of how much risk is embedded in their portfolios not just the absolute level of returns
Another major driver of active outperformance is the ability to position for the market environment and target specific risks. As an example, the vast majority of bonds issued globally have a fixed coupon rate and therefore a long duration position. Which means those bonds will perform poorly as interest rates rise.
Active managers can hedge or reduce this risk when it appears likely interest rates are set to rise. Given that many passive strategies follow indices with long duration, we would argue that active manager outperformance would have been even higher over the last 10 years if we had been in a rising rate environment.
There is a large pool of non-economic buyers in the fixed income markets, especially with respect to government bond markets. Non-economic buyers are not necessarily trying to maximise risk adjusted returns and are therefore much less price sensitive. Central banks may buy bonds to weaken their currency, boost inflation or stimulate growth. Insurance companies may be forced to buy bonds for asset-liability matching purposes, while banks may be forced to hold government bonds for liquidity and regulatory reasons. This activity by non-economic (less price sensitive) participants creates opportunities for active managers. By some estimates non-economic investors make up approximately 50 per cent of the global bond market.
Active equity managers tend to charge a higher fee than active fixed income managers. This means they have to outperform by that much more to beat their passive peers. According to data from Morningstar, average active equity fund fees are about 18 basis points higher than average active bond fund fees.
While passive management does seem to make sense in some equity markets, we do struggle to see a compelling argument for passive management in fixed income when better performing active strategies are so readily available, particularly in a low-interest rate environment. We would caution that, in our opinion, not all active management fees are fully justified, but in the main we do believe it’s a better hunting ground for investors looking for value for their management fee dollars.
Mark Mitchell is director, porfolio manager – credit at Daintree Capital
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