Some consultants are recommending that their clients move to passive fixed interest management. Is this a good time for such a move and what issues should be considered?
The answer is no and I will explain why.
The active/passive debate has been been around for some time; certainly since the mid-1970s when John Bogle started Vanguard Group and leading investment management thinker Charles D Ellis penned his award-winning article, “The Loser’s Game”.
The argument focused on the management of equities. Briefly, it made the point that the total return available to share investors, as a group, is the return companies earn on their assets. Share market prices reflect the collective judgment of what these future returns are currently worth.
The total return from investing in shares is given by the changes in market capitalisation over a particular period.
Investors can be split into two groups: those that invest passively (whose portfolio reflects the total market capitalisation index) and those that invest actively.
The additional costs associated with establishing and maintaining active equities portfolios ensure returns to active equities managers, as a group, are below those of passive managers, as represented by the market index.
The passive versus active argument for management of equities assumes there is an investable index that is a true reflection of the market.
With equities, this is relatively straightforward since it is possible to measure the total capitalisation of the share market at any time. For example, the S&P/ASX200 covers 78 per cent of Australian equity market capitalisation.
The logic underpinning passive investing in equity markets is not applicable to fixed interest markets.
The equity market is essentially exchange-traded; at any time there is a known number of shares outstanding, which are exchanged between buyers and sellers.
The fixed interest market, on the other hand, is essentially an over-the-counter market, with extensive use of derivative instruments to efficiently manage duration and credit risk without needing to sell the less-liquid physical underlying assets.
The share market is a deliverable market (sellers have to come up with the shares), whereas the fixed interest market is overwhelmingly a cash-settlement market (sellers don’t need to deliver underlying securities).
As a result of the high level of counter-party transactions, we really don’t know the extent of the fixed interest market. In short, it is quite possible (and highly likely) active fixed interest managers as a group will have a portfolio different to the index.
The most widely used index for the global fixed income markets is the Barclays Capital Global Aggregate Index. This index covers nearly 13,000 issues of investment-grade fixed interest securities with more than one year to maturity. Hence, it attempts to mirror the investable universe, but it doesn’t reflect the total market. As you would expect, it is dominated by the United States, Europe and Japan, and government-issued securities predominate.
As we know, we have had unusual times. Not often is the global banking system brought to the brink of collapse. Government bailouts varied among countries, depending on their banking system and their economy.
The reaction of the market to these events has had two phases: a flight-to-safety phase when investors sought the credit safety of government debt, and a stabilisation phase, when investors were able to assess credit risk in a more normal environment.
The flight-to-safety phase culminated in the bankruptcy of Lehman Brothers on 15 September 2008 and saw a large underperformance of credit issues relative to government bonds. There was then a period of bottoming while government bailout measures were put in place before the price of credit issues recovered from March 2009.
By the end of 2009, credit had fully recovered its underperformance and there was no difference in returns over the 18-month period.
The first quarter of this year has seen a continuation of this trend – with credit securities outperforming government bonds as investor risk appetite returns.
While the future is always uncertain, we can be confident about two things: economic growth will be slower than what normally happens after a recession and governments will need to issue a lot of bonds to fund their deficits.
This need for fresh funding, as well as the refinancing of maturing debt, is likely to put upward pressure on the interest rate that governments have to pay on their debt.
This will impact on the index in two ways: not only will there be more government debt to be funded, and its proportion of the index will increase, but the quality of that debt will deteriorate due to continued high budget deficits and worsening balance sheets.
A slow economic recovery will also impact on corporate credit. Net cash flows will not be as strong and, hence, corporate balance sheets will take longer to repair. As a result, there will be a need for accurate and insightful credit analysis.
Taken together, these considerations point toward the need for active management of fixed interest portfolios in the next few years as the world’s developed economies go through a painful de-leveraging phase.
