The Case For Active Bond Management by Carl Pappo, Columbia Management
- There have been instances where the passive approach to bond investing produced significant underperformance relative to a benchmark.
- Index funds are at a significant disadvantage to active portfolios in which managers incorporate valuation into their decision making process.
- The many nuances and inefficiencies of the fixed income market create both difficulties for indexing and opportunities for active management.
Investors have a number of ways to gain exposure to the fixed income markets. For those choosing to invest in a liquid and diversified portfolio, rather than building a portfolio of individual bonds, mutual funds offer a wide array of strategies. Of course, when selecting any mutual fund, investors must consider the various asset classes, investment objectives, risk profiles and tax implications among other key factors. A critical decision investors must make is choosing between actively managed and passively managed funds. There is currently $2.9 trillion invested in taxable bond mutual funds, including ETFs, of which $2.3 trillion is actively managed (Morningstar, June 2014). In this article, we will evaluate these two styles and build a case for the benefits of active management over passive/index strategies.
The objective of an index fund is to replicate the return of its stated benchmark. While this has proven to be a fairly easy task for the most popular equity indices, fragmentation and illiquidity in the bond market make true replication more difficult. A popular bond index, the Barclays U.S. Aggregate Index, has over eight thousand securities, many of which do not trade with reliable frequency. As a result, there have been instances where the passive approach to bond investing produced significant underperformance relative to a benchmark.
Index funds are defined by the strict boundaries of their stated benchmark, which eliminates active sector rotation and forces investors to rely on rating agencies for the securities held in the fund. As a result, index funds are at a significant disadvantage to active portfolios in which managers incorporate valuation into their decision making process. For example, the Barclays U.S. Aggregate Index requires two investment grade ratings from Moody’s, Fitch and/or Standard & Poor’s. When a company is downgraded below investment grade, all investment grade index funds are forced to sell at the same time, regardless of valuation. Furthermore, we have seen circumstances when rating agencies have been late to react to credit deterioration, leaving passive/index investors selling well after prices have declined. Additionally, the Barclays U.S. Aggregate Index is market value-weighted, meaning sector allocation decisions are determined simply by changes in outstanding market size. For example, the Treasury market grew from 20% in March of 2002 to 36% in June of 2014 (Exhibit 1). During that period, investors would have been better off with an underweight to the Treasury sector and overweight investment grade credit. Passive managers have been forced to continue to increase their allocation to Treasuries as the federal deficit swelled and was financed through the issuance of Treasuries.
Source: Barclays, July 2013
Unlike passive strategies, an active manager’s objective is to outperform the benchmark. They are able to do this by managing interest rate risk, identifying attractive sectors and utilizing fundamental research to drive security selection. Active management also allows the flexibility to capitalize when interest rates or credit spreads reach unsustainable levels. Portfolio liquidity can also be increased when necessary to limit overall risk exposure. Passive managers, on the other hand, lack the flexibility to proactively adjust the risk profile of the portfolio, regardless of technical and fundamental signals.
The Columbia Core Team utilizes an active management approach seeking to deliver strong risk adjusted returns, relative to our clients’ benchmarks. The team places heavy emphasis on bottom up security/company analysis to evaluate credit risk and valuation, actively managing portfolio sector weights and company exposures to deliver excess returns. We add value through investing in out of index securities (affording us the opportunity to invest in portions of the market that the passive managers are restricted from considering), focusing on high yield corporates, non-agency mortgages and preferred debt. Columbia Management proprietary fixed income research and trading teams are an integral part of our bottom up approach; these deep and experienced teams are significant contributors to our security selection process and our sector valuation work.
While passive funds may be appropriate in some asset classes, the many nuances and inefficiencies of the fixed income market create both difficulties for indexing and opportunities for active management. Over the long term, the benefits of portfolios actively managed by skilled portfolio managers have been shown to outweigh the higher fees typically associated with active management. When deciding whether to use active or passive funds for their fixed income allocation, investors should consider whether they are saving pennies in the short term at the expense of dollars in the future.
The Barclays Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity.
There are risks associated with fixed income investments, including credit risk, market risk, interest rate risk and prepayment and extension risk. In general, bond prices fall when interest rates rise and vice versa. This effect is more pronounced for longer-term securities.