Passive Investing May Not Work For Fixed Income. But What Does?

Passive Investing May Not Work For Fixed Income. But What Does?
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Gene Tannuzzo explains why a strategic beta approach makes a lot of sense in fixed income, particularly relative to traditional passive strategies.

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Passive investing poses a tremendous risk in the fixed-income market, says Senior Portfolio Manager Gene Tannuzzo. A traditional bond index is weighted toward the most indebted issuers and may not provide the risk diversification investors need. Tannuzzo describes a strategic beta approach as an alternative — one that uses rules-based filters to target a better balance of yield, quality and liquidity.

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In the fixed income market, I think passive investing actually poses a tremendous risk.

There has been a shift from active to passive investing across asset markets. So over the last year we've seen over $70 billion move into passive strategies that track the Bloomberg Barclays U.S. Aggregate Index.

I think it's important for investors to understand what that index is. Often it's tempting to think about that as “the S&P 500 of bonds,” but I think investors need to understand that bond indices are built a bit differently than equity indices. You get the largest exposure to the most indebted issuers.

So let's think about what that means for the U.S. Aggregate Index. For example, the U.S. Treasury had $9 trillion of public debt outstanding before the financial crisis. Today it has $19 trillion. So that has more than doubled, and that exposure is directly reflected in the exposure in passive fixed income indices like the U.S. Aggregate. So, for example, the U.S. Aggregate Index is very concentrated in interest-rate risk. Most of its returns are explained by changes in government bond yields. It's not really a diversified or “aggregate” exposure really at all.

Traditional fixed income benchmarks were never meant to be portfolios.

I think a strategic beta approach makes a lot of sense in fixed income, particularly relative to traditional passive strategies. A few elements that really benefit a strategic beta, fixed income approach are the ability to widen the opportunity set and apply a more constructive, smarter filtering to that process than you would see in a traditional benchmark.

You want to start with income, and you want to really filter and sort by yield, but then you realize that that can, on its own, push you pretty far out the risk spectrum. So after you sort by yield, you really want to filter then by quality. Quality filters allow you to remove tail risk from the market and from the portfolio so you're not buying the riskiest issuers or the riskiest companies. And then after that, I think it's very important to have a liquidity screen, and really focusing on liquidity allows the process to be repeatable. Because if bonds are liquid, it means that we know we'll be able to find bonds, and be able to put them in a portfolio, and repeat that process over again.

Article by Gene Tannuzzo, CFA - Columbia Threadneedle Investments

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