Investors are always looking for an edge. The hope is that they find one and are able to generate great returns while reducing their risk. It’s the holy grail of asset management, while also being the reason why active management remains popular with investors of all sizes. Finding that edge can be difficult even for the most professional investor.
But one area that active management can truly boost returns, provide lower risk and produce better overall results is in the world of fixed income.
Active bond management can have big benefits over indexing. Part of that reason comes down to how indexes are constructed in the fixed income world. With the surge in active ETFs covering bonds, investors now have a great, low-cost way to add this edge to their portfolios.
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Betting On Biggest Debtors
Passive investments are only as good as their underlying index. For the fixed income world, this poses a bit of a challenge. A broad stock index like the S&P 500 or Russell 2000 are market-cap weighted. That means the biggest stocks in terms of market capitalization are rewarded with more weight and a higher place in an index. In the case of the S&P, tech giant Apple (AAPL) makes up around 6% of the index, while small-fry retailer The Gap (GPS) only makes up 0.1%. Despite being broad, Apple’s higher weighting should influence the underlying index more than the GAP.
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Fixed income indexes are constructed in the same way.
Those firms, governments or agencies with the most debt get top billing in bond indexes. Despite covering the entire investments grade landscape, the benchmark Bloomberg U.S. Aggregate Bond Index has U.S. Treasury bonds and notes getting top billing because the U.S. government issues way more debt than the corporate world. When looking at corporate or high-yield/junk-bond indexes, the effect is the same. Telecom giant AT&T (T) has around $170 billion in debt on its balance sheet, while rival Verizon (VZ) has about $150 billion. As such, both firms are top holdings in the Markit iBoxx USD Liquid Investment Grade Index, which is the basis for many corporate bond ETFs.
The problem is, this is sort of counterintuitive. Debt isn’t necessarily bad on a balance sheet and certainly can be very useful for expansion plans/growth. However, when crafting bond indexes what we are effectively doing is rewarding firms that have taken out the most debt and have the worst balance sheets. Those at the top of the index have the most debt, while those at the bottom have the least.
If a firm with debts gets into trouble, sees lower sales, etc., a large debt load could be problematic for the company and underlying bond index.
Changing the Narrative
Active management in the fixed income space changes this script. Because they don’t have to track what the index says, managers can focus on a variety of other factors when making their portfolio selections.
For one thing, credit analysis can help unearth problems with a firm’s potential to repay their debts. Looking at various macro- and micro-economic factors can determine rates of cash flows, sales predictions, business trends and other forces that contribute to a company’s ability to cover their debts. This can also be done to overweight or underweight certain sectors of the market as we enter different portions of the business cycle.
This credit analysis can be taken a step further to help bond managers unearth potential values in the bond space. Extra yield can be had in these potential bargains without adding to the risk profile of the fund, which is similar to how value investing works with stocks.
Active bond managers can also manage duration and interest rate risk by tailoring their portfolios to the current and future predicted market environment, mitigating downturns when monetary policy shifts. Moreover, investors can go anywhere to choose the best bonds and fixed income investments from across the world to craft their portfolios.
All of this seems to work. A recent study by Morningstar showed that through 2018, actively managed fixed income mutual funds generated higher returns compared to passive funds during each of the one-, three-, five- and 10-year periods – and they did so in a big way. According to the study, the annualized returns for one year were 1.05% for actively managed bond funds versus negative 0.17% for passive bond funds. Looking out further, the three-year period was 2.98% (active) versus 2.82% (passive), 2.99% versus 2.49% for five years and 4.64% versus 3.71% for the ten-year period.
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Looking at Active Bonds for Your Portfolio
Given the outperformance and ability to navigate differently, investors may want to consider using an active strategy with regards to their fixed income allocations. With the number of active ETFs rising, investors have plenty of opportunities to take advantage of lower fees- which help boost returns further- and intraday tradability.
For example, the PIMCO Active Bond ETF (BOND) offers a broad, core choice for a fixed income sleeve. The SPDR Blackstone Senior Loan ETF (SRLN) could be used to boost income and add some rate protection, while BlackRock Short Maturity Bond ETF (NEAR) is a great cash alternative. These are just some examples, but they highlight the sheer number of active bond ETF choices out there.
Overall, active bond management plays a big role in outperformance. When you combine that fact with low-cost ETFs, the factor is multiplied. For investors looking at fixed income, using active strategies and ETFs makes total sense.
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