By Luis Maizel
Co-Founder and Senior Managing Director, LM Capital Group
Should investors prefer active fixed income investment management strategies over a passive fixed income investment strategy?
LM Capital Group believes that actively managed fixed income investment management strategies may meaningfully impact investors’ portfolios in five ways:
- Active Management Has Historically Outperformed Passive Investing
- Active Management Can Manage Duration
- Active Management Can Mitigate Risk
- Active Management Can Allocate Meaningfully
- Active Management Provides Broad Market Opportunities
Active vs. Passive Investing
R-I-S-K. In the world of investments, it’s the four-letter word we each try to minimize. Active fixed income investment management has the ability to reduce some or most of the risks that often unknowingly plague passive investors.
Yet investors have piled into passive fixed income portfolios since the global financial crisis of 2008. As of December 31, 2016, the percentage of net assets in all U.S. passive taxable bond funds was 27%, according to Morningstar. By contrast, U.S. passive taxable bond funds comprised only about 11% of the total U.S. fixed income taxable universe ten years earlier.
In 2016 alone, investors put $147.8 billion into passive taxable bond funds and $46.3 billion into actively-managed taxable bond funds, according to Morningstar.
While passive investing has its potential positives—low fees, transparency, tax efficiency, and indexing—the strategy carries its own risks.
When the investment seas get rough the experience and judgment of an active portfolio manager is going to matter.
Active Fixed Income Management Has Historically Outperformed Passive
A passive fund can match the market—but it will rarely beat it. According to research by Morningstar, for the five years ended December 31, 2016, sixty-five percent of active fixed income managers outperformed their benchmarks, net of fees. For the same time frame, only 37% of passive fixed income funds outperformed their benchmarks.
The median active fixed income manager has outperformed the median passive manager by about 50 basis points over the 10 years ended 2016, net of fees, according to Morningstar. When compounded over time, this differential has produced meaningful long-term growth for active investors.
Active Fixed Income Management Can Manage Duration
In an actively managed fixed income investment strategy, three factors control performance:
- Duration position
- Sector allocation
- Security selection
By far, the duration decision can impact performance the most. Duration is a clear way of measuring how much bond prices are likely to change if and when interest rates move. In technical terms, duration is measurement of interest rate risk.
Active managers who see a general cyclical or secular trend in interest rate movements, for example, can be more aggressive or defensive as appropriate with the duration decision.
If we expect interest rates to rise, we may focus on shorter-duration investments —those that generally have less interest-rate risk. Can passive portfolios do the same?
Active Fixed Income Management Can Mitigate Risk
Actively managed bond strategies can focus on risk and potentially produce favorable risk-adjusted returns by balancing:
- Inflation risk
- Interest rate risk
- Credit risk and
- Currency risk
Active managers can position portfolios for potential risks inherent in the movement of inflation, interest rates, credit, and currency. Passive managers, by contrast, can stand by.
Active managers understand that markets are not completely efficient, setting the stage to capture opportunities for investors. In addition, while passively managed index funds may rebalance on a regular schedule, this rebalancing may expose passive portfolios to price inefficiencies, style drift, and size drift.
Active Fixed Income Management Can Allocate Meaningfully
Active fixed income managers can potentially add value that passive people can’t. Passive investors automatically give up the ability to take advantage of the following.
Global Macro Changes. What if the Federal Reserve raises rates faster than expected? What if job creation remains above 200,000 per month, and hourly earnings move up further? What if Venezuela defaults? Active managers can proactively respond to potential global economic, political, and social events and their impact on client portfolio. By contrast, passive investors cannot respond.
New Offerings. While active bond managers can participate in new offerings, passive investors are on the sidelines. What’s more, passive fixed income fund investors typically can’t participate in any concessional pricing of new bond offerings to spur demand. Passive investors may have to wait to buy the bonds when they are listed in an index—often, according to Barron’s, at a higher price.
Flexibility. Active asset managers can over weight or underweight sectors, securities, and duration. In a rising interest rate environment, for example, Treasury, agency, and corporate sectors typically underperform; active managers can underweight those areas quickly, while passive managers would need to wait until the next re-balancing. Unlike their passive counterparts, active managers can also use derivatives to address and mitigate portfolio risk.
Individual Security Selection. Most active portfolio managers regularly seek to identify “mispriced securities.” These mispriced securities are often opportunities that passive managers cannot take advantage of—by definition.
Short-Term Price Movements. Unlike stock indexes, bond indexes change composition frequently. Active investors may benefit from temporary moves caused by passive investors forced to comply by the dictates of being in an index. (Source: Barron’s.)
Active Fixed Income Management Can Provide Broad Market Opportunities
With passive investing, no one examines the balance sheets, considers what-if scenarios, and thinks about major risk factors.
A core fixed income portfolio typically consists of U.S. Treasury securities, U.S. government agency bonds, U.S. mortgage-backed securities, and corporate securities.
Active managers who invest in more than those core fixed income securities—such as high yield bonds, global emerging market bonds, and non-agency mortgage-backed securities—can both spread investment risk while seeking higher long-term returns.
However, there is no multi-sector passive fixed-income fund that reflects the typical market exposure of an actively managed fixed-income strategy. It just doesn’t exist.
We believe that fixed income investors should actively pursue opportunities in active investment portfolios.
In summary, actively managed funds—with carefully researched security selection, risk management, competitive fees, and low turnover rates—have historically outperformed passive portfolios, and can help manage portfolio duration, mitigate risk of loss, allocate broadly and meaningfully, and provide superior risk-adjusted returns.
Statements herein by LM Capital are on its expectations, estimates, projections and opinions and involve known and unknown risks, uncertainties and other factors, or are otherwise forward-looking statements. Actual events or results may differ materially from those reflected or contemplated in such statements. In addition, certain statements contained herein are from, or based on data from, sources or data presumed by LM Capital to be reliable, including Morningstar and Barron’s, and LM Capital makes no representation or warranty, express or implied, with respect to their accuracy, timeliness or completeness. Accordingly, LM Capital expressly disclaims any responsibility or liability for any loss or damage that may be incurred by any party who relies on the written materials contained herein.
Investing in securities, including fixed income securities, involves risks. You may lose some, a significant portion of or all of your investment.
The performance comparisons contained herein between active and passive fixed income investing represents comparisons of past performance, and there is no guarantee that future results will be similar.
The information contained herein is being provided for discussion purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any securities. It also does not constitute a solicitation for LM Capital’s investment advisory services.
LM Capital is registered with the SEC as an investment adviser. SEC registration does not imply any certain level of skill or training.