Active vs. Passive in Fixed Income Funds

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1 Active vs. Passive in Fixed Income Funds White Paper February 2015 Not FDIC Insured May Lose Value No Bank Guarantee For Not financial FDIC Insured professional May Lose use Value only. Not Bank for inspection Guaranteeby, distribution or quotation to, the general public. INVESTMENT MANAGEMENT voyainvestments.com Voya TM Investment Management was formerly ING U.S. Investment Management

2 Table of Contents Executive Summary 2 Introduction 2 New Challenges in the Bond Markets 3 Problems and Limitations of Indexing 5 Cash Flows Suggest Investors Want High-Quality Active Managers 8 Active Bond Management Offers a Number of Compelling Advantages 9 Conclusion 11 Executive Summary Today s economic and market forces present threatening new challenges that are unlikely to be overcome by the mechanical portfolio construction of index funds. A complex, disparate bond market makes index replication a doubtful proposition. The lack of exposure to key debt market sectors makes most index funds incomplete solutions. Net flows show investors have preferred high-quality active funds over index funds. The average active bond fund has outperformed both index funds and ETFs. Given today s uncertainties, active bond funds offer compelling advantages. Introduction Today s economic and market forces present threatening new challenges for bond fund investors. Interest rates have trended lower for most of the last 30 years, enhancing fixed income returns, but the party may soon be over. Although yields are the dominant driver of bond returns, price fluctuations are the dominant cause of return volatility. The U.S. economy is growing at the fastest pace in many years. If growth is sustained, Fed accommodation will inevitably wind down, and rising interest rates will bring greater downside risk potential. On the other hand, if economic growth falters and interest rates remain low, credit spreads may widen, adding another potential risk dimension. Our view is that the challenges ahead call for active fixed income management in which experienced professional investors are on guard to protect the interest of clients. Index funds, in contrast, are a doubtful proposition at best; in the face of a complex, disparate bond market and uncertain macro environment, the rigid, mechanical portfolio construction that characterizes these funds puts them at a particular disadvantage. Over long time frames, active bond fund managers have generally outpaced the broad bond market indexes, and considerable evidence suggests that active funds should be the preferred choice in today s environment. 2 Active vs. Passive in Fixed Income Funds

3 New Challenges in the Bond Markets Financial market volatility, which was muted through most of 2014, is likely to increase as we approach an important turning point in this economic cycle. If economic growth is sustained and Fed accommodation winds down, interest rates and volatility are likely to climb. If growth falters, volatility may still rise as credit spreads widen. As can be seen in Figure 1, the Merrill Lynch Option Volatility Estimate (MOVE) Index, a measure of implied U.S. volatility, depicts the past few years as a fairly placid period during which volatility conditions have been comfortable for most investors. Figure 1. Relatively Placid Bond Market Volatility May not Continue MOVE Index of Implied Bond Volatility, Index Value /94 06/97 12/99 06/02 12/04 06/07 12/09 06/12 12/14 Source: Bloomberg, Voya Investment Management February

4 Meanwhile, increased financial regulations and other structural changes have raised the cost of maintaining inventories of financial assets, reducing liquidity. Market depth and the amount of fixed income assets that dealers are willing to hold on their balance sheets reached recent lows at the end of Sharp episodes of volatility as recent as October 2014 demonstrate what can happen when a thin market is forced to accommodate the unwinding of a major position. Low dealer inventories have reduced trading volume as traditional liquidity providers like broker/dealers and banks have become more risk-averse, making individual bonds more difficult to trade in the over-the-counter market. On balance, rising interest rates and/or rising credit spreads in the face of reduced liquidity will tend to increase bond market volatility. Figure 2. Broker/Dealer Inventories of Bonds Have Declined Dramatically Primary Dealer Holdings of Bonds $250, ,000 $ Millions 150, ,000 50, /04 10/05 08/06 06/07 04/08 02/09 12/09 10/10 08/11 06/12 04/13 02/14 12/14 Source: Bloomberg, Voya Investment Management 4 Active vs. Passive in Fixed Income Funds

5 Problems and Limitations of Indexing Given these challenges, index funds are unlikely to satisfy investors needs for a number of reasons. A complex, disparate bond market makes accurate index replication a doubtful proposition. An index such as the Barclays U.S. Aggregate Index, for example, is currently comprised of more than 9,000 holdings representing $17 trillion, a vast market of dissimilar securities traded over-the-counter. Although bonds may be conveniently classified according to three characteristics sector, credit rating and maturity in reality, there is enormous variety within the fixed income market, and even the broad market index funds, such as those based on the Barclays U.S. Aggregate, exclude many of the benchmark securities. Figure 3. The Bond Market Is Huge and Diverse, Defying Easy Replication Index # of securities % of index held in ETF S&P Dow Jones U.S. 1, S&P , Russell , Barclays U.S. Aggregate 8, Sources: FactSet, Dow Jones, Morningstar, Inc. Note: Holdings available as of November 2014 Bond sector returns within broad market indexes exhibit a wider array of nominal returns than many would believe, as shown in Figure 4. The average range of annual returns across sectors for the past eight years has been 19.9%. U.S. Treasuries were the best performer three times and the worst performer three times volatility that makes understandable the historic performance gap between active and index funds. Return diversity represents a significant sector allocation opportunity for active managers. Figure 4. Even Broad Bond Sector Returns Are not Homogeneous % 13.74% 58.21% C 20.40% 9.81% 15.81% 7.44% 7.46% 7.92% 9.08% C 28.45% 15.12% 8.15% C 10.04% C 0.23% 6.08% 6.97% 8.34% 24.72% 9.00% 7.84% 9.82% -0.27% 5.97% 6.90% 5.24% 18.68% 6.54% 6.23% 4.21% -1.41% 5.05% C 5.57% -4.94% 5.93% 5.87% C 6.02% 3.66% -1.53% C 3.86% 4.54% % 5.89% 5.85% 5.14% 2.59% -1.58% 3.65% 2.21% C % 1.95% 5.37% 4.98% 2.16% -2.02% 2.45% 1.83% % -3.57% % -2.75% 1.88% Source: Barclays. Past performance does not guarantee future results. Data represents returns of sectors within the Barclay s U.S. Aggregate Index and the Barclays U.S. Index. Investors cannot directly invest in an index. February

6 Further, an issue-size weighted index such as the Barclays U.S. Aggregate overweights the securities of the largest debtors, whose credit situations may make the efficacy of large positions questionable. While defaults have been relatively low in recent years, the economy is cyclical, and default rates will not stay low indefinitely. Is it prudent to overweight a bond portfolio in favor of the largest bond issuers solely because the index is constructed in that manner? Figure 5. Bond Index Sectors Are Heavily Weighted Toward Government Bonds Barclays U.S. Aggregate Sectors # of Issues Market Value (%) Market Value ($000s) U.S ,307,839,743 Government-Related 1, ,674,814,416 5, ,097,110,898 Securitized 2, ,529,042,391 Total 9, ,608,807,449 Source: Barclays Live, Voya Investment Management A byproduct of issue-size weighting is the Barclays U.S. Aggregate Index s position in government securities. While one might assume that government bonds have little or no downside risk that would be incorrect. The index s 45% weighting to government bonds offers historically low yield and outsized interest rate risk because the absence of default risk leaves no alternative sources of return, in effect, a pure, non-diversified interest rate play. Thus, the supposedly broad market index is skewed toward interest rate risk which only active managers may mitigate through sector allocation or duration management. The benefits of diversification in any asset class or investment process are well documented and hardly controversial. Diversification of sources of return is an indisputable advantage to active managers, who can mitigate interest rate risk by overweighting areas less sensitive to interest rate changes an option unavailable to index funds. Figure 6 shows the wide range of possible returns across fixed income categories in rising and falling interest rate environments. In the rising-rate period of 1994, the entire Barclays U.S. Aggregate had negative returns for the 12 months ended September 30, Only senior bank loans, a form of debt not included within the index had positive returns in both rising and falling interest rate conditions. An active manager s freedom to manage all risks interest rate, credit, country, currency, sector and issuer adds powerful diversification advantages even before manager skill is considered. 6 Active vs. Passive in Fixed Income Funds

7 Figure 6. Bond Sector Returns Vary Enormously in Different Interest Rate Scenarios 15.0 Rising Interest Rates 1-Year Return as of 09/30/ Year U.S bps U.S. IG Aggregate Total Return % Falling Interest Rates 1-Year Return as of 12/31/ Year U.S bps Global Agg Bank Loans Source: Morningstar, Inc., Voya Investment Management In fact, if we examine the average characteristics of relevant Morningstar bond categories, (see Figure 7), it s apparent that the typical active bond investor, on average, prefers about 14% less interest rate risk (effective duration of 4.78 years/5.55 years) and 38% higher yield (yield to maturity of 3.12%/2.25%) than an index fund can provide. Figure 7. Average Characteristics of Active Bond Funds Reflect Preferences of Investors Index/Category Name Morningstar Category Average Effective Duration Yield to Maturity Barclays U.S. Aggregate Bond TR USD Average U.S. ETF Intermediate-Term Bond Intermediate-Term Bond Average U.S. OE Intermediate-Term Bond Intermediate-Term Bond U.S. OE Bond Bond U.S. OE Bank Loan Bank Loan U.S. OE Bond Bond Source: Morningstar, Inc. The table also indicates how the Barclays U.S. Aggregate Index completely ignores important debt sectors, such as bank loans and high yield bonds to say nothing of inflation protected securities (TIPS), convertibles, emerging markets and non-u.s. dollar bonds. All of these can play key roles in adding incremental yield, total return and risk diversification. February

8 Cash Flows Suggest Investors Want High-Quality Active Managers Some observers have identified a trend of flows from active to passive fixed income funds for instance, investors abandoned PIMCO after the departure of key management personnel and reportedly parked their money in index funds or in cash. However, these events may not be as clear cut as they appear. The data below from Morningstar shows that investors continue to favor active funds over passive funds as long as they are perceived to be high quality as measured by the Morningstar star rating system. In fact, data show that over the last three years, actively managed funds rated five stars have gathered a majority of all the net flows in taxable bond funds. From this data it would seem that the majority of investors are really seeking high-quality management rather than a mechanical replication of the market s characteristics. Figure 8. High-Quality Active Funds not Index Funds Earn the Majority of Net Asset Flows Taxable Bond Funds 3-Year Net Flows by Morningstar Rating 200, ,000 Actively Managed Passively Managed 100,000 50, ,000 1-Star 2-Star 3-Star 4-Star 5-Star Source: Morningstar, Inc., Voya Investment Management 8 Active vs. Passive in Fixed Income Funds

9 Active Bond Management Offers a Number of Compelling Advantages If active bond funds are a better choice than passive ones it should be verifiable from performance comparisons between active funds and a suitable index as well as through the qualitative circumstantial evidence cited elsewhere in this paper. The conventional approach is to examine the median return from a fund universe. In an academic survey we might use a universe of all intermediate-term bond funds in Morningstar. However, for a business-oriented study some selectivity is appropriate to discard from consideration funds that would be unlikely to warrant inclusion in a professional fund search process: namely, small funds, unproven funds or those that simply are not managed to outperform a benchmark. Toward that end, our universe excluded index funds, enhanced index funds, funds with a track record of less than three years and funds with less than $500 million in net assets. We identified a number of characteristics of active funds, which together represent compelling advantages that the use of active funds has over index funds: Better long-term performance. Over the last ten years, the median active intermediate-term bond fund outperformed the Barclays U.S. Aggregate Index by 55 bps per year after expenses. Figure 9. The Median Active Fund Outperformed the Index Over the Last Ten Years Active Intermediate-Term Bond Funds Rolling 3-Year Annualized Returns, Barclays U.S. Aggregate 25th Percentile Median Manager 10-Year Average Returns Barclays Index % Median Fund % 25th Percentile % Q07 4Q08 4Q09 4Q10 4Q11 4Q12 4Q13 4Q14 Source: Morningstar, Inc., Voya Investment Management Note: The active fund universe included all funds in the Morningstar Intermediate Term Bond category, excluding index funds, enhanced index funds, funds with a track record of less than three years as of December 31, 2014, and funds with less than $500 million in net assets. February

10 Better recent performance. From , rolling three-year returns of the median active fund outdistanced the Barclays U.S. Aggregate Index and an average of three large bond market ETFs by 160 bps per year after all expenses. (The average ETF fund actually underperformed the index consistently by an average of 11 bps per year after expenses.) Figure 10. The Median Active Fund Outperformed the Average ETF by 160 bps per Year Active Intermediate-Term Bond Funds vs. ETFs Rolling 3-Year Returns, Rolling 3-Year Annualized Returns Median Active Fund beats Index 100% of the time and the average ETF fund by ~160 bps annually. Median Active Fund Barclays U.S. Aggregate Bond TR USD Average of 3 ETF Funds Source: Morningstar, Inc., Voya Investment Management Note: The active fund universe included all funds in the Morningstar Intermediate Term Bond category, excluding index funds, enhanced index funds, funds with a track record of less than three years as of December 31, 2014, and funds with less than $500 million in net assets. 10 Active vs. Passive in Fixed Income Funds

11 Better risk control. In Figure 11 each point represents the intersection of the return of the median bond fund and the Barclays U.S. Aggregate Index for a one-year period over the last 20 years. At the lower left we see the median active fund delivered an average of 59 bps of excess returns in down markets 100% of the time since 1998 which is particularly significant if downside risk increases going forward. Figure 11. Average Active Fund Outperformed in 100% of Down Periods for the Past 15 Years U.S. Intermediate Term Bond Median Fund Returns 1-Year Rolling Periods over 20 Years 25.0 U.S. Intermediate-Term Bond Median Fund Return Positive Excess Returns in Down Markets Average Excess Return of 59 bps in Down Markets Positive Excess Returns in Up Markets Negative Excess Returns in Up Markets Index Return Source: Morningstar, Inc., Voya Investment Management Note: The active fund universe included all funds in the Morningstar Intermediate Term Bond category, excluding index funds, enhanced index funds, funds with a track record of less than three years as of December 31, 2014, and funds with less than $500 million in net assets. Risk mitigation. Freedom to actively manage all risks interest rate, credit, country, currency, sector and issuer enhances manager ability to add value and enhance return consistency. For example, active management can mitigate interest rate risk through duration management and/or by investing in fixed income sectors with less interest rate sensitivity. Although index funds may be combined to balance and augment bond market exposures, only active funds can be blended to reduce active risk without reducing active excess returns offering potentially better mitigation of shortfall risks when other risky assets, such as equities, experience negative returns. Although active funds underperformed for some short periods (e.g., the credit crisis), judgments based on reasonably long time frames (see above) provide a more definitive picture. Excess returns are more valuable in a world of reduced nominal bond index returns 55 bps of excess return is 10% of 5.50% but 20% of 2.75%. Conclusion Barclays U.S. Aggregate Index Return The threat of rising interest rates, limited liquidity and other uncertainties has led investors to seek higher returns from bond investments and, at the same time, shelter from downside risks and potential capital losses. With its record of advantages over index funds, active bond management presents a potentially viable solution. February

12 Investment Risks There are no guarantees a diversified portfolio will outperform a non-diversified portfolio. All investments in bonds are subject to market risks. Bonds have fixed principal and return if held to maturity, but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates. All equity investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. Foreign Investing does pose special risks including currency fluctuation, economic and political risks not found in investments that are solely domestic. Emerging Market stocks may be especially volatile. Stock of an issuer in the Fund s portfolio may decline in price if the issuer fails to make anticipated Dividend Payments because, among other reasons, the issuer of the security experiences a decline in its financial condition. Securities of Small- and Mid-Sized Companies may entail greater price volatility and less liquidity than investing in stocks of larger companies. Diversification does not guarantee a profit or ensure against loss. Past performance does not guarantee future results. There is no guarantee that any investment option will achieve its stated objective. Principal value fluctuates and there is no guarantee of value at any time, including the target date. The target date is the approximate date when an investor plans to start withdrawing their money. When their target date is reached, they may have more or less than the original amount invested. For each target-date portfolio, until the day prior to its target date, the portfolio will seek to provide total returns consistent with an asset allocation targeted for an investor who is retiring in approximately each portfolio s designated target year. On the target date, the portfolio will seek to provide a combination of total return and stability of principal. Important Information This paper has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors. The opinions, views and information expressed in this presentation regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to daily change based on market conditions and other factors. Products and services are offered through Voya family of companies. Please visit us at for information regarding other products and services offered through Voya family of companies. Not all products are available in all states. This document or communication is being provided to you on the basis of your representation that you are a wholesale client (within the meaning of section 761G of the Act), and must not be provided to any other person without the written consent of Voya, which may be withheld in its absolute discretion. This material may not be reproduced in whole or in part in any form whatsoever without the prior written permission of Voya Investment Management Voya Investments Distributor, LLC 230 Park Ave, New York, NY Not FDIC Insured May Lose Value No Bank Guarantee For financial professional use only. Not for inspection by, distribution or quotation to, the general public. BSWP-ACTIVEFI

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