Six Reasons to Stay Active in Fixed Income

Transcription

1 June 2015 MONTHLY MARKET INSIGHT Six Reasons to Stay Active in Fixed Income Over the past several years, many individual investors have moved from active to passive fixed income strategies, assuming that the market offers limited alpha 1 opportunities, fewer idiosyncratic risks than equities, and is simply too efficient for active managers to exploit. Unlike equities, however, passive approaches have frequently underperformed active strategies in some areas of the fixed income market, and they tend to expose investors to several additional forms of potential downside risk. In this month s commentary, I will show that passive fixed income has underperformed and explain why active fixed income management can add value by aligning an investor s objectives with risks in several key areas divergence, debt, duration 2, downgrades, and dislocations areas in which index-tracking approaches tend to fall short. Nanette Abuhoff Jacobson Managing Director and Asset Allocation Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds Reason #1: Active Has Often Outperformed Advocates of index-replicating fixed income investment strategies argue that active managers cannot consistently outperform the Barclays U.S. Aggregate Bond Index (the Agg) 3, net of management fees. Yet active core-plus fixed income 4 approaches have fared well against the index over many time periods during the past 20 years. According to Lipper, the median active core-plus A mutual fund manager outperformed the Agg by margins of 100, 109, 110, 87, and 64 basis points (bps) 5 on an annualized net-of-fees basis over the 3-, 5-, 10-, 15- and 20-year periods ended March 31, 2015, respectively (Figure 1). FIGURE 1 Active Core Plus Managers Have Outperformed 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 3 Years 5 Years 10 Years 15 Years 20 Years 25th to 50th Percentile 50th to 75th Percentile Median Active Manager Barclays U.S. Aggregate Index Active core-plus and investment-grade corporate managers have demonstrated the ability to outperform over Annualized total returns, net of fees, as of March 31, 2015 Sources: Lipper, Wellington Management Past performance is not indicative of future results. Indices are unmanaged and not available for direct investment. 1 Alpha is a measure of the outperformance of a portfolio relative to its benchmark. various time periods. 2 Duration measures the sensitivity of the price of a fixed income investment to a given change in interest rates. 3 Barclays U.S. Aggregate Bond Index is representative of the broad U.S. bond market and is composed of securities from the Nanette Abuhoff Jacobson Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index. 4 Core-plus fixed-income is a fixed-income investment management style that permits managers to add instruments with greater risk and greater potential return to core portfolios of investment-grade bonds. 5 A basis point is a unit that is equal to 1/100th of 1%, and is 100% used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income Market-cap security. weighted A This is represented by Lipper s Core Plus Bond Funds category. These funds invest at least 65% in domestic investment-grade debt issues (rated in the top four grades) with any remaining investment in non-benchmark sectors such Equal-risk as high-yield, global weighted and NOT FDIC INSURED MAY LOSE VALUE emerging market debt. These funds maintain dollar-weighted 90% average maturities of five to 10 years. NO BANK GUARANTEE 1 80%

2 A similar pattern holds for investment-grade corporates B for several of these periods. Active managers outperformed their benchmarks over the past 15 years by between 3 and 88 bps, although performance lagged by 37 bps over the longer 20-year period. Much of active core-plus and active corporate outperformance is the result of managers tendency to be overweight in credit sectors (including corporate bonds and private-sector structured products such as asset-backed and commercial mortgage-backed securities), which have outperformed since the global financial crisis. Active managers may also use sector rotation, out-ofbenchmark allocations, duration positioning, and security selection to generate alpha. Global strategies can add value through country and currency selection. These levers can contribute to alpha and mitigate drawdowns during poor credit environments. As evidence, the top quartile active core plus managers have added alpha in over 90% of the past 20 years. A similar trend persists in investmentgrade corporates as the top quartile of managers added alpha in over 75% of the past 20 years. In high-yield, C active management has not fared as well, with the median manager turning in negative performance for most periods. I believe that this is because active highyield managers tend to be defensively positioned versus the index, and as a result, underperform when spreads remain unchanged or narrow, as has been the case since the global financial crisis. However, the top quartile of managers have produced alpha in over 70% of the past 20 years, indicating high-yield to be an area ripe for skilled active managers. Indexes Are Designed to Be Market Proxies, Not Investment Strategies The capitalization-weighted indexes that passive fixed income approaches typically seek to replicate, such as the Agg, are not constructed to meet investors needs. Rather, they are designed to be transparent, objective, replicable sets of securities that represent opportunity sets and summarize market information. Moreover, managing a portfolio to mirror a market index is more difficult than many assume. The standard fixed income market indexes or more precisely, the passive approaches that seek to closely mirror them have several shortcomings, including: Divergence Can fail to accurately mirror the target index Debt Concentrate exposure in the largest issuers of debt Duration Commit investors to substantial interestrate risk Downgrades Cost investors return due to mechanical rules on downgrades Dislocations Cannot take advantage of pricing dislocations I believe an investor s circumstances and goals should drive the composition of his or her portfolio, not an index provider s efforts to replicate a financial market. Any weighting scheme that excludes consideration of a market s duration, credit quality, volatility, and liquidity exposure is too narrowly based. Reason #2: Divergence Although investors assume that an index fund will mirror the index, this is not always the case, particularly in the high-yield market. The challenges of index replication are most evident among high-yield index-tracking exchangetraded funds (ETFs). Two high-yield ETFs have had dominant market shares since their launches in As of December 2014, these two large, prominent high yield bond ETFs held more than half of total U.S. ETF high-yield assets. However, nearly since their inception, these two instruments have fallen meaningfully short of the broad high-yield market, even on a gross-of-fee basis, as reported by Morningstar (Figure 2). These instruments target benchmarks that may lag the Barclays U.S. High-Yield Index 6 because of their greater relative liquidity; however, I believe it is appropriate to measure ETF returns and yields versus the broader index, as it is commonly used as a yardstick for the performance of high-yield portfolios. Not only have these ETFs underperformed this index but their yields are lower, and their tracking risk 7, a metric of price deviation, is quite high, further evidence that the underlying ETF assets are quite different from the index. The underperformance of these two ETFs versus the broad cash benchmark in the U.S. high-yield market does not extend to investment-grade securities, where returns of ETFs and relevant market benchmarks match much more closely. FIGURE 2 High-Yield ETFs Performance Can Differ Considerably From the Benchmark Barclays U.S. High Yield Corporate Index 11/30/2007* to 5/31/2015 Annualized Return % 8.77 ETF # ETF # * Earliest date that monthly data is available for both ETF #1 and ETF #2. The annualized return calculated based on total return assumes reinvestment of all dividends. Past performance is not indicative of future results. Sources: Morningstar, Barclays 6 Barclays U.S. High-Yield Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below. 7 Calculated relative to the Agg. Tracking risk measures the deviation in the performance of an investment relative to its benchmark. B This is represented by Lipper s Corporate Debt Funds BBB-Rated category. These funds invest at least 65% of their assets in corporate and government. C This is represented by Lipper s High Yield Funds category. These funds aim at high (relative) current yield from fixed income securities, have no quality or maturity restrictions, and tend to invest in lower-grade debt issues. 2

3 Reason #3: Debt By definition, the composition of capitalizationweighted fixed income indexes is biased toward the biggest debtors: the greater an issuer s debt, the larger its weighting in the index. Tilting a portfolio to emphasize a market s most heavily indebted borrowers 10% does not 10% typically align with an investor s objectives, as 9% a high 9% level of debt is often a sign of an issuer s weaker 8% credit 8% quality. 7% 7% One way an active manager 6% 6% can construct a portfolio with less risk than a cap-weighted 5% 5% benchmark is by equally weighting risk allocations 4% 4% to debt issuers. Figure 3, which is based on 3% an analysis of historical 3% data from the Barclays Global 2% Treasury Index 8 ex-japan 2% demonstrates the diversification 1% benefit of equally 1% weighting sovereign bond markets 0% by their estimated 0% volatility. The 3 Years top pie 5 Years chart illustrates 3 Years 10 Years 15 the Years actual 20 Years market-cap weightings of countries in the Index; the bottom pie chart illustrates an index which is riskweighted equally across countries. In the line graph, the light-blue line traces the potential decline in risk (volatility) as markets are added incrementally, diluting the impact of the 25th to 50th 25th U.S. to 50th and Euro area. Percentile Adding any asset with less Percentile than perfect correlation to an index will decrease 50th to 75th 50th the to 75th index s volatility because of the diversification Percentile Percentile benefit. Our research found that the resulting riskweighted Active 10-country Manager index is about half as risky (based Median Active Median Manager on estimated volatility) as a U.S.-only index and Barclays U.S. Barclays significantly U.S. less risky than the 10-market-capweighted Indexapproach. Aggregate Index Aggregate 5 Years 10 Years 15 Years 20 Years FIGURE 3 Equal Risk Weighting May Improve Diversification Market-Cap Weighted Total Estimated Risk (Volatility) as % of a U.S. Treasury-Only Portfolio o P D D N K US Euro GBP CAD AUD MXN DKK PLN ZAR SEK Equal-Risk Weighted 100% n United States n Euro area 90% n United Kingdom n Canada 80% n Australia n Mexico n Denmark 70% n Poland n South 60% Africa 100% Market-cap weighted Market-cap weighted Equal-risk weighted Equal-risk weighted 90% 80% 70% 60% n Sweden 50% 50% Number of Markets Included Pies represent the market-value distribution of the market-cap-weighted and risk-weighted versions of the Barclays Global Treasury Index ex-japan as of June 30, In the lower pie chart, risk is defined as total return volatility based on Wellington Management s estimates and analysis. Total returns are currency hedged to USD. Data displayed in the right-hand chart shows Wellington Management s estimates of volatility using the historical annualized volatilities of monthly yield change of the subcomponents of the Barclays Global Treasury Index ex-japan, January 2005 June Actual volatility and risk may vary, perhaps significantly, from the data shown above. Past performance is not indicative of future results. Sources: Barclays, Wellington Management U.S. Treasury securities are backed by the full faith and credit 5.5 of the U.S. government as to the timely payment of principal and interest. Fixed-income investments are subject to interest-rate risk, credit risk, liquidity risk, 5.5 and call risk. Foreign investments are subject to additional risks. Diversification does not ensure a profit or protect against a loss in a declining market. See page 8 for additional information. IMPORTANT: The investment model results used in this paper are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Forecasts and model results are inherently limited and should not be relied upon as indicators of future performance. 8 Barclays Global Treasury Index tracks fixed-rate local currency government debt of investment grade countries. The index represents the Treasury sector of the Global Aggregate Index and currently contains issues from 37 countries denominated in 23 currencies. The three major components of this index are the U.S. Treasury Index, the Pan-European Treasury Index, and the Asian-Pacific Treasury Index, in addition to Canadian, Chilean, Mexican, and South-African government bonds. The Barclays Global 4.5Treasury Index excludes Japan because of the outsized weighting Japan would have in the index, given its large outstanding debt and the debt s unusually low volatility. 4.5 Years Years

4 Market-cap weighted Reason #4: Duration Equal-risk weighted 90% Fixed income markets have grown rapidly since the peak of the financial crisis, thanks to robust issuance by private-sector borrowers 80% seeking to take advantage of cheap longer-dated funding. From December 2008 through January 2015, the Agg increased by 58% to over $18 trillion. 70% Heavy issuance of bonds at lower yields and longer maturities has lengthened the duration of the broad market indexes. During the 60% same period, the duration of the Agg rose to 5.4 years, above its 20-year average of 4.7 years (Figure 4). Years Source: Barclays 100% 50% FIGURE 4 The Duration of Broad-Market Indexes Has Been Rising Barclays U.S. Aggregate Index n Duration n Average Duration Over the Period Investors in passive strategies tracking the Agg are taking on increasingly longer duration, effectively betting on a continuation of lower rates whether or not that is their intention. For investors concerned about the impact of rising rates on their fixed income holdings, greater sensitivity to changes in interest rates may be counterproductive, exposing them to significant downside risk. Active managers, who typically have the flexibility to manage duration risk, can add value by anticipating interest-rate moves and making changes accordingly Reason #5: Downgrades Index vendors rules about credit downgrades can also cause passive strategies to underperform versus active strategies. In the Barclays Investment-Grade Corporate Index 9,securities downgraded to high yield by at least two of the three primary credit-rating agencies (Standard and Poor s, Moody s, and Fitch) exit the index by the end of the month in which they were downgraded. Because many active managers identify deteriorating credits through rigorous fundamental research before the rating agencies announcements, the market re-prices these bonds lower before the actual downgrades. Consequently, the indexes and any passive funds tracking them are often forced to sell the bonds after they have already fallen in price. Reason #6: Dislocations The global fixed income market is complex. Distortions can and do occur, causing significant volatility for passive investors, but creating opportunities that skilled active managers can exploit. Lack of liquidity, quantitative easing, and market segmentation are just a few of the factors that can cause dislocations. I believe that poor liquidity was the main driver behind the unprecedented spread widening in investment-grade and high-yield corporate bonds that occurred during the global financial crisis. In response, tighter regulations on banks were imposed, which have had the unintended consequence of exacerbating illiquidity, particularly in credit sectors. Active managers have been able to benefit from this lack of liquidity by acting as liquidity providers, purchasing higher-yielding corporate bonds at steep discounts when others are desperate to sell them. The quantitative easing programs launched by global central banks in the wake of the crisis have also been important asset-price drivers. The resulting declines in yields and narrower credit spreads have boosted the performance of active managers relative to passive managers, mainly because active managers can employ duration and credit positioning while passive approaches cannot. Finally, active managers can take advantage of market inefficiencies caused by market segmentation. For example, BB-rated securities are neither part of the investment-grade universe nor are they high yielding enough to garner much demand from high-yield investors. Without a natural buyer, their spreads tend to be high relative to their credit risk, providing savvy active managers another potential opportunity to outperform. 9 The Barclays Investment-Grade Corporate Index includes dollar-denominated debt from U.S. and non-u.s. industrial, utility and financial institution issuers. Subordinated issues, securities with normal call and put provisions and sinking funds, medium-term notes (if they are publicly underwritten) and 144A securities with registration rights and global issues that are SEC-registered are included. Structured notes with embedded swaps or other special features, as well as private placements, floating-rate securities and eurobonds, are excluded from the index. 4

5 Conclusion Active core-plus and investment-grade corporate managers have demonstrated the ability to outperform over various time periods. Many index trackers have exposures that investors may not want or be aware of, which can cause them to deviate from and often underperform the index they are supposed to mirror. Capitalization-weighted indexes are heavily exposed to the most heavily indebted issuers, which may be at odds with investors objectives. The fixed-income indexes commonly used as portfolio benchmarks expose investors to potentially costly index rules that force sell issues falling below investment grade. Active managers have more flexibility on the timing of trades and can often stay ahead of these situations. Finally, active managers are able to use market dislocations and inefficiencies to their advantage, whereas passive approaches must simply ride them out and endure the volatility they cause. 5

6 Notes: 6

7 Notes: 7

8 HARTFORDFUNDS Our benchmark is the investor. Hartford Funds believes that a mutual fund provider should deliver more than performance alone. That s why we developed human-centric investing: an approach that considers the emotional relationships between you, your money, and your financial advisor to ensure that your personal needs and wants are reflected in your investments. Human-centric investing: Meets challenges with insight You will face many challenges on the way to achieving your investment goals, and how you react can determine your success. That s why we partner with research institutions such as MIT AgeLab to develop deep knowledge of investors and the constantly changing markets in which they invest. The insight we bring to you and your financial advisor helps you make confident, informed decisions together. Builds strategies for today s investor We design, develop, and distribute actively managed funds that seek to address your needs, including growing your wealth, dealing with volatility, and generating retirement income. Nearly all of our funds are sub-advised by Wellington Management, one of the nation s oldest and largest investment managers. Investors should carefully consider the investment objectives, risks, charges, and expenses of Hartford Funds before investing. This and other information can be found in the prospectus and summary prospectus, which can be obtained by calling (retail) or (institutional). Investors should read them carefully before they invest. All investments are subject to risks, including the possible loss of principal. Fixed-income investments are subject to interest-rate risk (the risk that the value of an investment decreases when interest rates rise), credit risk (the risk that the issuing company of a security is unable to pay interest and principal when due), liquidity risk (the risk that an investment may be difficult to sell at an advantageous time or price), and call risk (the risk that an investment may be redeemed early). Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Investments in foreign securities may be riskier than investments in U.S. securities. Potential risks include the risks of illiquidity, increased price volatility, less government regulation, less extensive and less frequent accounting and other reporting requirements, unfavorable changes in currency exchange rates, and economic and political disruptions. These risks are generally greater for investments in emerging markets. The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice or as the views of Hartford Funds. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. Hartford Funds are underwritten and distributed by Hartford Funds Distributors, LLC. Hartford Funds Management Company, LLC is the Funds investment manager and the Funds are subadvised by Wellington Management Company llp. Wellington Management Company llp is a SEC-registered investment adviser and is unaffiliated with Hartford Funds. Hartford Funds does not distribute or underwrite ETFs. Any references to ETFs are for illustrative purposes only All information and representations herein are as of 6/15, unless otherwise noted MFGS_0615 hartfordfunds.com hartfordfunds.com/linkedin