Global Investing: The Price You Might Pay for Going Passive

Robert O. Abad

Executive Summary

  • The global bond market has grown dramatically over the past 20 years and now offers investors a much richer universe of investment opportunities from which to choose.
  • We believe active management is the most effective way to capture the return and diversification benefits of global bonds.
  • While a passive approach may make sense for highly liquid and well-researched markets, extending this approach to less transparent and less liquid markets means foregoing numerous opportunities to enhance portfolio returns and manage portfolio risk.

Introduction

We believe global bonds should have a role in your broad investment portfolio. The global bond market has grown dramatically over the past 20 years due to a number of secular forces and now offers investors a much richer universe of investment opportunities across a number of regions, sectors and currencies. In order to capture the return and diversification benefits of this market, however, we believe an active management approach is critical. While a passive approach may make sense for highly liquid and well-researched markets, extending this approach to less transparent and less liquid markets means foregoing numerous opportunities to enhance portfolio returns and manage risk.

Separating Signal From Noise

Since the 2008 financial crisis, investor interest in passive, index-linked bond strategies has mushroomed, with substantial flows moving out of actively managed strategies and into mutual funds and exchange-traded funds (ETFs). This herd mentality has been fueled in large part by financial pundits who assert that in today’s environment of low returns, active managers have limited opportunities to generate alpha, therefore actively managed strategies are not worth the higher cost.1 Such assertions have not only intensified the long-standing debate over “active versus passive,” but have also amplified the notion that ETFs are a low-cost and effective way to access investment opportunities across any market. In our view, investors should avoid being seduced by this siren song.

Passive strategies are grounded in the belief that markets are too efficient for active managers to reliably exploit over time. However, this disregards the obvious fact that markets vary considerably in terms of type, size, diversity and liquidity—key determinants of a market’s complexity and its potential for greater pricing anomalies, instability and technical noise. Indeed, while a passive approach may make sense for highly liquid and well-researched markets such as US large cap equities or US government bonds, extending this approach to less transparent and less liquid markets means foregoing numerous opportunities to enhance portfolio returns and manage portfolio risk. As illustrated in Exhibit 1, we believe that as a market’s complexity grows, so does the need for and value of active management—highlighting the importance of research and analysis, price discovery and negotiation, and risk management.

Exhibit 1
Conceptual Relationship Between Market Complexity and Active Management
global-investing-2017-03
Source: Western Asset

In our view, alpha generation through active management will be the key driver of total return performance going forward. The forces that drove the beta-generated performance of passive strategies over the past few years are waning (e.g., frequent central bank and government intervention and deeper global financial market linkages) as global macro conditions are now shifting and different sources of broad market risk are materializing (e.g., protectionism and populism).2 With this in mind, fixed-income investors looking to escape the gravitational pull of low returns from traditional asset classes should consider an allocation to global fixed income, which offers compelling return and diversification benefits.

Surveying the Global Landscape

The global bond market has evolved dramatically over the last twenty years. The accelerated pace of globalization and a growing demand for safe assets and income due to an aging population dynamic (particularly acute) in the developed world paved the way for a boom in first-time issuance by sovereigns and corporations globally. As a result, investors now have a much richer universe of investment opportunities across a number of regions, sectors and currencies from which to choose.

In developed markets (DMs), the opportunity set has expanded significantly to include corporate debt across the whole credit quality and maturity spectrum, bank loans, mortgage-backed securities, securitized assets, covered bonds and private debt. In emerging markets (EMs), newer asset classes such as “frontier market” debt3, corporate credit, local currency-denominated government debt and inflation-linked notes comprise a greater bulk of trading activity. We believe that as time passes, the breadth and depth of the global bond market will continue to attract more interest from retail and institutional investors as they begin to accept the opportunity cost of not diversifying globally.

The potential diversification power of global bonds can be seen in the wide dispersion of returns across investment-grade-rated global bond markets (Exhibit 2), and the varying degrees of correlations across a select number of global government bonds (Exhibit 3), all of which are a function of the differences in economic cycles, fiscal policies and central bank policies across countries.4 These findings should encourage investors to reevaluate continually the potential for home-country bias when considering their fixed-income allocations.

Exhibit 2
The Global Fixed-Income Landscape (Left)
Wide Dispersion of Returns Across Global Bond Markets (Right)
global-investing-2017-03
Source: Bloomberg Barclays. Investible universe represented by various Bloomberg Barclays indices. As of 31 Jan 17. (Left)
Source: Bloomberg, HSBC, JP Morgan, Western Asset. As of 30 Dec 16. Investment-grade indices. * Local EM index is USD unhedged and starts in 2008. (Right)
Exhibit 3
Correlations Have Varied Considerably Across Global Bond Markets (5-Year Monthly Returns)
global-investing-2017-03
Source: Bloomberg. As 31 Dec 16.

For investors with broad asset allocations, “going global” in fixed-income has historically provided the strongest portfolio offset when growth assets (e.g., equity) have disappointed. As Exhibit 4 highlights, global bonds, as measured by the Bloomberg Barclays Global Aggregate Index (Global Aggregate), can provide strong diversification benefits to domestic and global equities as well as other fixed-income asset classes.

Exhibit 4
Global Bonds Have Offered Strong Diversification Benefits (10-Year Monthly Returns)
global-investing-2017-03
Source: Bloomberg. As 31 Dec 16.

Avoiding the Landmines

In the same way that minefields carry the hidden dangers of landmines, portfolios that use a passive approach can expose investors to hidden dangers and costs. This is especially true when it comes to investing in global bonds. There are four important considerations to bear in mind:

1. Hugging a global fixed-income benchmark can inhibit longer term returns

Investors should bear in mind that the choice of benchmark is a critical part of the overall “beta” decision since it will heavily influence the risk and return profile of their portfolio. Within the global bond space, the Global Aggregate is the most familiar and most widely used benchmark.5 However, this index suffers from two major shortcomings:

  • Unlike equity indices where weights are market-determined (i.e. by fluctuations in share price), the Global Aggregate is constructed blindly on a market-capitalization weighted basis. Therefore, investors with a passive allocation to the index are biased to markets: a) with the highest outstanding issuance, b) whose prices and currencies have appreciated the most, and c) whose credit quality may be deteriorating (e.g., due to higher leverage or greater dependency on external financing). Note that the Global Aggregate has a heavy skew toward government bonds in the US, eurozone and Japan (approximately 80%); this is a result that has not changed much over the past 15 years.

Exhibit 5
Characteristics of the Bloomberg Barclays Global Aggregate Index
global-investing-2017-03
Source: Bloomberg Barclays. As of 31 Dec 16.

  • As a result of restrictive ratings and issuer eligibility requirements, the Global Aggregate excludes key parts of the broader investable fixed-income universe such as global high-yield corporate credit, global inflation-linked bonds and bank loans. Therefore, investors with a passive allocation to the index cannot participate in off-benchmark opportunities that offer less interest rate sensitivity and higher income and total return potential.

2. Replicating a benchmark is harder than it looks, and risks locking in underperformance

Fixed-income indices comprise a significantly greater number of securities relative to their equity counterparts, making it very difficult for a passive manager to build a cost-efficient, representative portfolio. The Global Aggregate, for example, has approximately 18,000 issues that span 70 domiciles and 24 currency markets. A passive manager trying to replicate this index would confront several headwinds, including but not limited to: a) higher transaction costs due to the dealer-driven (negotiated price) structure of the bond market; b) tracking error risk stemming from the greater frequency of issuers entering or leaving the index due to call features, maturities, debt buybacks, credit ratings shifts, etc. and c) exchange rate fluctuations when transacting in foreign currency denominated securities. To circumvent these issues, some passive managers utilize sampling techniques to break down the benchmark into a representative portfolio based on certain characteristics (e.g., sector exposure, duration, credit quality, etc.). However, these techniques can be unreliable given the complexity of a global fixed-income benchmark and may engender higher than expected tracking errors.

3. Be wary of the asymmetric duration risk that comes with global fixed-income benchmarks

Fixed-income strategies in general performed well since the 2008 crisis on the back of steadily declining yields in the US, slower global growth and diminishing inflation pressures. However, with markets pricing in the increasing probability of additional rate hikes by the US Federal Reserve this year, investors should be mindful that the Global Aggregate now offers significantly less yield buffer (or compensation) against interest rate risk. This should not be surprising. As highlighted in Exhibit 6, the bulk of index duration comes from the US and Japan, with the latter offering a zero to negative yield contribution.

Exhibit 6
Index Duration Dominated By the US and Japan (Left)
Compensation for Interest Rate Risk at the Lows (Right)
global-investing-2017-03
Source: Bloomberg Barclays. As of 31 Jan 17. (Left)
Source: Bloomberg Barclays. As of 31 Jan 17. (Right)

In our view, the most effective way to mitigate this risk (and improve portfolio yield) is to diversify duration in those markets where the interest rate cycle is stable or easing. This means being thoughtful about which countries to own and where duration is held along the yield curve. Given the substantial variance among the change and movement of absolute yield levels, slopes, and shapes of government bond curves, both within and across countries, an active manager can add value for investors by anticipating and capitalizing on these differences.

Exhibit 7
What Is the Better Choice – Unhedged or Hedged? (Comparative Annual Returns)
global-investing-2017-03
Source: Bloomberg. As of 31 Dec 16.

4. At the end of the day, currency risk can only be managed through an active approach

A major source of appeal for global bonds, in addition to coupon income and capital appreciation, is the incremental return that can be obtained from currency exposure. However, unlike income, which is a fixed component of a bond’s total return, currency moves are unpredictable with the potential of negatively impacting the value of income payments and amplifying bond price volatility. Therefore, investors need to be mindful of the risk-reward of investing in global bonds on an unhedged basis, where one assumes currency risk, or on a hedged basis, where one avoids currency risk.

A comparison of annual returns between the unhedged and hedged versions of the Global Aggregate suggests that the former may be the best option. However, when looking back over a 20+ year period, we would note that the volatility of the unhedged series has consistently been higher than the hedged series. As a result, the risk-adjusted return of the hedged series (as measured by the Sharpe ratio6) is much more attractive.

Exhibit 8
Hedged Bonds Produce Better Risk-Adjusted Returns Over Time (3-Year Rolling Sharpe Ratio)
global-investing-2017-03
Source: Bloomberg. As of 31 Jan 17.

This finding underscores two important points:

  • The outlook for major global currencies plays a key role in the choice of a hedged or unhedged global bond benchmark. For example, the US dollar rallied significantly during 1995-2001, experienced a period of sustained weakness during 2002-2013 and is now back at a 10-year high. The choice of the wrong benchmark, particularly at the start of a key inflection point, could result in serious performance challenges.
  • The benefit of hedging away currency risk does outweigh its cost (which is low given the breadth and depth of the forward currency market).

For investors looking to make a global bond allocation, we suggest using a hedged benchmark as a starting point and then allowing some currency latitude (i.e., the ability to go both long and short select currencies). A more active approach to currencies may moderately increase portfolio volatility, but will—over a market cycle—lower the correlation (and therefore improve diversification benefits) of the portfolio with other asset classes.7

To summarize, we believe actively managed global bond strategies have an inherent advantage over passive strategies in five key areas:

  1. The latitude to invest across the full spectrum of global interest rates and credit markets, including those that are off-benchmark
  2. The ability to rotate across sectors, i.e., overweight sectors that offer value or underweight sectors that are expected to lag
  3. The flexibility to tactically manage duration and yield-curve positioning to mitigate interest-rate sensitivity
  4. The ability to manage (and seek to exploit) currency volatility over different market cycles
  5. The flexibility to enhance diversification and complementary strategies within a portfolio

Given the complexity of global bonds and the numerous pitfalls associated with taking a passive approach toward this market, we encourage investors to look for an asset manager with: a) an active management philosophy, b) the global scale and resources, and c) a proven track record in successfully managing global portfolios (see Exhibit 9).

Exhibit 9
5-Year Investment Results (Left)
Global Core Plus Representative Account Performance Since Inception (Right)
global-investing-2017-03
Source: Western Asset. As of 31 Dec 16. (Left)
Source: Bloomberg, Western Asset. As of 31 Dec 16. (Right)

Conclusion

The forces that drove the beta-generated performance of passive strategies over the past few years are waning as global macro conditions are shifting and different sources of broad market risk are materializing. In our view, active management will be essential to: a) navigate through the complexity of global bond markets, b) overcome the investment limitations associated with passive strategies, and c) generate alpha which will be the key driver for total return performance going forward. With this in mind, we encourage investors looking for a global solution to consider a truly global firm such as Western Asset.

Endnotes

  1. Alpha represents the excess returns of a portfolio relative to the return of a benchmark.
  2. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market.
  3. A developing country that is considered to be too small to be classified as an emerging market.
  4. Note that correlations are not necessarily stable, and might change over time; manager judgment might be necessary.
  5. The Bloomberg Barclays Global Aggregate Index is a multi-currency benchmark that comprises global investment grade debt; it has a market capitalization of $45 trillion. The other widely used benchmark is the Citigroup World Government Bond Index (WGBI) with a market capitalization of $20 trillion.
  6. The Sharpe ratio is a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment.
  7. Interestingly, when passive managers tie a strategy to an unhedged or hedged benchmark, they are essentially making an “active” decision.
Past results are not indicative of future investment results. Investments are not guaranteed and you may lose money. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence.
Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorised and regulated by Comissão de Valores Mobiliários and Banco Central do Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business, investment management, and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and members of JIAA (membership number 011-01319) and JITA. Western Asset Management Company Limited ("WAMCL") is authorised and regulated by the Financial Conduct Authority ("FCA"). In the UK this communication is a financial promotion solely intended for professional clients as defined in the FCA Handbook and has been approved by WAMCL. Potential investors in emerging markets should be aware that investment in these markets can involve a higher degree of risk.