- The median active manager has outperformed both the median passive manager and the Bloomberg Barclays U.S. Aggregate Index on a one-, three-, five-, seven- and 10-year basis as of September 30, 2016.
- Active managers have also exhibited higher levels of risk efficiency than have passive managers.
- The composition of the fixed-income market has changed and we believe the Aggregate Index is more limiting than many investors realize. Most passive bond strategies do not provide the multi-sector exposures that most active managers invest in.
- We believe value investing is particularly powerful in capitalizing on persistent market inefficiencies.
We believe your bond allocation is the place for active management. Since the financial crisis, passive flows into equities have accelerated and as of late they seem to have accelerated on the bond side of the equation as well. Buying inexpensive index performance may, on the surface, look like a good solution for your fixed-income allocation, but fixed-income is different from equities. Bowing to the Bloomberg Barclays U.S. Aggregate benchmark construction criteria may dramatically inhibit your return potential. There are structural reasons why fixed-income managers, and value investors in particular, can outperform the index and provide better risk-adjusted returns to investors. In fact, the median active manager has consistently outperformed the index.
In this paper we compare active and passive investment choices in fixed-income. First we look at the data, then we elaborate on why they are occurring and outline why we believe that in bonds, active beats passive.
Over Time Active Management Has Outperformed
Median passive fixed-income has generally performed as expected. With tight tracking error around the benchmark, passive managers lock in underperformance roughly in line with their fee levels. Meanwhile, the median active manager has outperformed the median passive manager over time (Exhibit 1).
This picture holds across all time periods we analyzed. The median passive manager locks in underperformance, while the median active manager has outperformed the median passive manager and the Aggregate Index (Exhibit 2). This holds across one, three, five, seven and 10 years. This indicates that fixed-income managers with broad capabilities have outperformed the passive alternative on a consistent basis.
Looking at overall performance, however, is only a part of the picture. We also need to look at the risk level and risk efficiency of these strategies. Exhibit 3 compares Sharpe ratios for the Bloomberg Barclays U.S. Aggregate Index, the median active and median passive managers as well as the top-quartile active manager. The Sharpe ratio is a measure of the returns achieved per unit of risk, thus a measure of how well the risk budget is used. We note that over time, active management has resulted in a higher Sharpe ratio than either the Aggregate or the median passive alternative.
We Expect Bond Markets to Remain Inefficient
We believe the reason that there are managers, including Western Asset, that have been able to consistently outperform the market is that there are structural aspects of the fixed-income market that make it very inefficient. Managers that have a broad set of capabilities have generally been able to capitalize on these inefficiencies.
The negotiated nature of fixed-income trading provides opportunities for active fixed-income managers not paralleled in the exchange-traded equity market. Today, inefficiencies also arise from the current regulatory environment creating a liquidity-constrained backdrop that results not only in potential peril but also in potential opportunities for active managers to add value. Additionally, rating-agency moves have the effect of forcing issues in and out of benchmarks, as well as forcing ratings-constrained investors to buy and sell securities based on these changes. Last, the growth of fixed-income opportunities and the increasing complexity of available options may provide active managers with many more options than do passive strategies that mirror the benchmark.
We believe these inefficiencies will persist.
What’s in the Aggregate Benchmark?
The Bloomberg Barclays Aggregate Index is a market-cap-weighted index including bonds with more than one year left until maturity, is fixed-rate only (which is why TIPS are not included), investment-grade and must meet a minimum issue size. If you’re a big issuer of debt, then you’re a bigger piece of the index than a company that issues less debt. Also, the major components tend to be pretty tightly correlated with each other. Roughly 95% of the index is Treasuries (36%), pass-through mortgage-backed securities (28%) and investment-grade credit (32%). Adhering to these weightings makes it nearly impossible to embed a variety of different themes, leaving you with less of the benefits you’d hope to see from a diversified portfolio.
As of 10 Aug 16.
A particular area of inefficiency is the composition of the Aggregate benchmark. It’s not that the Aggregate benchmark serves no purpose—it’s widely used for providing an apples-to-apples comparison of traditional active managers. In our view, however, it’s making a leap to move from seeing it as a useful measurement tool to always using it as the best investment. By going active you don’t have to throw out the benchmark, but you don’t have to mimic it either. For a full and detailed exploration of the Aggregate benchmark, see the related white paper, "Trends and Opportunities in the Bloomberg Barclays Aggregate Index," by Western Asset Portfolio Manager Bonnie Wongtrakool.
Investment opportunities have grown dramatically over the last few decades, providing a large opportunity set both in the US and around the globe (Exhibit 4). The composition of the market has changed but the index has remained the same. Allowing prudent allocations to “plus” sectors from today’s global opportunity set go a long way to fix what’s limiting with the Aggregate benchmark—something index-based passive investing can’t do.
As a point of reference, the Aggregate Index has a correlation of 0.91 to the performance of US Treasuries over the past 20 years. When you take a peek under the hood of the Aggregate Index, it is easy to see why this strong correlation persists.
Most traditional bond managers in the core space are benchmarked to the Aggregate and while risk and return measures are benchmark-relative, within some defined boundaries, most utilize non-benchmarked or plus-sector exposure as part of a core allocation to a fixed-income portfolio. Active management may opportunistically provide access to:
- Opportunities for higher income
- Better diversification with inclusion of sectors not tightly correlated with US interest rates
- Diversification away from the US business cycle
- Securities with adjustable-rate features
The Power of Value Investing
The core belief driving Western Asset’s decision-making process is that markets often misprice securities. While prices can deviate from fundamental fair market value, over time prices will typically readjust to reflect credit quality, liquidity conditions and inflation. The magnitude of the mispricing, coupled with our confidence in our view of fundamentals, determines the emphasis in our clients’ portfolios. Additionally, we look to diversify and add value through interest rate duration, positioning along the yield curve, sector allocation decisions, currency and country allocations as applicable, and the specific issues that make up those allocations. Deploying multiple diversified strategies that benefit in differing market environments so that no one strategy dominates performance has enabled us to provide value to our clients over multiple time periods.
The power both of value investing and of focus on risk-adjusted returns is evidenced by Western Asset Core Full Composite’s outperformance of the Aggregate Index, the median active manager and the median passive manager over all time periods.
- Median Passive Manager consists of passive US institutional fixed-income strategies that are benchmarked against the Bloomberg Barclays Aggregate Bond Index and included in the eVestment database (limit of two strategies per manager).
- Median Active Manager consists of active US institutional fixed-income strategies that are benchmarked against the Bloomberg Barclays Aggregate Bond Index and included in the eVestment database (limit of two strategies per manager).
- Top Quartile Active Manager indicates the lowest return in each period required to be in the top quartile amongst active US institutional fixed-income strategies that are benchmarked against the Bloomberg Barclays Aggregate Bond Index and included in the eVestment database (limit of two strategies per manager).