Active fixed income: Finding value amid the challenges

Kamyar Hazaveh's picture

As passive penetration into fixed income picks up, active managers are increasingly making the case for how active management can benefit fixed income. Arguably, the debate between active and passive management of fixed-income investing is driven by asset-accumulation incentives on both sides. This article outlines a portfolio manager’s views on the value of active management in fixed income and how this may be right for your portfolio.

Active management can add value for Canadian investors, including pension plans, not by promising market timing or fear mongering about exchange traded funds, but by identifying what we can reliably offer at the right price. This article provides details on some solutions and how they can address some of the challenges including the poor risk concentration and lack of diversified global content of Canada’s fixed-income indices. First, let’s briefly examine the meteoric rise of passive investment products.

The rise of passives

The stampede to passive solutions away from actively managed funds is one of the most significant shifts in the asset management industry in recent years. Combined with regulatory changes (such as the Markets in Financial Instruments Directive, known as MiFID), this has led to a product and value-proposition rethink for active products and to consolidation within the asset management industry.

The move to passive investing has been most visible in the equity markets, but the growth rate of passive solutions has been highest in fixed income. The commoditization of fixed-income exposure via ETFs, and the (perceived or real) liquidity on equity exchanges, has attracted both retail and institutional investors to passively managed products.

For some time, ETF providers have sought to dispel fears about passive solutions, which have been blamed by some for market melt-ups, crashes and liquidity crises. One of the strongest arguments against passive fixed-income instruments has been that they can constitute “fake liquidity” when the underlying instruments are not nearly as liquid. Conversely, the biggest “win” for passive fixed-income providers is avoiding a designation by regulators as systemically important financial intermediaries (SIFIs). Such a designation would subject these providers to heightened supervision based on SIFI’s transparency and prudential supervision framework. The bull market of the last 10 years combined with expectations of falling returns and relatively high active management fees have helped passive solutions to attract average investors and accumulate astronomical assets in a relatively short period of time.

The verdict on active versus passive fixed income

So how does active management of fixed income compare? Active managers on average are not mathematically able to outperform market indexes after fees. There are active managers who have and will outperform passive solutions consistently, but it can be difficult to identify them beforehand. In addition, the nature of fixed-income alpha among the winners is poor. Various studies show that actively managed fixed-income products generate alpha by chronically overweighting credit or exposing the portfolio to illiquidity risk.

The problem with chronic credit exposure in fixed income is that credit correlates positively to the equity market (corporate debt and stocks are both pro-cyclical), taking away from the desirable attribute of fixed income for investors: portfolio diversification. Investors could replicate active funds’ outcome by having more pro-cyclical exposure via more equity holdings than paying active fees for chronic overweight credit allocations inside their fixed-income portfolios.

While suggesting that a chronic overweight credit allocation amounts to “alpha” is disingenuous, exposing the portfolio to illiquid fixed-income securities could be detrimental if the liquidity risk isn’t properly managed. The liquidity risk premium is consistently mispriced in fixed income because episodes of market illiquidity (“no-bid” scenarios) are rare. These rare episodes are exactly the times when investors need the safety and liquidity of their fixed-income portfolios the most. Time and again, many fixed-income active managers are found to have excessive exposure to illiquid products in periods of market stability (in their attempt to outperform) without a proper liquidity risk-management framework.

For these reasons, passive solutions are a welcome innovation for the fixed-income market. The technology and transparency of these instruments can be superior to active funds. They provide retail investors with greater access to different parts of the fixed-income market at a lower cost.

For institutional investors, passive products like ETFs provide equity exchanges as a venue for exchanging fixed-income risk, in many cases bypassing the cash market altogether, like derivatives. This is certainly true for some of the large ETFs, in which risk changes hands on the equity exchanges without the need for unit creation or redemption. The added feature of fixed-income ETFs (and ETF options) relative to interest rate and credit derivatives is that the liquidity premium of the cash market is captured within the ETF’s price.

One of the biggest shortcomings of fixed-income ETFs relates to governance issues, which I believe should be addressed by ETF providers to improve these products. As an example, authorized participants (AP) in charge of market-making and the creation/redemption process have no obligation to either ETF investors or providers to offer these services. Currently, APs are driven purely by arbitrage opportunities with no-one acting as a back-stop for a “no-bid“ market. This means that the value of the ETFs may deviate substantially from the underlying index during difficult market periods, thereby violating the very promise they are built on: tracking the index.

Even in “normal” markets, the performance of some well-known fixed-income ETFs have deviated from the underlying index. In a bid to lure APs to make markets in ETFs, providers have tilted the creation and redemption baskets towards more liquid bonds. This creates unwanted tracking error that sometimes leads to substantial deviation from index performance.

The way forward for active fixed income

In the markets of the future, beta will be almost free for all investors, small and large. In my opinion, there is little difference in active management of fixed income and equities as passive solutions are as useful in fixed income as they are in equities. Certainly, equity markets are years ahead in standardization, execution, and overall technology. However, the “over-the-counter” nature of fixed income will change as technology, better security and benchmark design disrupt this still mysterious corner of the global capital markets.

Accepting this likely evolution will help to focus efforts in active fixed income on many genuine services that active managers can provide, instead of getting bogged down by asset accumulation incentives. The opportunity for adding value in fixed income starts by questioning the very foundation that ETFs are built on: the index.

In the Canadian fixed-income context, that means understanding that the returns of index solutions benchmarked against the commonly used FTSE/TMX Canadian Universe Bond Index are primarily driven by long maturity bonds of heavily indebted provincial issuers, as well as by shrinking and increasingly less-diversified Canadian corporate bonds. As such, the primary determinant of total returns in the Canadian fixed-income benchmark is the 30-year interest rate, not the Bank of Canada overnight rate target or any other interest rate or spread. Given the risk-reward trade-off at the long-end, Canadian fixed income indices offer poor risk-reward.

Another critical feature of Canada’s fixed income market is that it represents less than 2% of the available global fixed-income market. All segments of the fixed-income market, from developed and emerging market sovereigns to various shades of corporate credit, mortgages and inflation-linked securities swamp the Canadian market opportunity set many times over.

The Signature fixed-income model

To address the shortcomings of Canadian fixed-income indexes in terms of risk concentration on 30-year interest rates or their lack of global diversified content, Signature’s solutions rely on the following model:

 

 

In this model, efficient sampling replicates the benchmark’s exposure more effectively and with greater liquidity. The set of Core Total Return adjustments are designed to improve the risk-reward dynamic of the Canadian benchmark away from long-term provincial bonds and into other sectors and global yield curves.

The Core Portable Beta component is a collection of diversified global fixed-income exposures (global developed and developing sovereigns, corporate credit, mortgages, inflation-linked, etc.) that are actively managed to provide diversified exposure to duration as well as various other fixed-income premia. Implementing a globally diversified fixed-income risk premia overlay requires developing internal expertise in global developed and developing fixed-income markets to capture currency, duration, credit, curve, inflation, and volatility risk premia.

In this construct, security selection resides in Portable Alpha, which is the final building block in our active solutions. The central bank policy-driven bull markets of the last 10 years and the stampede to passives have masked the importance of this component; however, this should make active management in the downturn easier and investors will appreciate the importance of successful security selection in difficult markets.

I strongly believe that genuine fixed income value-add via global portfolio construction for Canadian investors can coexist alongside a surge in passive fixed-income investing. These solutions can be custom designed for investors within other jurisdictions, or with different objectives, beyond the Canadian bond universe.

 

Kamyar Hazaveh is head of rates for the Signature Global Asset Management Team.

 

This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

Signature Global Asset Management is a division of CI Investments Inc.

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