When the Going Gets Tough in Fixed Income, Turn to Active
By Gary Manguso
At this point, you’re hearing concerns about the current economic expansion being late stage or long in the tooth from financial analysts and clients alike as the global economic expansion passed the decade milestone. Paradigm shifts in the global economy have institutions like the World Bank suggesting global economic growth will grind upwards, albeit slowly, through the remainder of 2019 with significant headwinds troubling markets.
Just because the investment environment is losing momentum doesn’t mean that opportunities aren’t out there, especially in the fixed-income sectors. If you are an advisor looking at the fixed-income sector and scratching your head at what to do in today’s environment there’s a case to be made for turning to active management.
The case against passive
Passive funds in the fixed-income space have undoubtedly seen major inflows since the rise of low-fee investment vehicles. When you look beyond the low sticker price, however, there’s much more to the story that’s worth considering. While cost matters, it should never be the only thing you consider when investing. Here are some key reasons for why active deserves a second look:
Married to the index
A core component that makes passive fixed-income less desirable in the current environment is that passive funds are tied to an index. Passive funds tend to hold only a portion of securities that an index contains – usually the largest or most liquid debtors. Even the most comprehensive index, the Bloomberg Barclays U.S. Aggregate Index, is comprised of just over 50% of the total US bond market. Passive funds end up being more concentrated than an investor might think – resulting in less diversification. In the active space, fund managers have the capability to invest across the asset spectrum. Don’t miss out on the possibility of uncovering a diamond in the rough by sitting in passive funds.
Rapidly changing environment
Today’s news cycle is 24/7. Global events are unfolding weekly with the influence to alter the investment landscape in a matter of minutes. Brexit, global trade and geopolitics are all evolving matters with global consequences. An active manager has the freedom to analyze the situation and make unconstrained decisions that could work in favor. With more risks on the horizon than in recent years, a good active manager can prepare a portfolio that is risk-adjusted and tactically positioned to capture gains as they come.
If you do believe that a recession is on the horizon and there are structural credit risks in the fixed-income sector, consider an active management team that focuses on risk management. While passive funds might offer a “defensive strategy”, it is not actively managing risk, this leads to the potential for misallocation. When things turn south quick, a single default can impact a fixed-income portfolio greatly. In active management, fund managers can move up and down the credit spectrum, shorten their duration and look globally. Active managers can take advantage of the inherent inefficiencies and dislocations ever-present in the bond market.
Three things to look for in active management
Correlation to traditional fixed-income
Don’t view the goal of moving from passive to active as just that. Understand a team’s correlation to a traditional fixed-income benchmark. In today’s environment beating a benchmark is one thing, but being prepared to go off the beaten path when traditional sectors turn sour is the real value in active management. As an advisor, capital preservation for a client in a downturn is worth the extra cost. Understand the team’s processes and investment thesis to be sure they are bringing ideas that aren’t found in a basic passive fund.
Breadth of asset classes
While it is important to invest in the core fixed-income areas, accessing the variety of investment opportunities in the fixed-income space is necessary in late-stage cycles. Few stones should go unturned. Active managers have the ability to invest in areas like Non-Agency RMBS, CLOs, interest rate derivatives, and other forms of ABS. While we don’t think it’s necessary to invest in these areas having the option to do so offers value to the investor and could lead to performance that bests a standard benchmark like the Bloomberg Barclays Agg.
Management track record
An often overlooked aspect of the active management space is the historical management of the fund – not just the performance. Before making a decision, review the management team and the decisions they made in previous late-stage cycles. Where did they turn for value? How did they manage duration and interest rate exposure? Does their core thesis provide a compelling argument or is it fluff? These are the types of questions that an advisor can ask to help sort through the array of active management funds.
Going beyond cost to find value
The argument here is that cost is not the main driver when it comes to the passive versus active debate in fixed-income. In a low interest rate environment, active managers are positioned well to add more value to a portfolio based on the main reasons laid out early. The fixed-income space is complicated, especially in today’s environment. Risks in a passive fund could be magnified, with little mobility. Active funds can capitalize on this risk, and tactically take advantage of the dislocations. In many cases, a few extra basis points are worth the added value.