The Paradox of Active Fixed Income Management (Tucker)

by Matt Tucker, iShares

Lately, I have been fielding a lot of questions from investors who have been disappointed with the performance of some of their fixed income investments. The basic story is always the same. The investor built a diversified, multi-asset class portfolio. The investor included fixed income in the portfolio to provide diversification from riskier asset classes such as equities and commodities. But now the investor is unhappy with their portfolio’s performance.

Why? On the surface, it appears they did everything “right.” The fixed income holdings were meant to provide an anchor in the portfolio and some stability in uncertain times. As we know, this year markets have been highly volatile, Treasury yields have declined, and most fixed income asset classes have had strong performance in 2011.

So, why are investors not getting the performance they expected from their fixed income holdings? One reason may be that many investors use active mutual funds for their fixed income exposure. A staggering 95% of active intermediate bond funds have underperformed year-to-date relative to the Barclays Capital US Aggregate Bond Index, the common benchmark for the Morningstar US intermediate term bond category, according to data from BlackRock and Morningstar as of September 30, 2011.

But Morningstar data as of September 30 shows it’s not just a 2011 phenomenon — over the past 10 years, 68% of active intermediate bond mutual funds have underperformed.

A lot has been written in the active vs. passive debate, and I will address that topic in a future blog. Today, I want to focus on what I see as the troubling issue here: the conflict between an investor’s goal with their fixed income investment and the strategies employed by many active fund managers.

As a group, active fund mangers look to add yield to create outperformance. The yield that is added typically comes from lower quality, higher risk securities. But these higher risk securities tend to underperform in market dislocations when investors sell riskier investments and move to Treasuries and other more conservative asset classes.

The chart below helps to illustrate this dynamic. It shows the 3-year correlations for the Barclays Capital US Aggregate Bond Index versus a number of other markets. As you can see, the correlation was low or negative to all of the riskier asset classes.

The chart also shows the correlation of the average Intermediate term active bond fund in the same period. Their correlation versus these same indices was positive in every case. If you looked at a time series of this data you would see that the active fund correlations to equity and commodity market performance actually increased when markets sold off.

(Please see footnote 1)

This shows that at exactly the moment that an investor was faced with a declining equity market and was likely looking to fixed income for stability, their active fund’s alpha turned negative. This is what I refer to as the Paradox of Active Management. The strategies employed by many active fund managers are designed to add yield when markets are calm or improving, but it can often lead to underperformance when markets dislocate and riskier asset classes sell off.

This is counter to the role that many investors expect fixed income to play. They want their fixed income investment to be MORE stable when markets dislocate, not less. But many investors continue to invest this way.

The question investors should ask themselves is not whether active or passive is better — it’s what role they want fixed income to play in their portfolio. Invest in fixed income asset classes that are expected to perform in-line with that role, in up and down markets.

If you want lower risk fixed income exposure, consider US Treasuries. If you want more diversified investment grade exposure, consider the iShares Barclays Aggregate Bond Fund, AGG. If you want additional yield in return for taking on more credit risk, then buy high yield. But make each decision with awareness of the relative risks and rewards. Don’t blindly believe all fixed income is the same.

This is exactly what the fixed income ETF was designed for — to provide investors with a vehicle they could use to tailor their fixed income exposure and customize risk. It is designed to give investors complete transparency into what they own, and what they don’t own — in short, to avoid the Paradox.

Footnote 1. Morningstar Direct and MPI Stylus, as of 9/30/11. Correlation based on weekly returns. Correlation refers to the degree to which two securities, on average, move together.  A +1 correlation implies they move in lockstep while -1 implies they move in opposite directions. Intermediate Term Bond Average includes actively managed mutual funds in this Morningstar category.  Percentages are survivorship-adjusted and reflect the fund universe that existed at the start of the analysis period (e.g., the analysis includes funds that existed at the beginning of the analysis period but are no longer available due to fund mergers or liquidations over the analysis period). Analysis is based on the oldest share class of active open-end mutual funds to avoid double-counting of multiple share classes. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise. Diversification and asset allocation may not protect against market risk.

Past performance is not indicative of future results.