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The fixed income market dislocations triggered by the onset of the COVID-19 pandemic left active portfolio managers with extraordinary opportunities to generate alpha not seen since the 2008 global financial crisis. Accordingly, many are well ahead of their benchmarks since COVID: The percentage of active core bond-plus and global aggregate bond strategies besting their benchmarks has spiked sharply to over 80% and 90%, respectively.1 Many fixed income allocators have, of course, benefited mightily from this recent spurt of active manager outperformance.
On the surface, there doesn’t seem to be a problem here, right? However, a closer look at this “golden era” of excess returns reveals structural manager biases and stylistic tilts that most investors may not expect, or necessarily want, from their fixed income allocation. These risk factor leanings have enabled many active managers to not only deliver alpha, but to more or less move as one in their outperformance of broad market indices. Investors in these strategies have, in turn, “ridden the wave,” so to speak.
The most glaring behavioral bias we observed amid the early 2020 market volatility was a significant overweight to credit risk beta shared by large numbers of active fixed income managers (Figure 1). Allocators to these strategies were often surprised, even dismayed, to learn that their manager’s investment approach exhibited a similar hidden risk bias, which may have been at odds with the particular role — such as stable, consistent total returns — the strategy was meant to play in the client’s overall investment portfolio. In many instances, the substantial credit overweight drove much of the strategy’s performance during the height of COVID.
For example, as illustrated in Figure 1, the majority of active US core-plus, global credit, and global aggregate fixed income strategies that are typically intended to serve a defensive “risk-aversion” function in client portfolios have displayed an alpha profile that has arguably been dependent on beta-heavy, risk-seeking, cyclically-oriented credit risk factors. We venture to say that many end fixed income allocators would likely not be comfortable with that level of credit risk — and it could also lead to other unwelcome portfolio implications for allocators.
Notably, the alpha profile associated with these risk factor leanings could be highly correlated with the performance of other potential sources of return in an investor’s portfolio, such as equities and liquid alternatives. Consequently, investors constructing fixed income portfolios around core “risk-aversion” bond allocations and selecting active managers to implement the underlying security selection may well be losing some portfolio diversification benefits to factor and other structural biases. That’s why we believe understanding an active manager’s path and style of alpha generation should be a critical part of anyone’s manager evaluation process.
This is not to say an overweight credit risk style of investing doesn’t have a place in portfolios. A critical area of focus for capital allocators should continue to be monitoring their active managers’ alpha-generating style biases. To ensure adequate diversification benefits, consider adopting a robust portfolio construction and manager selection process designed to source complementary manager alpha-generation styles. In this way, “smoothing out” the path of fixed income alpha and aligning a manager’s style with the intended role of a bond allocation can help optimize overall cross-asset portfolio outcomes.
Given the historic recent backdrop for credit-risk-driven returns, with the resulting valuation proposition existing today, we believe there is arguably limited future upside for outright directional overweight to cyclical credit risk in the period ahead. At the same time, fixed income investors these days are increasingly feeling the pinch of every incremental bit of bond market volatility. To help address these challenges, the Fundamental Factor Team is developing a factor-based fixed income manager selection framework for today’s environment.
1Sources: Wellington Management, eVestment, FactSet, Bloomberg. Percentages of active managers outperforming their respective category benchmarks are based on trailing three years of monthly total returns as of 31 October 2021.