The increasing popularity of passive strategies for equity investment raises the question of whether similar approaches can and should also be applied to fixed income markets. While passive strategies’ promises of reduced costs may seem attractive in the current low-interest rate environment, we believe that the size, variegated nature and inefficiency of the $46 trillion global bond market offers opportunities that astute active managers are uniquely able to capture on behalf of their clients.
Active fixed income managers especially stand out in the corners of the market which are more niche, and hence less followed. In fragmented and inefficient categories—such as US municipal bonds, securitized bonds and emerging market debt—the rigorous research and skillful security selection practiced by active managers are indispensable in achieving return while managing risk. In markets such as these, where the quality and quantity of information about issuers’ creditworthiness varies widely, active investment managers have a clear advantage over index-based strategies that may overlook entire sectors of the investible universe. The Barclays Capital Aggregate Bond Index, for example, doesn’t include high-yield bonds, inflation-linked securities or floating rate debt.
Instead of the precise security selection practiced by active managers, passive investment offers the opposite. Like trawler nets scooping up debris as well as fish, index investing in fixed income pulls in all sorts of things an investor might prefer to avoid. This includes large quantities of sovereign bonds whose prices have been inflated by central banks’ policies of buying up large swathes of debt without concern for price. This problem is an especially serious one for passive strategies investing in global bonds. Consider the makeup of a passive ETF based on the Barclays Global Aggregate Index. At present, 25% of its holdings are bonds with negative interest rates and nearly 40% are securities with yields of fewer than 50 basis points. Even when rates increase, this “bycatch” will remain in the portfolio, placing a drag on overall return.
While index-based strategies expose investors to securities they might prefer to avoid, they can also deny them opportunities for exposure to securities they might otherwise consider. For instance, a passive strategy may have index rules that prevent exposure to so-called “fallen angels”; on the other hand, the manager of an active strategy may thoroughly research the fundamentals of these issuers and identify value. Index-based investing will include or exclude securities based on the judgment of ratings agencies, which alone can be inefficient.
It may be worth considering that the rise of passive equity investment has not been driven by passive strategies’ track record of success at generating alpha. Rather, it reflects a lowering of expectations on the part of investors who have lost confidence that active management can deliver consistent outperformance.
While this lower-cost, lower-expectation passive approach may make sense in today’s highly efficient equity market, adopting a similar approach to the far larger and more diverse fixed income universe would mean trading away proven tools for generating alpha and managing risk in favor of a false economy and diminished expectations.
The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of such information. Please contact Standish for current information about our views of the economy and the markets. Portfolio composition is subject to change, and past performance is no indication of future performance.
BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s affiliated investment management firms, wealth management services and global distribution companies. BNY Mellon is the corporate brand for The Bank of New York Mellon Corporation. Standish is a registered investment adviser and BNY Mellon subsidiary.