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Fixed-Income: The Achilles Heel of Indexing

Passive managers on the insulation of fixed-income from the index investing sea change.

Morningstar, 04/27/2017

This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference. 

The active-passive debate is a hot-button issue in today's investment world. Low costs and outperformance versus active complements, in some cases, have led many investors to more readily allocate their portfolios to passives than traditional actively managed funds in equities, where passive investments have taken meaningful market share from their active counterparts in recent years. 

While passive instruments have developed a meaningful presence in that space, they have yet to gain as much influence in fixed-income. Morningstar's Ben Johnson sat down with three passives panelists: Karen Schenone of BlackRock, Gemma Wright-Casparius of Vanguard, and Natalie Zahradnik of PIMCO to discuss the idiosyncrasies that have, thus far, insulated the bond market from the index investing sea change.

Johnson pointed to a recent Morningstar active-passive study that shows that the lowest cost intermediate-term bonds have regularly beaten their benchmarks. Each panelist weighed in on why this is the case in fixed income while stock peers have not been able to produce similar results. Many ideas were raised around market liquidity, including Zahradnik's point about the preponderance of central banks and insurance companies in fixed-income markets that tend to buy and hold because they are not invested to make the highest returns. Wright-Casparius also mentioned the limited amount of electronic trading in fixed income, which limits efficiency in comparison to equity markets.

Schenone said active bond outperformance is connected to managers' investable universe. Many intermediate bond funds have the option to invest up to 20% of their portfolios in high-yield investments, while the Bloomberg Barclays US Aggregate index is investment-grade only.

From there, the conversation shifted to discuss potential index solutions for beating active management. Zahradnik said the amount of academic research pointing to the importance of asset allocation in determining performance outcomes.

Johnson then shifted the focus of the conversation to potential limitations of bond indexing, where Schenone discussed issues related to indexing illiquid markets, specifically high-yield bonds.

Each panelist then weighed in on the potential for "smart beta" or active ETFs, in fixed-income markets. Schenone discussed BlackRock's efforts in the space and talked about the importance of balancing credit risk and interest-rate risk, considering the outsize influence that interest-rate risk has in most bond benchmarks. 

Wright-Casparius then discussed the similarities of smart beta and active fixed-income management, due to the fact that many managers currently implement rules based approaches to bond investing. Zahradnik offered her opinion of the smart beta opportunity largely being in the equity space.

All of the  panelists mentioned TIPS in connection to the current inflationary environment. Zahradnik also discussed potential within the municipals market. Wright-Casparius emphasized Vanguard's focus duration and inflation. 


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