Ben Johnson: For Morningstar, I'm Ben Johnson. Active fixed-income managers have by most measures been far more successful than their stock-picking peers when it comes to beating their benchmarks. But is that really, truly something we can attribute to skill as opposed to luck, or just loading up on factors that investors could combine on their own more cheaply. Here to explore this topic in more detail is AQR's Jordan Brooks. Jordan is a managing director with AQR and sits within the firm's fixed-income team.
Jordan, thanks for joining me.
Jordan Brooks: Thank you very much, Ben.
Johnson: Jordan, your team has recently produced some research that looks at the success or at least perceive success among active bond fund managers and tried to distill down what the sources of their returns have been. What were some of the key findings of that research that you've done?
Brooks: Very good question. We've looked at performance across fixed-income managers. And in line with your observations, we see very similar results. Fixed-income managers across categories--so both U.S. aggregate base core plus managers but as well as global aggregate, global unconstrained managers--have tended to outperform their benchmark over the past couple of decades, while their equity counterparts have been much less successful at beating their benchmarks. This has led many within the industry to make statements along the lines of that fixed-income investing for whatever reasons is somehow easier than equity investing. They point to factors such as there is a nonprofit seeking players in fixed income markets or there is ad hoc benchmarking rules and these create more inefficiencies.
First of all, I think those things exist in all markets. You've got nonprofit seeking players and there is some degree of inefficiency. But I think the story in fixed income actually is a little bit clearer once you scratch the surface a little bit. It's a little bit of a clear story on what's going on there.
Some of our research, in particular a piece we had at the end of 2017, looked across fixed-income categories and documented that across the major fixed-income categories and geographies, the vast majority of active returns--returns in excess of benchmark--can be explained by exposure to high-yielding, higher-risk segments of the fixed-income market, in particular, if you look at something like high-yield credit, you'll see that equal weighted portfolio across core plus managers is something like 0.95 corfelated to high-yield credit. This exposure to traditional risk premia that tends to be the driver of the outperformance of fixed-income managers as opposed to generating some uncorrelated, truly diversifying excess return.
Johnson: In theory, this is a type of risk that investors could readily take themselves through an instrument that, in theory, again, might be less costly, might be easier to do. They might, again in theory, by overpaying for exposures that they could cobble together themselves.
Brooks: That's exactly right. And that's the immediate implication. The immediate implication is, wait a minute, this is a pass of premium. Just to contrast with where fixed income is in terms of its evolution, this is something that we knew and we are looking at equity managers, we did back in the '60s that you had to measure the market beta of your equity manager. If an equity manager was running a 1.5 beta to the market, and they returned 12% when the market was up 10%--wait a minute that manager didn't outperform, right?
Johnson: They just took more risk.
Brooks: Exactly right. On the fixed-income side, we're still a little bit devoid of those type of analysis when you are seeing that you have, again core plus managers for example that have massive exposures to high yield credit. Wait a minute, I have to adjust the active performance, I have to adjust that manager's returns in excess of the benchmark for exposure to traditional risk premia. In fact it's really the equivalent of an equity manager who runs a beta greater than 1 and says, hey look, I've been outperforming the market on average; you have been taking more risk on average. You definitely have that dimension, that this is a passive premia that investors can access potentially more cheaply and that's one immediate implication of this.
I think there is a second implication that's probably a little bit less appreciated and perhaps even more nefarious. And that's related to the fact that typical investors are investing in investment grade fixed income, yes because it generates income and it has a positive expected return, but primarily because it has a positive expected return that's not perfectly correlated and tends to be diversifying to equity risk.
Johnson: Investors think of bonds as being ballast in their portfolio.
Brooks: Exactly right. When you are allocating to a core plus manager that has a U.S. aggregate benchmark, the hope is, that core plus manger is going to need to deliver returns that, from a risk perspective, are somewhat in line with the index that they are benchmarked to the U.S. aggregate. But indeed we see that given the magnitude of this high yield overweight, given the magnitude of these managers have--the higher yielding, higher sectors of the fixed income market--that they are selling the diversification property of fixed income as an asset class. I'll just give you one stat.
If you look over the past 20 years, the U.S. aggregate has been negatively correlated with the S&P 500, no surprise there. We know this has been a period where stocks and bonds have been negatively correlated with each other. You look at typical core plus manger over the same period, positively correlated to the equity market. That's the size of this high-yield overweight. That's the size of the risk that these investors, the non-investment grade risk, these managers are putting into the portfolios.
Johnson: Investors should be aware that despite the fact that, in theory, beating one's benchmark should be a positive outcome to the extent that these managers are taking on risks that are correlated to stock market risks, it could be reducing the diversification benefits of what is in otherwise thought-to-be-stable part of their overall asset allocation, their overall portfolio.
Brooks: That's exactly right. I think that's exactly what investors have to be thinking about. Obviously, as we mentioned there's the supplemental implication that you can't just look at active returns to figure out the performance of a manager, the skill I should say of that manger. You do need to then adjust for their market exposures. We had some recent research actually that's looking into that and it's kind of saying what's left once I take out these exposures. Do I have alpha on correlated returns? But ultimately, I think that's exactly the right conclusion: really understand the risks your managers are taking, because if you know when its rears its head when its too late ...
I'll just give you one data point I like to hit on, if you look at the fourth quarter 2008, this was the period when equities were down over 20%. It's a period where you're hoping for that diversification--excuse me U.S. aggregate didn't disappoint. I think it had its best quarter in the last 20 years, was up about 4% and change in the fourth quarter of 2008. Typical core plus manager: flat. In other words, typical core plus manager lost relative to their benchmark by about 4% during that quarter. Of course credit spreads widened and they were overweight credit.
So, the period where you needed that diversification most was the period where it was most delusive. I think that's something investors should be very, very wary of. I think perhaps--and maybe going on a limb here--perhaps the fact the benchmark was up that quarter, so the total return for core plus managers were only flat, that might have created a little bit more of a tailwind, there might be a little bit more of a headwind, excuse me, for those mangers had, say, the benchmark been flat and they've been down 4% as opposed to benchmark being up 4% and then being flat.
Johnson: Well, this is a timely topic especially given the turmoil we've seen in the markets in recent weeks. Jordan I appreciate you being here to share with us the findings of your research.
Brooks: Oh, my pleasure. Thank you very much, Ben.
Johnson: For Morningstar, I'm Ben Johnson.