Sion Cole, executive director at UBS Global Asset Management discusses the recent trend towards passive management but why an active approach to fixed income still has a place within your scheme's portfolio.
Over the past few years we have seen an increasing trend towards passive management across a range of asset classes.
There are some key attractions for investors to consider passive; not least for those sectors with easily replicable benchmark indices and sufficient liquidity it can offer a convenient cost efficient way to gain market exposure.
However, within fixed income, the attraction of passively tracking a market capitalised weighted index is less obvious.
Fixed income: active vs passive
Bond indices are typically market cap weighted so a company (or government) borrowing more becomes a larger weight in the index.
By borrowing more a company increases its leverage, a metric typically associated with declining credit worthiness.
Slavishly buying the bonds of companies increasing their borrowings (i.e. passive management) is therefore counterintuitive.
Bond indices usually have minimum credit quality criteria based on ratings provided by agencies such as Moody’s or S&P.
When a bond is downgraded below the minimum rating it will be removed from the index at month end.
This results in passive managers becoming ‘forced sellers’ at month end, usually after the actual downgrade event.
Investing in bonds is expected to have limited upside – a long-term holding is more associated with the return of principal with interest.
For pension schemes, a strategic allocation to bonds – particularly those backed by the government – is more about matching liabilities and dampening the volatility of funding levels.
However, an allocation to corporate bonds is often taken to generate some extra return and their place as a matching asset is less obvious compared to that of government bonds and swaps.
The downside of bonds is not limited though, and just a single default in a portfolio can make a significant impact on return.
The management of credit risk is therefore particularly important. However, passive managers have no need to conduct independent credit research and are beholden to credit rating agencies.
There are a large number of bonds in issue (about 1,000 for a typical broad sterling bond index), some exist in very small lot sizes.
Passive managers are therefore unable to replicate the index completely.
Instead they often rely on quantitative analysis to identify a sample of the bonds in the universe that can capture the most relevant characteristics of
the index.
This introduces basis risk – the difference between the actual index and the smaller sub-set of bonds the manager relies on to mimic the returns of the index.
In recent years liquidity (how easy and cheap bonds are to buy and sell) in these
markets has ebbed and flowed more significantly with the prevailing investor confidence.
Less liquidity may mean the cost of the frequent re-balancing (required by a passive manager) can eat further into their returns.
Active fixed income can offer a better bet
Some sectors of the fixed income market hold challenges for the passive manager, and the nature of market cap weighted indexation seems less appropriate for bonds than equities.
The active manager can: embrace the technical nuances of the fixed income indices as an opportunity to outperform them, employ teams of independent credit analysts to look to better manage default risk, anticipate credit rating changes and identify mispriced bonds.
This combination of downside risk management to mitigate loss and active positioning to increase return is optimal.
Within fixed income, passive management can be an efficient choice for pension schemes, especially when used as part of a strategy to match liabilities.
However, as described above, when moving into the world of corporate bonds the use of passive management is more questionable and, in our opinion, active management in this arena can be the smarter choice for pension schemes.
At UBS Global Asset Management we manage £155bn in fixed income client assets worldwide.
To find out how your scheme could benefit from our expertise in this area please contact Sion Cole on 020 7901 5619.
