The Fixed Income Opportunity Set
In today’s landscape of ever-increasing market sophistication, it appears there is a low-cost passive investment fund for nearly every asset class. While index funds can be an attractive option for certain investment needs, the view that every asset class should be indexed is misguided. Fixed income markets have inefficiencies and structural constraints that experienced managers can utilize in pursuit of long-term alpha.
Several characteristics make fixed income particularly well suited for active management.
1. Non-Index Securities – Many opportunities for excess yield exist outside fixed income benchmarks such as the Bloomberg US Aggregate Bond Index (US Agg). Securities may be excluded due to issue size, registration status, credit rating, or structure. These exclusions create a broader opportunity set for active managers.
2. Risk Management – Active fixed income investors can adjust credit and interest rate risk as market conditions evolve. This flexibility can be a source of alpha, but it is also an important risk management tool, helping investors avoid unintended exposures that can develop in passive instruments.
3. Investor Landscape – Fixed income markets include a wide range of participants, many of whom are not focused on total return. This presents active managers with opportunities to identify potentially mispriced securities.
4. Market Depth – The fixed income market is vast, as evidenced by the more than 14,000 individual securities in the US Agg. Issuers may have multiple bonds across different maturities, coupons, seniority levels, and structures. In addition, many bonds do not trade daily, and fixed income markets generally rely on dealer networks rather than centralized exchanges.
5. Index Rebalancing – Passive vehicles may be required to buy or sell securities as they enter or leave an index, regardless of valuation or trading conditions. Active managers are not bound by the same rebalancing schedule, creating opportunities.
Active vs. Passive Considerations
All investments should be tailored to each client’s objectives, risk tolerance, and time horizon. However, the decision to incorporate active or passive management in fixed income should consider the distinctions of the asset class and market functioning. Passive strategies have changed the investment landscape and can be useful for gaining broad, low-cost market exposure, particularly over shorter time horizons. For investors with a longer-term focus, however, active fixed income management can provide additional tools to manage risk, broaden the opportunity set, and pursue stronger risk-adjusted returns.
Historical Results Support an Active Approach
The table below shows that the median manager in both the Core and Core Plus peer groups has historically outperformed the US Agg. Perhaps more importantly, the US Agg has generally ranked toward the lower end of both peer groups. This suggests that a passive strategy designed to track the index would also have underperformed a meaningful share of active managers.
