When it comes to yield, most government debt (e.g., the U.S., E.U. and Japan) generally has the lowest yield for items of similar duration. In addition, the international passive indexes include the world’s negative yielding debt (Japan and the E.U.). Those negative yielders are there for political and/or central bank policy reasons. But because of the size of the debt and the intent of the benchmark, they must be included. In the end, passive investors pay a premium for liquidity that the benchmark needs, liquidity that does not benefit them, and they also receive substandard returns. So it isn’t any wonder that active managers easily beat the passive fixed income fund returns.
Turnover
Most passive fixed-income investors are unaware of the frequent turnover in the benchmarks. For the three years ending 10/31/17, the turnover rate for the U.S. Aggregate Index was 40%, compared to the S&P 500’s turnover rate of less than 5 percent over the same period. Even worse, in the 12-month period ending 2/28/17, the passive ETF that follows that index, AGG, had a 242 percent turnover rate. Such turnover increases trading costs, and could radically change an investor’s exposure in a passive fund. For example, since the recession, the composition of AGG has changed such that today, its duration is 62 percent longer and its exposure to U.S. lower yielding Treasury Notes is 15 percent higher. Lower yielding! Longer duration! What was I thinking when I purchased that!
The Benchmark’s Limited Universe
The concentration of the benchmarks—and the funds that mimic them—in the largest debtors and the most highly liquid debt also means that a large portion of the investible universe is excluded. For example, the U.S. Aggregate Index excludes all non-rated issues, all inflation indexed issues and foreign currency issues. In addition, because most passive funds are algorithmically driven by computers, their portfolios are rebalanced monthly or quarterly.
Active managers, on the other hand, trade opportunistically. Active managers can own the debt of small issuers, normally at higher yields and with higher quality balance sheets, income statements and cash flows than those of the largest debtors. Active managers have more choice and they don’t have to concentrate on lower yielding, and sometimes lower quality, sovereign issuers.
The Judgment Factor
Passive strategies have no human management or macro- or micro-analysis. In an actively managed fixed-income ETF, the managers can detect an oncoming rise (or fall) in the general level of interest rates, or changes in the shape of the yield curve, and position the fund to take advantage. In addition, the managers can change asset allocations to take advantage of business conditions in different sectors, while passively managed funds are stuck with the allocations of their benchmarks.
Conclusions
• In the equity world, the cycle determines if active or passive strategies outperform. Of late, passive equity strategies have outperformed, but the tide appears to be turning;
• Unlike the equity world, in the world of fixed income, active managers significantly outperform passive strategies with the median outperformance of 1.14 percentage points gross of fees;
• The benchmarks, which passive funds mimic, select the largest debt issuers and the most liquid of those issues. Investors in such passive funds generally get lower quality and lower yield than they would with active managers who are more skilled and nimble in their asset selection, in trade execution, and in the implementation of strategies that fit into the current macro- and micro-economic picture.
Robert Barone, Ph.D., is a Georgetown-educated economist. He is a financial advisor at Fieldstone Financial.