In this environment, where market beta adds little value or even detracts from returns, it becomes fundamentally important to tap into other return sources (alpha). This is where investors need to make choices, and there is a spectrum of strategies from which to choose.
Indexed strategies generally rely heavily on beta as a source of returns. Non-indexed strategies have the potential to also generate alpha through in-depth analysis on duration, sectors, credit spreads and yield curve structure (Display 4). In our view, only by taking advantage of these more idiosyncratic opportunities in global markets can investors achieve alpha.
The Right Alpha-Producing Conditions
Market beta is easy to come by, but alpha is a scarce commodity. Producing alpha is a delicate art and science: Managers need to have the right analytical resources and infrastructure to support their ability to find alpha.
Large asset managers may struggle to generate alpha because they may not be able to secure enough individual bonds to fill their needs. To compensate, they may frequently rely on derivatives to gain synthetic exposure. These derivatives usually behave like indexes and thus are largely beta-driven, defeating the purpose of active alpha-seeking strategies. Reliance on derivatives can also be costly, and it is no substitute for a durable portfolio of actual securities. (Display 5)
In general we advocate owning a bond fund over individual bonds because it reduces concentration risk. The reason is that a fund has the advantage of diversification across a wide range of sectors.
Conclusion: A New Era Requires A Focus On Alpha
Today, fixed income markets are at an inflection point. The beta forces that dominated in the past are diminishing as central banks withdraw monetary stimulus and interest rates inch higher. The diversification benefits of fixed income remain intact, but investors can no longer rely on passive strategies with simple market exposure (beta) to earn competitive returns.