AQR Capital Management contributes to the literature with their December 2017 study, “The Illusion of Active Fixed Income Diversification.” The firm’s researchers studied the performance of institutional fixed-income managers from 1997 through 2017.
AQR extracted monthly manager and benchmark returns that belonged to three categories: global aggregate, core-plus (U.S. aggregate credit index-benchmarked portfolios with allowance for out-of-benchmark exposures) and unconstrained bond (go-anywhere) funds. They limited themselves only to funds within a category that had a benchmark clearly mirroring the category. In addition, they required the base currency to be U.S. dollars.
For global aggregate managers, they were able to find 89 bond funds in their database, and ended up with 53 funds that had the global aggregate index benchmark as well as sufficient returns data for the analysis. For core-plus managers, the same filtering criteria yielded 115 funds. For unconstrained bond managers, it yielded 27 funds.
The funds they eventually used represented 70% of the number of eligible funds available on eVestment in these three categories (and 69% of the assets under management).
Following is a summary of their findings:
- On a returns basis, active fixed-income managers have outperformed their benchmarks. However, the majority of active returns for fixed-income managers can be explained by exposure to credit markets, not security selection or market timing. For example, active returns for all three categories have a very strong correlation with high-yield excess returns: 0.76 for global aggregate, 0.95 for core-plus and 0.82 for unconstrained bond.
- Credit tilts are consistently positive and do not vary significantly over time. Inasmuch as managers adjust their exposure to credit, they tend to vary between long and very long (they tend not to take short positions). To the extent that there are deviations in credit tilts, they only weakly predict future credit returns. In other words, there is scant evidence of timing ability.
- Most active fixed-income returns are a result of the credit risk premium, which is related to the equity risk premium. The resulting diversification loss can dampen the risk-adjusted performance of an investor’s overall portfolio. And this has been the case.
These findings led AQR to conclude that “a significant portion of [fixed income] manager active returns comes from being overweight, structurally and permanently, sources of return that are highly correlated with [high-yield] credit.”
They also warned that “there is a downside of this effective credit overweight to overall strategic allocations, namely a reduction in overall portfolio diversification.”
AQR’s researchers showed that, while over their full sample the U.S. aggregate credit index has tended to provide excellent diversification to equities, realizing a -0.33 correlation with the S&P 500 Index, an equal-weighted portfolio of core-plus managers has actually realized a correlation to equities of 0.05 over the full sample, changing the sign of the correlation of fixed-income returns to equity returns from negative to slightly positive.
This effect has been even stronger since 2008, when active fixed-income managers across categories have tended to have an even higher effective credit exposure. During this time period, the correlation of U.S. aggregate credit index returns to the S&P 500 Index was -0.22, while an equal-weighted portfolio of core-plus managers had realized a correlation of 0.33.
Making matters worse is that the correlation tends to turn strongly positive at exactly the worst time, when equities are crashing, increasing portfolio drawdowns.
The bottom line is pretty simple: There is an overwhelming body of evidence that active management in fixed-income markets is even more of a loser’s game than it is in equity markets.
The winning strategy for investors is the same for both stocks and bonds: Decide how much exposure you desire to common factors, and then implement the appropriate allocations using the lower-cost, passively managed mutual funds and ETFs that give you the most effective exposure (considering not only expense ratios but also fund construction rules and trading strategies) to those factors.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.