In the blog “Equity factors outperformed in 2022, did active managers?,” the UBS Chief Investment Office (CIO) discussed the performance of equity factors vs. the S&P 500 Index in 2022. They also looked into if the strong factor performance translated into active manager outperformance. *Spoiler alert* It did. But what about fixed income? Did active fixed income managers have similar success last year?
Like equity managers, fixed income managers have lots of different levers to pull to try to outperform the traditional benchmarks. Some of the most common ways are through sector, duration, geography, and credit quality positioning vs. the benchmark. Last year, we saw a large dispersion in returns as rates rose, creating additional opportunities for active managers who could navigate a challenging environment.
In general, shorter duration bonds outperformed longer duration, which is not surprising given the sharp move higher in interest rates. Similarly, floating rate bonds outperformed fixed rate bonds and were able to collect additional carry as rates rose. In the municipal bond market, higher quality prevailed over lower quality. The opposite was true in the corporate bond market though, with high yield corporate bonds returning -11.2% outperforming the investment grade corporate market, which returned -15.3%. The best performing segment we analyzed returned 1.5% (Bloomberg US Treasury Bill 1-3 Month Index) while the worst dropped 27.1% (Bloomberg US Aggregate 10+ Year Index).
With such dispersion in returns, there were ample opportunities for fixed income managers to add value vs. the passive exposure…and, in certain segments, they did.
Evaluating active manager performance for fixed income is more challenging than with equities for a number of reasons. Fixed income indices generally do not reflect the “real-world” costs of accessing a strategy. Often times, it’s not possible to fully replicate fixed income indices as not all the securities in the index are actively traded. We also note that indices usually do not account for transaction costs, which are often higher with fixed income strategies, especially when dealing with less liquid markets. Therefore, investors should evaluate the performance of an actively managed strategy vs. a passively managed one with the same underlying market focus. This will lead to a better comparison of the “investable” opportunity set that accounts for the real-world implementation costs of both strategies.
The senior loan and municipal high yield markets present good examples of this challenge. These active fund categories struggled to outperform the benchmark across all periods analyzed. However, we do not believe this means investors should avoid active management in these markets.
We ran the same comparison to evaluate success rates for fund category performance vs. a passively managed ETF. For certain categories, where there’s a low-cost ETF tracking the same, or very similar index, success rates didn’t significantly change. This will be the case for most of the more liquid fixed markets. However, in certain markets, such as municipal high yield and senior loans, there was a significant improvement in success rates across all time periods. The cost difference between active and passive exposure is not as steep as in other fund categories and the higher transaction costs will impact both active and passive strategies alike. While these two segments saw the highest improvement in success rates, most segments did see an improvement in success rates in most of the time periods analyzed.
So what are the takeaways?
- Investors should not rely strictly on absolute returns vs a benchmark when evaluating the performance of an actively managed fixed income strategy.
- There’s value in combining active and passive exposures for fixed income portfolios. As previously discussed, active manager success rates have been higher in less efficient markets. Also, we’ve seen higher success rates in segments where active managers have more flexibility to take advantage of the various drivers of potential outperformance, such as those around sector, credit, and curve positioning.
- We do believe the low success rates highlight the importance of manager due diligence/selection. In certain categories, the benchmark return is sufficient to outperform most active managers. For many markets, especially those that are more liquid, there are ETFs that are able to closely replicate the benchmark returns at a very low cost. Therefore, it’s become increasingly important to be able to select those managers/strategies with a higher probability of outperforming.
Of course, past performance is not indicative of future results. As we look ahead, we expect higher yields to boost the opportunities for active managers to capture excess return.
Source: UBS
