Forget active versus passive: We should all be proactive fixed-income investors

For as long as most can remember, there has been ongoing debate over whether investors should be utilising active or passive approaches to investing in fixed income markets. Unfortunately, such a debate runs the risk of failing to answer this key question: is the investor achieving their desired investment outcome or simply tracking a particular benchmark? From this perspective, the choice of a benchmark is a means to an end, not the end itself. Put another way, the issue is less about whether active or passive is better but rather whether investors have confidence in the ‘appropriateness’ of fixed income benchmarks to reflect their desired investment outcomes both at a point in time as well as over time. In this sense, whether an investor regards themselves as active or passive is irrelevant as in practice every investor needs to consider themselves a proactive investor.

A benchmark is not necessarily your friend

The central issue facing investors with respect to selecting a fixed income index to serve as a benchmark is the complexity inherent in fixed income markets and the resulting implications for the construction of the associated indices. Given (a) the broad range of fixed income securities, and (b) the lack of central clearing/pricing exchanges, traditional fixed income indices establish specific criteria for determining which fixed income securities will be included in an index and how the weightings will be established. The result is that not only are fixed income indices by necessity a subset of the investible opportunity set available to investors, there also tends to be a wider range of usable fixed income indices which could be potentially used as benchmarks. 

Differentiating between each potential benchmark is complicated as each is trying to capture a different part of the fixed income market rather than capturing what may be termed ‘the entire’ fixed income market. It is for this reason that the overall risk characteristics of a fixed income index become more relevant to an investor than the exact nature of the individual securities included in the index, i.e. the factors the investor is exposed to in an index are more important than the precise way in which those factors are assembled.

Complicating the choice of a benchmark is not only the range of indices available but that the resulting risk characteristics of the indices are driven by the actions of market participants, i.e. the issuers, since traditional fixed income benchmarks are constructed on the basis of outstanding issuance. This focus on issuance outstanding not only results in changes to the risk characteristics of an index over time as issuance patterns change or evolve, but it also tilts the index’s exposures increasingly toward the largest borrowers within the subset. 

This creates a dilemma, as the general risk characteristics of an index being used as a benchmark may not coincide with an investor’s desired risk characteristics. 

More importantly, even if the general risk characteristics of the index do coincide with an investor’s desired risk characteristics at a point in time, there is no certainty that they will continue to do so over time. This has important implications for both active and passive investors, as the definition of the appropriate benchmark is essential for establishing the ‘neutral’ medium-term absolute risk/return characteristics desired by the investor.

Don’t focus on the wrong measure of risk

Though the focus of investors should be on considering the outcome in terms of absolute results, often the active versus passive debate is phrased in terms of outcomes relative to the benchmark. The danger with this type of focus is that an investor is at risk of becoming largely indifferent to the overall risk characteristics of the selected benchmark, with the focus instead being on tracking error, or potential mismatch versus the benchmark, as the definition of risk. This can lead to some perverse results with respect to risk management, especially where a benchmark is relatively concentrated; namely, by focusing on tracking error as the relevant risk characteristic, an investor may be increasing other forms of risk. 

To highlight this point, recall that the exposures in a fixed income index (a) represent just a subset of the investible universe, and (b) are biased toward the largest issuers of debt. As a result, traditional indices may not necessarily represent the best risk/return profile for an investor. To illustrate, consider the situation where a benchmark may be relatively concentrated, with the major driver of risk being domestic credit premiums. Now assume that an investor introduces a range of ex-benchmark exposures/premiums within the portfolio which exhibit a low correlation to domestic credit premiums. 

Any simple statistical analysis based on tracking error and returns would conclude that the addition of such exposures has resulted in a deterioration in expected outcomes, as tracking error has increased while expected returns are unchanged. But is that really the case? While there is greater tracking error, the increased diversification of premiums has materially reduced the absolute risk faced by the investor. Not only has the addition of ex-benchmark exposures added to the diversification of return sources, but it may have also reduced the exposure to default risk by adding a more diversified pool of credit and/or reducing the investor’s reliance on domestic credit as the key source of value add. This simple example seeks to highlight how a focus on tracking error can have the effect of exposing the investor to increased risk, especially where a benchmark may be relatively concentrated. Not only that, but the risks of the benchmark will be changing over time and, consequently, so too will the range of risks the investor is exposed to. Due to the nature of fixed income indices, there can arise the rather perverse result that by trying to minimise tracking error an investor may actually be increasing the total risk profile of their portfolio. It is for this reason that investors need to focus on the absolute risk characteristics desired within their portfolio and then, by extension, the chosen benchmark.

‘Know what you own and know why you own it.’

When constructing a portfolio, an investor, therefore, needs to start with the basics. This entails knowing their own medium-term risk/reward preferences as well as ‘knowing the benchmark’; not only at a point in time but also over time. When selecting a benchmark, investors need to ensure they utilise a fixed income index that represents their desired risk characteristics over a full cycle. This in turn requires that they must understand and define their desired risk characteristics, or beta. Such risk characteristics could include specifying criteria according to measures such as:

• Interest rate duration.
• Credit spread duration.
• Average or minimum credit quality, i.e. level of desired default risk.
• Total volatility.
• Desired diversification characteristics both within fixed income and between fixed income and other asset classes.
• Other requirements such as income needs, prohibited securities, etc.

Once this has been done, one approach is for the investor to then look for an appropriate traditional index that best approximates the desired range of risk characteristics. Having done this, the investor can then decide whether they should either invest passively or undertake some form of proactive management via the introduction of exposures that differ from those of the benchmark. The introduction of such ex-benchmark exposures becomes more important if the benchmark chosen is deemed to be concentrated, thereby providing lower levels of diversification. The important point worth stressing is that whichever approach is selected, the onus is still on the investor to ensure that as issuance patterns change over time, the underlying absolute risk characteristics of the portfolio remain consistent with the investor’s desired strategic risk characteristics. Accordingly, the investor will need to proactively monitor and manage the structure of the exposures to ensure this consistency over time.

Be a proactive investor

For some fixed-income investors, the use of a standard broad market benchmark as the basis for constructing fixed income portfolios, either active or passive in nature, may provide adequate approximations of their desired risk/return characteristics. However, given the approach to constructing most traditional-style benchmarks, investors must be careful not to take for granted that the benchmark reflects their risk/return characteristics, nor that it will continue to do so over time. In this context, the debate over active versus passive management misses the key point. Investors need to proactively monitor and, if need be, modify their portfolios and their benchmarks to ensure that over time they remain consistent with their absolute risk tolerances. 

It is this proactive management of portfolio exposures that facilitates the ability to create more efficient portfolios, especially where the traditional fixed income indices are more concentrated. The ability to create more efficient portfolios is just as important a contributor to superior returns for investors as the more traditional, explicitly directional views that investors normally associate with active management. Accordingly, the distinction between an active investor and a passive one becomes blurred when one considers that ‘all investors should be proactive investors’.