Investors who think active bond funds need to be taking big bets against the index to outperform are making a mistake, according to Ales Koutny and Sarang Kulkarni, co-managers of the Vanguard Global Credit Bond fund.
Active funds’ higher fees cause managers to think the fund should look significantly different from the index to justify their costs and outperform, but this can backfire, said Koutny.
“Some managers are searching for the highest amount of returns at all times, even when the opportunity set is scarce, because they have a high fee to meet and so they think they need to keep producing these results non-stop.”
In pursuit of this, some strategies are constantly chasing opportunities that make them more like “low volatility equity products” in terms of their risk.
This was the case during the Covid-19 pandemic, with funds that were “supposed to be globally diversified” having around 80% in high yield because the managers were attempting to deliver supranormal returns. However, this resulted in many funds underperforming common benchmarks such as the Bloomberg Global Aggregate Credit index, he said.
Indeed, in the IA Global Corporate Bond sector, more than 50% of the peer group underperformed the index during 2020, according to FE Analytics data.
Instead, active funds should resemble the index they are measured against, Koutny said. If active funds behave like the benchmark “within reason”, this creates a strategy that doesn’t rely on certain big trades to make or break performance and allows the fund to generate outperformance through a series of smaller trades that may not add a lot of value on their own, but “add up day in and day out”.
Creating a fund like this means that risks are diversified across different areas, so the amount a single mistake can cost the fund is limited.
“The core of our philosophy is that we know we're going to be wrong, so the best thing we can do is build a budget for it,” Kulkarni said.
This is preferable to building a fund that makes a supranormal return one year but has “tumbleweeds blow through the portfolio for the next three”.
“Nobody buys bonds to become a hero,” he said.
Vanguard’s is not the only fixed-income team to draw attention to the value of having funds that resemble their benchmark.
David Roberts, head of fixed income at Nedgroup Investments, agreed that it is a “good way to increase certainty for clients”.
Investors buy bonds because they provide security. “If a client needs a bond fund, why buy a fund taking quasi-equity or currency risk?” he asked.
“There are so many small wins available to bond investors, it seems sensible to target a 'sleep easy' style”.
Thomas Hanson, high yield manager at Aegon AM, was less convinced of the benefits, as closely following the benchmark is “a suboptimal endeavour and a poor substitute for true active fund management”.
Part of this is due to the construction of benchmarks in fixed income markets, where the biggest weighting goes to the most indebted companies with “no regard given to underlying fundamentals and their expected direction of travel”.
On top of this, there is no natural meritocratic rebalancing mechanism in bond indices like there is in equity indices, Hanson stressed. In equity markets, companies that are performing well have higher weights in the index, but “in the fixed income world, the opposite is true”.
As a result, using benchmarks as a blueprint for portfolio construction is “unlikely to lead to good outcomes for investors”. Extracting the most value in fixed income involves constructing a genuinely differentiated, high active share portfolio, he concluded.