If the Silicon Valley Bank debacle has taught us anything, it is that the days when an institutional investor could simply store assets in long-dated government bonds and not worry about them have gone. Pension funds may have long-dated liabilities to which, in theory, fixed income should be the perfect match. But last year’s liability-driven investing (LDI) crisis has shown that in practice, this match can be messy.
As uncertainty on inflation and rate hikes dominates the agenda, pension funds can face sudden liquidity pressures and end up as forced
sellers of long-dated debt, just as prices are falling. For many institutional investors, these challenges could prompt a review of their fixed
income portfolio.
In theory, a more volatile market environment should favour an active management approach. As rates rise, investors could be facing heightened duration and default risks in their fixed income assets, a challenge best left to a dedicated portfolio management team analysing the underlying credit quality of assets, rather than replicating an index, the argument goes.
But this does not explain why asset management giant Blackrock reported record inflows of more than $146bn (£118.5bn) into its bond ETF
range last year. Historically, institutional investors have shown little interest in ETFs. But Blackrock’s annual report also shows increased
demand from institutional investors for its bond ETF range, precisely when bond markets are as volatile as they have been for a decade. What has happened?
A complex picture
A brief glance at the average allocation in institutional portfolios sketches a more complex picture than a simple juxtaposition of either active or passive strategies. Most large defined benefit (DB) pension funds already pursue an active approach to fixed income, but with a considerable allocation to passives alongside. Funds in excess of €2.5bn (£2.1bn) tend to have on average, three active bond fund mandates. Across the board, defined benefit schemes allocate about half of their fixed income assets to active strategies and half to passive, according to Mercer, a trend that has so far remained relatively constant.
In other words, institutional investors have found a middle ground whereby they use a combination of active and passive funds to implement their fixed income strategy, with little evidence of dramatic swings towards either active or passive funds. Having said that, there appears to be increased appetite for fixed income overall. Philip Kalus, chief executive of Accelerando Associates, a consultancy, says that this is not so much a tale of active versus passive, but more a case of the tide lifting all boats. “We need to bear in mind that passives have grown significantly, particularly in the ETF space, but active funds have grown more,” he adds.
This pattern changes somewhat when factoring in defined contribution (DC) schemes, which due to the cost constraints of the charge cap have so far overwhelmingly opted for passive approaches to fixed income. But even here, a rethink is required because many index-based strategies have had a punishing year in 2022, says Joanna Sharples, chief investment officer in Aon’s DC solutions team. “We have just come through a period where index investing has given you the best returns. We now have a period of potentially more market volatility so all this could change,” she adds.
The government’s announcement of significant exemptions to the charge cap could offer some room for DC schemes to invest
more in actively managed funds, but these investors will have to be convinced, Sharples says. “The asset management industry will have to show us the value they can deliver through active management. We need concrete evidence of outperformance.”
Concrete evidence
And when it comes to concrete evidence, last year has been an interesting test case as investors witnessed a significant increase in interest rates across developed markets and levels of bond market volatility not seen for more than a decade. So how did active and passive bond strategies perform?
Last year did indeed show a new trend, as Morningstar’s latest active passive barometer indicates. While active equity funds still let investors down (less than a third outperformed passives), on the bond side, 46% of actively managed funds outperformed. “Shortening duration was an effective way to cushion the downside brought about by the rise in interest rates. Passive funds tracking all-maturity indexes were at a clear disadvantage in that environment,” the report states. This marks a significant turnaround. Over a 20-year timeframe, less than 10% of active bond fund managers outperformed passives.
These results chime with asset owners’ experiences. While last year was universally tough for bond investors, active strategies appeared to perform better, says Daniel Spencer, portfolio manager at Brunel Pension Partnership. The £30bn local government pension pool has about £5bn invested in fixed income, of which £4.4bn is actively managed. “The rise in interest rates and credit spreads made it a tough
year for active and passive approaches,” Spencer says. “Our passive gilt portfolios performed in line with their benchmarks; the over 15-year and over 5-year index linked gilt funds fell by approximately -40 and -38%, respectively. “The active portfolios performed better due to lower interest rate exposure,” he adds. “Our sterling corporate bond and multi-asset credit funds returned approximately -18% and -8.5%, respectively in 2022.”
But whether this outperformance could translate into increased appetite for active fixed income strategies among his partner funds remains to be seen. In the case of Brunel, partner funds are still considering their options, Spencer says.
Where active pays
Fund flow data for the past few months show that there has been an increased appetite for actively managed bond funds, Accelerando Associates’ Kalus says. “Institutional investors have started to eye alternative asset classes as a fixed income substitute over the last five to six years. But things changed at the end of last year when fixed income started to make a comeback.
“At the same time, we saw a flip towards more active strategies,” he adds. “This is the sort of environment active managers have been waiting for, there are now a lot more opportunities for actively investing in corporate bonds.
“We wouldn’t even be surprised to see some money which has been in alternatives now going back into liquid fixed income funds. Nowadays, there is no point paying for an illiquidity premium if you can get similar returns in a fully liquid fixed income portfolio,” Kalus says.
Investors who are considering exposure to actively managed fixed income funds might want to consider their sectors carefully. Unsurprisingly, for those who might need to sell bonds before they mature, long-dated treasuries or gilts remain a bad idea and the chances of outperformance are also slim. Investors in actively managed sterling inflation-linked bond funds had a 15% success rate over passives, according to Morningstar.
But in other segments, the odds have increased dramatically. For example, a whopping 85.9% of actively euro-denominated diversified bond funds outperformed passives last year, this stands against a 20-year track record of 7%. Similarly, euro-denominated money market funds and UK corporate bond funds also reported higher success rates last year, of 82.4% and 63.9%, respectively, Morningstar data shows.
While Brunel’s asset allocation is ultimately set by the individual partner funds, Spencer does see why active bond fund management has become more appealing. “One reason is that we are seeing an increase in spread dispersion between issuers and sectors, an active approach allows investors to capitalise on this.” Another factor is that we could see higher default rates over the next two years, he adds.
“For example, top-down based sell-side estimates for 2023 default rates have risen as high as 6% for US high-yield bonds. “Bottom-up predictions from managers are equally concerning, with downside cases for 2024 default rates as high as 8% to 9% for US high-yield bonds,” Spencer says. “A skilled active approach allows investors to undercut elevated market default rates.”
He argues that some areas within fixed income will behave in a heterogeneous manner if rates remain higher for longer. “For example, companies who issue leveraged loans have payments linked to floating rates. Periods of prolonged inflation and higher rates ultimately results in a higher interest burden and additional pressure on borrowers,” he adds.
While this might be bad news for the asset class as a whole, he believes that asset managers can produce better outcomes. “Some loan issuers have hedged their floating rate liabilities back to a manageable fixed level, meaning they are less implicated by rising floating rates,” Spencer says. Another factor to consider could be companies passing on inflation costs to the consumer and a strong dispersion of leverage and earnings before interest, taxes, depreciation and amortisation (EBITDA) stability across the loan universe, he predicts.
Sharples also sees increased opportunities for more actively managed bond exposure in DC, especially because many retirement date funds burnt their fingers on long-dated gilt exposures last year. Rather than just focusing on costs, DC investors should be focussing more on overall outcomes for members. “It’s quite ironic that in the DC space, there has been so much focus on cost and you can haggle over and over on one or two basis points. But when you then look at the dispersion of returns between the best and worst performers, that overshadows the cost question,” Sharples says.
Passives: when the going gets tough
Does this mean more investors could be ditching passives in favour of active managers? Fund flows since the start of this year suggest otherwise. While it remains difficult to gauge the exact scope of institutional flows, with most data providers focussing on mutual fund flow data, there nevertheless appears to be continued appetite for passives.
In the UK, money market funds, which had reported a surge of more than £60bn in inflows in September, are now reporting outflows as investors turn to bonds. While mutual fund flows are by no means a proxy for institutional allocations, it remains hard to explain this pattern in isolation from last year’s LDI crisis.
In January, bonds celebrated a comeback, attracting £3.5bn, according to Lipper, roughly two thirds, or £2.1bn, of which went into passive funds. More than half (£1.6bn) went into passive mutual funds with the remainder into ETFs. Interestingly, passively managed corporate bond funds appear to be the main beneficiaries so far, with corporate sterling bond attracting more than £1bn in January alone, highlights Dewi John, head of UK and Ireland research at Lipper. “While you might expect short-dated bonds to have been popular over the past year of rising rates, that’s not been the case, with the classification having suffered £3.9bn of outflows during the year to January,” John says.
“And, while bonds are back, baby, it’s a tad surprising to see Bond Global High Yield GBP (£308m) appear in the top 10, with investors generally keeping high yield at arm’s length, with the default rate expected to rise.” But fresher fund flow data from Blackrock shows that this trend might be about to reverse. After a record 2022, where the asset manager reported $146bn (£119bn) of flows into its exchange traded products (ETPs), accounting for more than half of all investment into such products globally. In February this year, Blackrock reported $1.6bn ($1.3bn) of outflows from investment-grade bond ETPs and a whopping $6.7bn (£5.4bn) from high-yield passive vehicles. Simultaneously, US treasury ETPs reported net inflows of almost $11bn (£9bn) in one month alone. These sharp swings in sectors, depending on the interest rate outlook, suggest that investors might be using ETPs for shortterm tactical trades. This may even include active bond fund managers, who might find it easier to implement a strategy using an ETF, rather than buying the underlying bonds, Kalus says.
Detlef Glow, head of EMEA research at Lipper, believes there are good reasons for investors to opt for passives in times of crisis. “Over the last 15 years, we have had three major market incidents with massive outflows from the active side where we still had inflows on the passive side. The 2008 crisis, the euro crisis in 2011 and the market turmoil during the second half of 2018, through all these three incidents, ETFs enjoyed inflows. “I would say, investors are moving into the direction of passives when markets get tough. When the going gets tough, the tough get going,” he adds.
Glow sees transparency and liquidity as the key factors driving investors towards passives during a crisis. “In times of market turmoil, you want to know exactly what is in your portfolio,” he says. “If you buy an actively managed fund, you buy a black box. You might have country or sector allocation but you won’t have full knowledge of all constituents of your portfolio so you can’t hedge those risks, you do not know exactly what is in your portfolio.”
Glow adds that institutional investors might use the liquidity of ETFs to execute tactical short-term portfolio adjustments in a volatile market environment. “An ETF can be bought and sold within a minute. Whereas on a mutual fund you have T+2 plus order deadlines. If you consider a situation like the crisis in gilt markets, it would have blown over before you had been able to liquidate,” he says.
But the question of ETFs as liquidity providers in times of market stress remains hotly contested. This is because the arbitrage mechanism in bond ETFs is set up differently to equity ETFs. Bond ETF sponsors have greater levels of flexibility as to the composition of their baskets, rather than exactly replicating the index. Some academics warn that this feature can accelerate imbalances between creations and redemptions in times of market stress, as authorised participants might be reluctant to purchase more of the same titles that they already hold in their redemption basket. Indeed, evidence from the 2020 bond market volatility shows that some ETFs traded at discounts to their net asset value.
But advocates of the argument that bond ETFs bolster market liquidity would point to the fact that throughout these periods of market distress, overall ETF trading volumes reached record levels, while liquidity of the underlying bond markets dried up.
Best of both worlds
The jury is out on the active versus passive debate. Much will, as so often, depend on the needs of the individual investors. But rather than passives replacing actives or vice versa, a clear pattern seems to emerge whereby institutional investors are opting for a combination of active and passive strategies in their fixed income portfolios, even including ETFs in some cases.
The rising rate environment has offered interesting opportunities for active managers in some sectors, as the higher levels of outperformance in sectors such as corporate debt illustrates. But passive funds, and ETFs in particular, are also taking on an increasingly important role in institutional portfolios. In volatile markets, investors want to manage risks more actively. Paradoxically, this could be by using a passive vehicle.
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