Just like the phoenix in Greek mythology that rises from the ashes, the debate over active versus passive management has come back to life, based on the misperception that 2014 was rather a bad year for active management. In reality, only the fourth quarter was a bad quarter for active fixed income managers and for 2014, the returns of Barclays U.S. Aggregate Index was a second-quartile performer when ranked against a universe of the net returns of intermediate-duration fixed income managers. This occurred despite the near consensus view that U.S. interest rates would rise and non-Treasury sectors would outperform. I’d also like to point out that this one quarter of “underperformance” doesn’t reflect a systemic challenge — considering how poorly the Barclays U.S. Aggregate performed in 2013.
As the table below shows, when compared to the Barclays U.S. Aggregate, a proxy for the performance of passive managers, active fixed income managers have substantially beaten passive managers over the past one-, three-, five- and ten-year periods. Going forward, we don’t expect this scenario to change, even as we leave the easy beta world to enter a place where there will be more opportunities to add alpha.
Indeed the landscape for active management in the fixed income space remains constructive. Sector rotation, security selection, and risk management hold the keys to adding alpha; not making big macro calls nor being passive in your investment strategy. A combination of monetary divergence and the end of quantitative easing (QE) in the United States, lower liquidity since the global financial crisis, and increased money in motion will lead to more prices swings that will influence more sector dispersion and increase idiosyncratic risk between securities.
Let’s consider the high yield market. As the table below shows, the average fourth-quarter returns in high yield varied significantly among industries. While returns on energy companies were down over 9%, high-yield banking companies were up over 2%, on average. In addition, the performance dispersion within the high-yield energy industry varied greatly. Independent high-yield energy companies were down 15.2% for the quarter, yet midstream energy companies were only down 1.3%. This type of dispersion creates pockets of opportunities that a passive strategy cannot capture or idiosyncratic risk that a passive strategy cannot avoid.
A passive manager cannot avoid those energy sectors that are most tied to the price of oil. They also cannot sort through the carnage to buy distressed energy bonds in 2015 of companies with revenues who have little sensitivity to the price of oil. An example would be independent oil companies, whose revenues are hedged or aren’t tied to the Bakken Shale Basin.
I would expect active management to continue its long track record of outperforming passive investing. As we begin 2015, the increase in dispersion and volatility in the fixed income market will result in an increase in trading opportunities. In addition, as the Fed’s rate intentions become clearer in the second half of the year, it will create a different set of opportunities for investors.
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