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Active share keeps delivering healthy returns

| April 26, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Fee pressure has made delivering excess return on benchmarked portfolios arguably more important than ever before, but generating excess typically takes more than just a few tweaks to asset mix or security selection. It usually means stepping well away from the benchmark, which may not be for the faint of heart. Returns on US mutual funds benchmarked to fixed income in the last year are just the latest clear example.

Of the 32 US fixed income mutual funds or ETFs with more than $10 billion in assets, the ones that swung asset allocation away from the benchmark the most were also the ones that delivered the most excess return. On a scale from zero to 100, where zero means no difference between fund and benchmark asset allocation and 100 means complete difference, funds generally needed a score of 50 or more to start showing alpha (Exhibit 1). That means that half the asset allocation or more had to differ from the index. The nine funds managing $377 billion with scores above 50 showed an asset-weighted alpha of 8.1 bp; the 19 funds managing $578 billion with scores below 50 showed an asset-weighted alpha of 0 bp.

Exhibit 1: Alpha improved as funds moved away from benchmark allocation

Note: Data reflect returns on US funds screened on Bloomberg to have the Bloomberg/Barclays Aggregate Bond Market Index as primary benchmark and at least $10 billion in AUM. Of the 32 funds identified,30 had sufficient data for analysis. Excess return reflects weekly performance against the primary benchmark ending April 19, 2019. Overlap with benchmark asset allocation calculated as a distance measure with [SUM(Fund Allocation to Asset Class X – Benchmark Allocation to Asset Class X)^2]^(0.5). Source: Bloomberg, Amherst Pierpont Securities calculations.

The road to alpha took different routes, but the five funds with the highest alpha also had the highest allocation to equity and corporate debt (Exhibit 2). Equity might not seem obvious for a fund benchmarked primarily to a bond index, but investment guidelines can offer broad flexibility. The generally lower correlation of equity to fixed income creates a more diversified portfolio and often helps lift excess return against a fixed income benchmark. Of the funds with no equity, higher alpha was slightly correlated—but only slightly—with going overweight corporates, mortgages or preferred debt and underweight Treasury debt. That means some portfolios swung for the fences in these assets and ended up negative.

Exhibit 2: Overweights in equity, corporate debt and MBS helped alpha

Note: Data reflect returns on US funds screened on Bloomberg to have the Bloomberg/Barclays Aggregate Bond Market Index as primary benchmark and at least $10 billion in AUM. Excess return reflects weekly performance against the primary benchmark ending April 19, 2019. Asset allocation based on Bloomberg algorithm. Source: Bloomberg, Amherst Pierpont Securities calculations.

It’s worth noting that this level of analysis only addresses broad asset allocation and not the potential gains from security selection within an asset classes, from out-of-index exposures or from other strategies. These are other roads to alpha that could have contributed to these results, too.

For veterans of the benchmarking wars, these results may come as no surprise. Since Martijn Cremers and Antti Petajisto at Yale first asked How Active is Your Fund Manager? A New Measure That Predicts Performance, investors have focused on the tendency of investment performance to improve as managers either allocate away from benchmark asset class weightings or go strongly overweight or underweight securities within an asset class. Cremers and Petajisto found that differing from a benchmark often by 50% or more is essential to beating it. Managing against a benchmark is not for the timid.

The pressure to show a high active portfolio share clearly increases as the fees on benchmark returns fall. High active share broadly worked over the last 12 months. With passive funds and ETFs making the falling price of benchmark performance increasingly clear, asset managers will likely have to keep looking for relative value opportunities and other exposures that keep them ahead of the crowd.

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The view in rates

Rates sold off through the first half of April, but reversed course over the last two weeks, retracing most of the move. Q1 GDP surprised to the high side, but that was partially based on an inventory build that will likely be reversed in Q2. Underlying inflation data was also weak, now threatening to drop to 1.6%, falling below the Fed’s 2.0% target. This has markets speculating on the chance of two rate cuts by year end.

The yield on 2-year notes has dropped to 2.28%, consistent with nearly two Fed rate cuts over the next two years. That suggests a Fed willing to defend growth, or act solely to stimulate inflation. That first seems realistic if growth slows below 2.0%, which appears increasingly unlikely. The latter seems unnecessary at current levels, though it’s unclear what threshold inflation would need to breach for the Fed to consider a standalone move.

The view in spreads

Relatively low volatility and heavy net Treasury supply should help spread products tighten. The corporate market still has issues with leverage in investment grade debt and loose underwriting in leveraged loans; a slowing economy should put pressure on those sectors. But corporate management is starting to deleverage. Still, credit concerns linger. Agency MBS should broadly outperform corporate debt, with investment grade in particular looking tired.

The view in credit

Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. Households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.

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