The average fixed-income manager outperforms their benchmarks — but it’s not because of their investing prowess, according to investment professionals at quantitative investment firm AQR Capital Management.
The phenomenon runs counter to what is happening in the equity markets, where active managers often fail to beat benchmarks, according to a new episode of AQR's podcast, “The Curious Investor.”
The reason? Fixed income managers regularly beat their indexes both because the indexes themselves aren’t always reliable, and because managers tend to buy riskier bonds than the passive investors who simply buy the index, according to the podcast’s hosts, Dan Villalon, a managing director at AQR, and Gabe Feghali, a vice president at the firm. The episode relied on data from the eVestment database on core, core plus, and unconstrained fixed income managers between 1997 to 2017, as well as AQR’s own analysis of fixed income returns.
According to Tony Gould, a managing director at AQR who helped the firm build out its fixed-income platform, part of the problem is the way indexes are constructed. Because the indexes leave out a wide array of securities, most portfolio managers will reach for bonds that are not included in them. If those securities outperform the indexes, so too will the average bond manager.
“The broadly-used indices like the U.S. aggregate market by no means represent the total bond market,” Gould said on the podcast episode.
Another reason fixed income managers beat indexes so often? According to Villalon, central banks that buy bonds aren’t trying to beat the market.
“It’s easy to beat the benchmark when lots of fixed income investors aren’t in it for the profits,” he said.
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But there’s more to beating the benchmark than the benchmark’s own flaws.
Gould and his colleagues tested fixed income returns and found that simply being long credit risk is another way to beat the benchmark.
“Most managers take even more credit risk than the benchmark,” Feghali said. In other words, much of the success of active fixed income managers can be attributed to them owning more credit risk, he added.
This has the opposite effect on managers when markets go south. Gould noted that in the fourth quarter of 2008, the average active U.S. aggregate fixed income manager underperformed the benchmark by four percent.
“Those periods when equity markets are under pressure, like the fourth quarter of 2008, also tend to be periods where corporate bond markets or credit risk is also under pressure,” Gould said.