Legg Mason’s subsidiary Brandywine has attacked passive fixed income products as unfit for investors.
David Hoffman, chief investment officer of US asset manager Brandywine Global, said the problem with investing passively in bonds was that there was “no fixed income index that makes sense in the long term”.
As with equity indices, where stocks are weighted by market capitalisation, most fixed income indices are weighted by the amount of debt issued, so the companies or countries that issue the most debt are the biggest index constituents.
Mr Hoffman said this made passive fixed income investing “unattractive” compared to accessing the asset class through active management.
“Fixed income indexes are driven by who issues the most debt and the biggest debtors are not always the best performers,” he said.
“They might be sometimes and they might not be, so to us the index construction tells you absolutely nothing about how you can make money in the world of bonds.”
Within the two main indices for global government bonds – the Citigroup World Government and the Barclays Global Aggregate indices – bonds denominated in dollars, euros or the yen make up the vast majority of the indices.
Mr Hoffman said this meant that an investor in a passive global bond product was unlikely to be getting much diversification.
He pointed out that the question of currency fluctuations was also an issue for fixed income indices, and the passive investors that follow them.
Mr Hoffman said passive investors were required to ride out the currency fluctuations even if they only wanted access to the underlying bonds.
“No index buys the bonds and hedges out the currency, but I think it is really important to separate out interest rate [risk] and currency [risk],” he said.
Mr Hoffman said the funds managed at Brandywine had been “index agnostic” for the past 20 years, in that the managers have ignored the composition of their benchmark index when constructing a portfolio.
“Our definition of risk is losing our clients’ money rather than having a tracking error risk, which assumes the benchmark is the right place to be,” said Mr Hoffman.
In spite of the apparent problems of tracking fixed income indices outlined by Mr Hoffman, passive fixed income products have become increasingly popular, particularly in the US.
Mr Hoffman said some passive fund groups such as Vanguard had done very well out of promoting the low-cost aspect of passive fixed income investment.
This could have particular resonance when the returns from fixed income are predicted to be fairly low in the widely-expected rising interest rate environment.
However, Mr Hoffman suggested another reason for the popularity of passive fixed income products is that many investors do not understand how the fixed income markets actually work in practice.
Selecting the right bond products is key, says Fidelity’s Greetham
Brandywine’s David Hoffman is likely to espouse the benefits of active management given he is himself an active manager.
However, Fidelity’s multi-asset manager Trevor Greetham, who runs both active and passive strategies, seems to suggest allocating to fixed income – particularly in the high-yield space – should be done actively.
Mr Greetham said while default rates had been low, “any change in these conditions may result in an increase in these worst-case scenarios”.
“Such an increase in default rates among high yield bonds would make security selection even more crucial,” he added.
“The fate of Phones4U this September served as a stark reminder of the importance of individual security selection in the high-yield market.
“When this prominent UK company went into administration, investors in its payment-in-kind notes and senior bonds (each a form of high-yield bond) incurred significant losses.”
Mr Greetham added many passive funds are weighted according to market capitalisation, which while reflecting the market, “could also leave investors with unintentional skews towards particular types of companies or certain global regions”.
“For high-yield investors, this is particularly important,” he said.
“The size of a company’s debt issuance is rarely a reliable indicator of its strength, but particularly large amounts could be a negative signal. Market cap weightings in the high-yield space can also create biases to countries like the US, giving insufficient attention to regions like Asia, where opportunities are growing.
“Of course, passive instruments can be used as part of an overall active investment strategy, and give good exposure to wider high-yield markets if managed effectively.”
