Active Bond Funds Juicing Returns With Junk Not Talent, AQR SaysBy
Fixed income returns are highly correlated with junk bonds
Investors can’t rely on funds for diversification, quants say
The skill of active fixed income managers may have been grossly overstated, according to new research from AQR Capital Management.
While parabolic stock indexes create a hard foe for equity managers to beat, their peers in the fixed income world consistently surpass benchmarks. It’s allowed them to evade the kind of cull seen across the rest of the active industry, but the outperformance isn’t due to talent, AQR said.
Instead, managers have simply been loading up on junk bonds to juice returns. Since the category is closely linked to equities, that’s stripped away the diversification benefit bond funds normally provide, researchers at the $208 billion money management firm contend.
“A large portion of active FI manager returns can be explained by exposure to credit markets,” AQR wrote in a recent paper. “The less favorable diversification benefit of active FI managers has also tended to rear its head at quite painful times for investors.”
Of course, the research is a handy way for AQR to promote its factor products, which use a systematic approach relying on a security’s characteristics to try to outperform the market. But it also has implications for the most popular asset allocation strategies.
The study focused on fixed income categories including global and U.S. aggregated benchmarked portfolios, and unconstrained bond portfolios typically benchmarked to cash. While U.S. large-cap equity managers lagged their benchmark by 0.4 percent over the past four years, fixed income managers competing against the global aggregate returned 0.5 percent more, according to eVestment data compiled by AQR.
Yet across categories, excess returns are highly correlated with junk bond markets, the data show. The researchers argue it doesn’t take much skill to tie your fortune to one chunk of the market that behaves a lot like equities, and warn that when stock losses pile up the typical active bond fund won’t adequately protect investors.
For example, in 2008 when U.S. equities fell 24 percent, the aggregate benchmark gained 4 percent and bond managers were “effectively flat (up 0.3 percent) due to the underperformance of credit,” they wrote.
But a skilled and disciplined active manage can provide benefits beyond a passive product, according to Lance Humphrey, a money manager in the global multi-assets team at USAA Asset Management. That’s especially true in a market as illiquid and opaque as fixed income.
“Given the inefficiencies that still exist today in the corporate bond market, my preference would be to have traders, portfolio managers and analysts that can navigate that market,” Humphry said. “Having some flexibility in there makes more sense than on the equity side.”
AQR anticipated that some might defend managers by touting their ability to time markets, for example tilting to high-yield and pulling back at the right moment. But there’s a consistent exposure to credit, and when managers do adjust their holdings “they tend to vary between long and very long,” the researchers wrote.