By: Kristin Aleksandrowicz, Portfolio Specialist and Arkady Ho, CFA Fixed Income Portfolio Strategist
In the world of investment management, the active versus indexed debate is a longstanding one. As the discussion has evolved over time, a new question has emerged as to whether an active, indexed, or systematic approach makes more sense for certain fixed income sectors, and for the asset class as a whole.
For a long time, active strategies dominated the entire investment landscape. As indexing options developed, investors came to value the efficiency and lower costs inherent in such strategies. More recently, systematic investing has emerged as a powerful approach, leveraging data and algorithms to optimize investment decisions. As a result, bond investors can benefit from the experience and skills of investment professionals, as well as the rigor and breadth of systematic investing strategies.
As we focus attention in this piece on fixed income investing styles, there are two points worth emphasizing at the outset:
- Market expertise is required for active, indexed, and systematic fixed income investing.
- Asset managers that possess expertise across a breadth of capabilities and investment styles can most effectively deliver solutions to investors.
Understanding the challenges that investment managers face in each bond sector is important, as are the techniques that are utilized to meet investors’ objectives. Investors armed with this knowledge can determine what risks they are comfortable with and what their return objectives are. An asset manager with broad active, indexed, and systematic capabilities across fixed income sectors and geographies can allocate to sources of risk and return from various markets to fulfill unique client objectives. Recognizing when an active, indexed, or systematic approach to bond investing makes sense can be invaluable for investors.
When Active Makes Sense
The case for active largely depends on objectives, constraints, and fees. Assuming that an investor does not want out-of-sector positions (but guidelines are not otherwise constrained), credit and securitized mandates are two examples of sectors that lend themselves well to active management. Excess returns of 25–50 basis points (bps) or more, before fees, are possible — assuming moderate discretion — in these sectors due to structural inefficiencies, cyclical fluctuations, and security selection opportunities.
When Indexing Makes Sense
In general, the case for indexing in fixed income is strongest when alpha potential is low, and the cost of indexing is also low (i.e., where liquidity is high and bid/offer spreads are reasonable). However, this should not be interpreted as implying that indexing should only work for developed market government bonds, where liquidity is inexpensive; the argument is also strong when an experienced fixed income index manager has an investment process that adds value and can effectively reduce the cost of indexing. Such a process may include stratified sampling, thoughtful buy/sell timing, participation in new issues, and minimizing turnover.
When Systematic Makes Sense
Systematic fixed-income investing makes sense for investors seeking alpha generation through a consistent, rules-based approach to security selection. It is particularly effective in bond markets with extensive data history and coverage, where quantitative signals demonstrate efficacy over multiple cycles and in different market environments. In these contexts, data-driven models can identify opportunities that may not be apparent to human managers. This approach reduces biases and emotions in decision making, ensuring a disciplined adherence to the predefined strategy. Additionally, systematic investing can be advantageous in managing large, complex portfolios where scalability and efficiency are paramount, allowing for precision risk management and cost control.
When It Depends
The decision to employ active, index, or systematic strategies will ultimately depend on an investor’s objectives and risk appetite — not all investors in fixed income markets are profit-maximizers. For some, like insurance companies and defined benefit (DB) pension schemes, the priority may be risk-minimization rather than benchmark outperformance.
The lines separating active, index, and systematic strategies begin to blur when an investment management firm has vast market knowledge, experience, and cutting-edge research capabilities and technology.
Though widely used within equity investing for many years, systematic investing is a relatively newer concept in fixed income due to the relative complexity and illiquidity of bond markets vis-à-vis equities.
Where Expertise Matters
Liquidity and turnover costs are incurred by active, indexed, and systemic strategies alike. Indexers must reallocate according to new benchmark weights, while active managers must adjust to maintain their preferred positions through benchmark changes or align portfolios with their latest views. With systematic strategies, dynamic updating that’s also turnover aware can keep the overall strategy attuned to current market trends and maintain positive tilts to our alpha factors, while recognizing that excessive portfolio churn can materially erode performance. However, not all sectors of the bond market are created equal.
As expected, developed market government bonds are very liquid, followed by US and Global Aggregate indices that are largely made up of governments and mortgage-backed securities (MBS). Beyond this, higher points in the chart include credit, emerging market government debt, and high yield. Some more complex beta strategies require frequent and expensive trading to remain in-line with strategy objectives.
Key Takeaways
- Alpha potential exists in almost every sector covered, with opportunities also available for index managers to add value through intelligent indexing, and for systematic investors to capitalize on data-driven strategies.
- Much of the same expertise is needed for active, index and systematic management – the primary difference lies in how that ability is deployed.
- The risk factors driving alpha are different between sectors, as are the skills necessary to successfully implement an active, indexed, or systematic strategy. For each sector covered in a mandate, investor preferences and a manager’s expertise should be aligned.
Originally Posted August 29th, 2024, SSGA
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