Active fixed income strategies tend to beat their benchmarks — but much of that excess return just comes from passive exposures to traditional risk premia, according to researchers at AQR Capital Management.
Instead of delivering “true alpha,” active fixed income managers have been mostly “repackaging” traditional risk factors such as duration, corporate credit, emerging markets, and volatility risks, found researchers Jordan Brooks, Tony Gould, and Scott Richardson. Brooks and Richardson are AQR principals who serve as co-heads of fixed income, while Gould is a managing director at the factor investing firm.
Fixed income alpha “may be merely an illusion,” the trio wrote in a recent paper on the findings, noting that they detected “little evidence” of manager skill in active fixed income. “The repackaging of traditional risk premia appears to be a pervasive phenomenon in active management, and investors should be wary of paying active management fees for passive exposures.”
For their study, Brooks, Gould, and Richardson analyzed a sample of 665 fixed-income managers operating U.S., global, and unconstrained bond strategies between March 1998 and September 2019. “At first glance the story is clear,” they wrote. “Active [fixed income] managers beat their benchmarks.”
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However, a deeper dive showed that most of these excess returns could be explained by exposure to risky credit.
“It does not necessarily imply that active [fixed income] managers are simply buying risky corporate bonds,” the three authors wrote. “But it does suggest whatever it is they are doing (carry trades, overweighting securitized assets that embed credit risk, etc.) ends up providing the investor with something that resembles — and is highly correlated with — credit exposure.”
According to the AQR researchers, passive exposures to risk premia can be “particularly nefarious” in fixed income, because they can make the portfolio “significantly” more correlated to equities.
“This is hardly comforting for an investment into an asset class that is meant to provide diversification from equity markets,” they wrote.
Brooks, Gould, and Richardson found that actively managed fixed-income strategies tended to underperform their benchmarks during the worst quarter for U.S. equities, mitigating the diversification benefits of investing in fixed income. A 60-40 portfolio of stocks and bonds also experienced an “undesirable” increase in volatility when it was overweight active fixed-income strategies, according to the paper.
“The commonality in this ‘reaching for credit risk’ may lead to a substantial reduction in the diversification benefit of the [fixed income] asset class when hiring multiple active managers,” the authors wrote.
