OPINION | The ‘climate wars’ pitting the two major political parties against each other have been one of the most debilitating features of the public policy debate in Australia over the past decade. It’s been a zero-sum game in which neither side can concede even a sliver of merit to their opponent’s position.
In the investment industry, the endless passive-versus-active contest is the equivalent. It’s time to declare an end to this conflict by acknowledging that at the highest level, there is always an active decision.
Asset allocation decisions are the most important active decisions investors can make and, in this context, both investment approaches have validity and deserve a place in client portfolios.
Our research shows that quality managers consistently outperform benchmarks across a wide variety of fixed income asset classes, delivering outperformance 75 per cent to 95 per cent of the time. Moreover, the median manager also did well, outperforming core fixed income benchmarks 50 per cent to 60 per cent of the time. The research also reveals that manager quality and selection are especially important in the specialised fixed income niches of inflation-linked, emerging markets and currency.
Fixed income v equities
These results may be different to those from equity markets. What might explain the fixed income difference?
First, the differing motivations and behaviour among the three investor groups in the fixed income world – passive, active and less economically sensitive actors – make like-for-like comparisons are inappropriate. The less economically sensitive group is dominated by central banks, whose currency and interest rate management priorities (not returns) drive bond ownership programs and also, to some extent, by insurers required to hold bonds owing to accounting and regulatory requirements. This group makes up almost half of the global bond market.
Investment constraints on these less economically motivated investors and on passive investors create opportunities for active investors. Furthermore, the investment environment has shifted profoundly, making the case for active investing even more resounding.
During the 30-year bull run in fixed income markets, being invested solely in the index garnered capital returns for investors. That tailwind is now poised to morph into a headwind. An index-only approach may be suboptimal.
At best, passive indices will be an income source but risk capital attrition. Furthermore, amid greater regulatory pressures and central bank monetary policies that have dampened volatility, greater breadth is required in portfolios to achieve desired returns.
Discipline of capitalism
While there may be a perception that active returns have diminished across the board compared with the pre-GFC era, the reality is different. Strategies with strong credit weightings are doing better, as the rewards from carry are now greater. By contrast, unconstrained bond and emerging markets strategies are rewarding less, casualties of the low-volatility environment and the chase for yield.
Our analysis reveals that owing to correlations across the different components of fixed income, diversification is rewarded. Different return drivers work well at different points in the cycle, as markets respond to diverse liquidity drivers or look ahead to the impact of macroeconomic and geopolitical events.
Perhaps above all else, the discipline of capitalism is the strongest case for active investing. Capital allocation stemming from active investing serves a virtuous economic purpose. It withdraws capital from governments and companies exhibiting financially harmful behaviour. It also rewards governments and corporations that manage their finances well with lower borrowing costs.
It is time to call an end to the passive-versus-active duel. Both groups have to become closer to clients to create true partnerships focusing on problem-solving and transcending products or even investment philosophy fixations.
Susan Buckley is a managing director of QIC, where she leads the global liquid strategies team. She will be part of a panel discussion titled “Tied to the benchmark or unconstrained”, at the Investment Magazine Fixed Income, Cash, and Currency Forum, to be held in Healesville, Victoria, on July 25-26, 2017. To view the agenda or register, visit the event website.