Andy Hunt, Co-Head of Wells Fargo Asset Management Global Fixed Income, shares reasons why and how we believe active fixed income managers add value to investors.
Laurie King: I’m Laurie King, and you are listening to On the Trading Desk®. Our guest believes that skilled active managers in the fixed-income space have successfully demonstrated a consistent ability to add value for investors. Here to explain why this is the case in fixed income, and how, is Andy Hunt, Co-Head of Global Fixed Income at Wells Fargo Asset Management. Andy, welcome.
Andy Hunt: Laurie, thanks for having me on the program.
Laurie: This will be the first of two episodes on this topic. In the second part of our conversation with Andy, we’ll discuss where active managers add value for fixed-income investors. This discussion stems from research he and his team have done to deliver a paper that details the topic at length. But Andy, what inspired the research effort? Why now?
Andy: Well, really, it was based on a couple of observations. We’d been hearing a lot about the gradual move from active management to passive management, and what caught my attention one day was I saw a number for fixed income that said 20% of fixed income was passively managed. And that surprised me—I always believed that active management would win in fixed income. And then I saw some performance numbers that verified active fixed income managers do, generally, after adjusting for risk, quite routinely beat the benchmarks that they are measured against. And then, by extension, would that naturally curb investors’ enthusiasm for passive management in fixed income?
Laurie: So, the outperformance that your paper indicates, it’s due to three areas of structural inefficiency. The first area was investor and market composition. Can you tell us a little more about that?
Andy: It’s basically borrowers borrow when they need to borrow, and different types of borrowers will borrow at different points in the cycle and for different reasons. And investors have, almost, a preferred habitat. And it’s not always the case that capital is freely flowing. It can get, sort of, trapped. And that leads to pricing to go out of line, or moving out of line, or away from where true market-clearing pricing should really be.
But that’s the tension between issuance and demand that can create relative value opportunities. And this is no more apparent than in the home-country bias. Lots of fixed-income investors buy their equity exposure globally, but yet buy their fixed income exposure domestically. So, put it all together and we see there’s opportunity for active managers to either observe, predict, or rotate between and amongst the market sectors as all these sort of supply/demand factors are washing through different markets at different times.
Laurie: Very interesting. The second area you’ve identified as there being structural inefficiencies is an area you call benchmark construction. Can you say more about that?
Andy: Yeah, this is a personal favorite of mine. Fixed-income benchmarks aren’t, frankly, all that good. Equity benchmarks are constructed in a way that most investors’ money goes towards the opportunities that are deemed to be most beneficial.
The market collective wisdom suggests that there are best places to put your investment dollars. Fixed-income benchmarks aren’t really created that way. They are created by market issuance and rating agencies. Put it another way, your capital allocation isn’t optimized for yield or risk. It’s following market supply and rating agencies. And I think there’s a lot of work being done to try and improve benchmarks, but none-the-less it’s fruitful territory for credit-based or security selection-based active managers to exploit the inefficiency. The market does vote with its feet ahead of rating downgrades and defaults and spreads move ahead of those activities, suggesting that active managers can predict rating agency behavior. So again, a fruitful area for active managers to capture some added value.
Laurie: And the third area you characterize as practical complicity. Tell us about that.
Andy: Yeah, it would be nice if the world were simple. Unfortunately the world of fixed income isn’t simple.
And that complexity just means that it’s actually quite challenging for passive managers, or passive mandates, to actually deliver on their promise, which is they will track the market. Therefore, if passive management fails to achieve its goal, it’s easier for an active manager to beat it. You don’t have to beat the market by a lot to beat passive management, which often fails to achieve market exposure. And that has a lot to with the fixed-income market being so very diverse and heterogeneous—tens of thousands of bonds. Mispricing between individual securities is therefore very likely to occur.
And so, put it all together, active managers with skill understand, forecast, and avoid bad events, where passive mandates essentially buy the bad bonds as well as the good bonds without any filter, without any discernable ability to be able to avoid the bad events.
Laurie: Andy, we want to hit the pause button on this discussion for now and we’ll start again in part two where you help us understand where active managers add value to investors. So thank you for your insights today.
Andy: And I thank you Laurie. I’ve enjoyed it.
I’ll remind our audience to visit our blog AdvantageVoice® to stay informed on this topic and others. And if you’re an institutional investor or an investment professional, reach out to your relationship manager for Andy’s full market insight paper. Until next time; I’m Laurie King, take care.
Mr. Hunt’s active management performance observations are based on data obtained from eVestment Alliance and Wells Capital Management, Inc. as of December 31, 2017.