When considering whether active versus passive investment management is the best method, an important facet to the debate is often overlooked. Active management extends to not only the overall asset allocation decision, but also to each of the respective asset classes. Here at Zurich, we manage approximately €6.3 billion in fixed income investments with a large proportion of it held across our range of actively managed bond and multi-asset funds*.
The benefits of active management in bonds are not as well publicised, but are just as important as those in other asset classes, namely equities. We are a focused active bond manager, with a remit to manage European sovereign debt and higher quality non-sovereign bonds across a range of markets.
An important point to note within fixed income investment is how bond indexes are constructed. For example, an index could be constructed based on the amount of debt issued, meaning that the most indebted countries could make up a proportionally large part of the index. This scenario is curiously referred to as the 'Bum's Problem', but an active manager has the discretion to mitigate and reduce such a risk in a fund or portfolio.
The biggest borrowers don't necessarily have good credit. Another key point with attempting to track a bond index is how difficult they can be to sometimes replicate. The liquidity and availability of some bond issuances can prevent some passive managers from holding all the constituents of an index. Many bonds are also traded on secondary markets, or 'over-the-counter'. This means that price information is not always readily available, and would not be as transparent or widely disseminated as in other asset classes. Geographical and duration exposure can also drift significantly without altering the composition of an index. As yields and coupons move downwards, the duration of a bond fund can move upwards. In general, bond index composition tends to be more complicated.
Different participants in bond markets also have different motivations. The overriding incentive to invest in equities is to receive a positive return on the capital employed. Whilst this can be a reason there can also be other 'non-economic' factors at play within fixed income markets. Central Banks, Commercial Banks, pension funds and insurance companies all may have a need to purchase bonds; irrespective of the capital outlook.
Accounting rules, market regulations, liability matching, and the implementation of macroeconomic policy are all potential reasons to enter the bond market. Indeed, Quantitative Easing is a prime example of this. Recent data from JP Morgan shows that Central Banks now own a third of the $54 trillion global bond market**.These differing motivations have been evident across the majority of developed world sovereign debt in recent years, where investing has often implied owning bonds with a negative yield - guaranteeing you would lose money if held to maturity. This has not always been a deterrent to purchasing a bond, with the above reasons often an influence.
Duration is a concept with has become particularly prevalent to investors in recent times. It is something that can be hard to understand, yet can have a material impact on the performance of your investment. Duration can be most simply defined as a measure to illustrate how sensitive a bond's price is to changes in interest rates. Active managers retain the ability to alter the duration of their bond holdings. As interest rates rise, bond values fall, and the opposite is also true. Therefore, depending on where a country (or economic union) is in the economic cycle, and what the current expectation for interest rate changes are, a manager could lower the duration of their holdings in order to reduce their exposure to a rise in interest rates.
This is a course of action that has been taken by the active bond managers here in Zurich over the last two years. Whilst we do not conform to the theory of a 'bond bubble', we believe there is limited upside potential in European sovereign debt. We remain cautious in this area and maintain that fixed income valuations do not look attractive at current levels.
By having the ability to adjust our funds' duration, average maturity and credit quality, we retain the possibility to take advantage of opportunities in fixed income markets, as they present themselves. These same core principles are also applicable to our multi asset funds, including our Active Asset Allocation and Prisma Multi-Asset Fund range. The above points, (index construction, index replication, participant motivations, bond duration) illustrate that tracking an index is not the best way to gain exposure in the fixed income universe.
We at Zurich maintain that the debate is not centred on active versus passive, but more on how active will you be with your investments. At the asset allocation level there is no such thing as passive, just differing levels of active. Finally, not all bonds are the same, duration and geographical splits are a key influence. The Eurozone crisis is a good recent example of this, whereby the credit ratings and borrowing costs of countries within the one currency union fragmented significantly. A percentage allocation alone does not tell you how bonds will impact on your portfolio. It is worth considering this principle with respect to your bond holdings, to be fully aware of what you hold, and what the risks are.
*Source Zurich Life, April 2017
**Source JP Morgan June 2017