As markets reach an inflection point in the interest rate cycle, investors need to consider how active managers can exploit the opportunities created by passive trading and extract more return from the market.
Short-term credit has been in high demand in recent years and many retail investors have opted for passive funds to gain exposure. According to Morningstar, passive fixed income funds saw new flows in 2023 estimated at £241 billion, compared to £43.2 billion in active funds. Around a quarter of the all-maturity sterling corporate bond market is passive (£12bn of £48bn), compared with almost half of the short-term bond market (£4.3bn sterling over £10 billion)*.
But while an interest rate cut is almost certainly forecast for 2024, there is reason to rethink this passive stance, particularly when analyzing asset classes such as short-term credit.
“The market is looking for beta and that is why we have seen growth in liabilities in recent years. But today, relative value is becoming increasingly important due to volatility and greater dispersion. This is where active investors will be able to generate more alpha,” says Shamil Gohil, manager of the £496m Fidelity Short Dated Corporate Bond Fund.
Kris Atkinson, senior portfolio manager of the strategy, agrees that, citing recent economic tailwinds, opportunities for short-duration active managers have increased significantly. “After a long time, central banks no longer have the influence they once had. And we’re already seeing greater dispersion across asset classes and investments, both on the credit and equity side. As growth trends decline, it stands to reason that we’re going to see more of them, so we have a lot more opportunities to take advantage of now.
SUB-OPTIMAL PERFORMANCE?
In a passive approach, the fund replicates the benchmark index, which means regular rebalancing, higher turnover and increased transaction costs. Overall, passive funds also tend to underperform indexes on a net basis due to these fees. In the short-term credit sector, this underperformance is even more pronounced and often means that the passive performance of this asset class may be “sub-optimal”.
The figures support this consensus. The short-term passive fund with the longest track record in the IA £ corporate bond sector has generated an average calendar year underperformance of 0.15% against its respective index since its inception in 2014 Considering that the average return of the index over a calendar year was 1.5%. over the period (2014 to 2023), an underperformance of 0.15% represents almost 10% of the total return lost.
Additionally, passive assets are also liable for market emissions. That’s not a surprise, but it means investors have more exposure to bigger names that tend to have higher leverage, according to Gohil.
“When the market is volatile, we as active investors tend to overweight or underweight, and when there are generally bargains relative to fundamental quality, we can overweight these names in time . But a passive vehicle holds market weight by default.
NON-INDEX EXPOSURE
Liabilities are also known for high trading levels, but this is exacerbated in the short-term market where fund managers note that new bonds are constantly entering and leaving the 1-5 year index as they approach their deadline. As a result, passive funds are forced to buy and sell at both ends of the maturity spectrum.
According to Ben Deane, director of fixed income investments at Fidelity, this represents an opportunity for active investors, being able to gain exposure outside the index.
“If you think about a one-to-five-year benchmark tracked by passive funds, you’re limited to buying one-to-five-year bonds. When a bond takes less than a year to mature, you are a forced seller,” he explains. “This presents a good buying opportunity for active investors. Similarly, active investors can purchase bonds with a maturity of 5.5 years before entering the benchmark by one to five years and thus benefit from forced passive purchases when these bonds enter the benchmark. .
“Also, the 5-6 year part of the curve is quite steep and we are able to let these bonds play out.”
COMPLEX OPPORTUNITIES
Meanwhile, Atkinson explains that another area where the team can add value through active management of short duration bonds is in “complex” credit, such as asset-backed securities, or credit opportunities. within regulated public services such as the water sector.
The ability of managers to explore these sectors and find attractive investments allows them to identify opportunities that some fund companies will be less likely to access.
“Asset-backed securities, and we also rely on sectors that have physical assets, offer a defensive asset at a good value. Similarly, in the area of regulated utilities, we like the water sector which, despite the headlines, remains recession and inflation proof, highly regulated and quite cheap . These are areas where we place a lot of value and, as active managers, we believe we have an advantage due to corporate access to companies. We know and understand the bond documentation, the regulatory framework, how this intersects with government policy, and our insight has allowed us to take a high conviction view on this.
IMPORTANT INFORMATION
This is for investment professionals only and private investors should not rely on it. The value of investments and the income from them may rise or fall, so you may get back less than you invested. Past performance is not a reliable indicator of future performance. Investors should note that opinions expressed may no longer be current and may have already been subject to action. Reference herein to specific securities should not be construed as a recommendation to buy or sell such securities and is included for illustrative purposes only. The value of investments in foreign markets may be affected by changes in exchange rates. Investments in emerging markets may be more volatile than in other, more developed markets. There is a risk that bond issuers will not be able to repay the money they borrow or pay the interest. Rising interest rates may cause the value of your investment to decline. The price of bonds with longer lives to maturity are generally more sensitive to interest rate movements than those with shorter lives to maturity. The risk of default depends on the issuer’s ability to pay interest and repay the loan when due. The risk of default can therefore vary between government issuers as well as between different corporate issuers. Below investment grade bonds are considered riskier bonds. They present an increased risk of default which could affect both the income and capital value of the fund investing in them. They may also use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and result in greater than average price fluctuations.
Investments must be made on the basis of the current prospectus, which is available free of charge on request by calling 0800 368 1732 together with the key investor information document (key investor information document ), the annual and half-yearly reports in force. by FIL Pensions Management, authorized and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and the F symbol are trademarks of FIL Limited. UKM0424/386592/SSO/NA
