Given the rise of new technologies and investment products — such as high-frequency trading, exchange-traded funds (ETFs), smart beta and alternative data — the efficiency of capital markets, the ability to quickly adjust a security price to a new equilibrium level when new information is available, has dramatically improved. Active managers, who profit from the inefficiency of the market with a high-conviction approach, have faced much more difficult challenges.
Over the last two decades, an abundance of research has been conducted on the underperformance of active investing against its benchmark over time. The most famous research on the value of active investing came from Fama and French. Their factor model breaks down the active manager’s excess return, return over the benchmark, or so-called alpha, into a set of risk premia on a small number of well-defined risk factor exposures. It turns out that most active managers’ alpha could be decomposed by static exposure to some risk factor premia, which enables investors to easily replicate active investing with a combination of ETFs that provide much lower cost and increased transparency. According to the model, most of the alpha generated by active managers is simply the result of taking on more risk. As a result, the risk will penalize active managers in the long term, with underperformance against simple market portfolios such as the S&P 500 Index.
More recent research, however, shows substantial evidence in support of active managers’ ability to generate alpha, and criticizes the methodology of conventional research so far. Researchers argue that active managers utilize various skills that are not readily available in the capital market.
This week’s chart illustrates active managers’ performance over a 10-year period in equity and fixed income markets. In the equity market, consistent underperformance against its benchmark over time combined with high fees has resulted in active investing being replaced by passive investing.
The chart supports this trend, with exceptions in diversified emerging markets and foreign large blend categories ─ both of which achieve small excess returns over the benchmark. All large cap active equity funds show negative excess return over time. In contrast to the equity market, most of the fixed income categories demonstrate outperformance over their respective benchmark.
How could fixed income managers achieve consistent alpha? Some argue that the fixed income market is less efficient than the equity market, in that fixed income securities are traded in a less liquid, dealer-based auction market. Additionally, fixed income has a less developed secondary market than primary market, which makes the price discovery process less efficient for the security that has been issued. Fixed income securities bear significantly less volatility than equities, so fixed income managers are able to focus more on macroeconomic risks and hedge them more effectively than equity managers who are likely more focused on company-specific risks.
These characteristics provide a better opportunity for active fixed income managers to take liquidity premium from security selection, and to time the market with macroeconomic changes, such as non-farm payroll, Consumer Price Index, Gross Domestic Product and the Federal Reserve’s interest rate policy. However, even considering these market characteristics, outperformance among active fixed income managers is remarkably consistent, and almost seems too good to be true. The benchmark should incorporate all information within its scope into its price, therefore yielding the most efficient price.
Key Takeaway
Many fixed income active managers generate sizable alpha against their benchmark in the long term after fees. More recent research suggests that investors could benefit from active funds more than simple index-replicating fixed income ETFs. However, we should be cautious to conclude that active investing is always better than passive investing in fixed income, because those active managers may have excess exposure in some risk factors over the long term, and may not have been penalized by that risk yet. The most highly regarded active fixed income managers will be the ones with the ability to navigate through all stages of the credit cycle and add value in any environment.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
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