How fixed income markets are primed for active management success
Why passive management cannot take advantage of market dislocations
Learning from historical performance over varying time periods
Fixed income markets are primed to reward active management
Fixed income markets are not as efficient as many other asset classes, particularly equities. The fixed income asset class is often fragmented, as bonds are not traded on an exchange. Noneconomic investors, such as central banks and insurance companies, engage in the market, buying and selling bonds without the intent of making a profit. Bonds also demonstrate an asymmetric risk profile in which they may fall in value much more than they increase.
Active portfolio managers have several advantages over passive fixed income strategies, including more flexibility on timing and volume of trading. They can use market dislocations and inefficiencies to their advantage while most passive strategies lack the flexibility to take advantage of those opportunities and often must ride out unnecessary volatility.
Passive approaches cannot take advantage of market dislocations
Within credit sectors, liquidity across new and older issued securities tends to widen. Active managers can provide liquidity and purchase bonds potentially offering higher yields and price discounts. Active managers can also take advantage of credit quality dispersion. For example, passive strategies with a specific mandate to follow may not own a security that is rated BB until its rating is potentially increased to BBB and considered investment grade. An active manager can purchase that bond at its BB rating before it is upgraded and take advantage of the market dislocation.
How important might this intentional composition be? The chart below shows the sector-level dispersion of bond market returns as a range around the annual return of a generally representative and widely used index, the Bloomberg US Aggregate Bond Index. Over each year, different sectors of the bond market have had a range of returns relative to the aggregate market overall. An active portfolio manager may seek to generate excess return by having more exposure to sectors they think are likely to generate better returns, and less exposure in the remaining sectors.
Range of returns across various fixed income sectors relative to the Bloomberg US Aggregate Bond index return Calendar year returns 2012–2023
Bloomberg & ICE represented by Bloomberg as of 12/31/23. Range comprised of Bloomberg US Treasury Index, Bloomberg US Corporate Bond Index, Bloomberg US Agencies Index, Bloomberg US MBS Index, Bloomberg Emerging Markets USD Agg-IG, Bloomberg Emerging Markets USD Agg-HY, S&P LSTA US Leveraged Loan Index, ICE BofA US High Yield Constrained Index. Past performance is not indicative of future results. It is not possible to invest directly in an index, which also does not include the application of fees.
The proof is in the historical performance
Seasoned active managers, aided by research analysts and trading desks, strive to achieve superior returns. Conversely, passive investment approaches aim solely to replicate the performance and risk level of a benchmark index by mimicking its underlying characteristics and are restricted to securities meeting the index’s criteria for inclusion.
Active managers have the flexibility to explore a wider range of investment opportunities and can leverage informed assessments and market insights to build portfolios that diverge from the benchmark-driven allocations of passive strategies. These benefits have enabled active managers across various bond fund categories to surpass their benchmark performance, as shown below.
Most active managers in these categories beat their benchmark over various time periods (as of 1/31/2024)
Morningstar Direct as of 1/31/2024 using the institutional share class of each fund in the corresponding Morningstar category. Past performance is not indicative of future results. It is not possible to invest directly in an index, which also does not include the application of fees.
What’s the right approach for you?
For certain investors, passive index funds may suit their objectives better than actively managed funds. Index funds provide a predetermined opportunity set of portfolio holdings, making them useful components for investors aiming for specific exposures to various sectors or maturity ranges within the bond market. During periods of low market volatility, index funds may also outperform active management due to their relatively lower fees.
Nevertheless, active bond managers can nimbly employ diverse strategies to assist investors in generating returns and navigating risks across various interest rate environments. The relevant fact is that active managers possess the flexibility to dynamically adjust the nature of holdings in an active portfolio. They can utilize a range of strategies with the potential to boost total return across different market conditions, albeit with additional inherent risks.
About the author
Chris McCrea, CFA®, CAIA®,isasenior director, investment specialist sub-advisory responsible for business development with Strategic Partnershipsand sub-advisory relationships. Prior to joining the organization, Chris held positions of portfolio strategist, national sales desk director, business development consultant, variable internal wholesaler, and guaranteed internal wholesaler for Jackson National. Chris also served as an insurance and financial service associate at Prudential Insurance. Chris has been in the industry since 2008 and started with the firm in 2017. He earned his BS in business administration from Elizabethtown College. Chris is a CFA® and a CAIA® charter holder. He achieved the CFA Institute Certificate in ESG investing. He maintains the Series 7, 24, 63, and 65 licenses and is a registered representative of Foreside Fund Services, LLC.
All opinions, estimates, projections, and security selections contained herein are those of the sub-adviser. It does not constitute investment advice and should not be used as a basis for any investment decision.
Mutual funds are subject to market risk, including loss of principal. Past performance is not indicative of future results.
Mutual funds are sold by prospectus. Before investing, consider the funds' investment objectives, risks, charges, and expenses. This and other important information is contained in the prospectus. Please visit transamerica.com or contact your financial professional to obtain a prospectus or, if available, a summary prospectus containing this information. Please read it carefully before investing.
Fixed income securities are subject to risks, including credit risk, interest rate risk, counterparty risk, prepayment risk, extension risk, valuation risk, and liquidity risk. Interest rates may go up, causing the value of the fund's investments to decline. Changes in interest rates, the market's perception of the issuers and the creditworthiness of the issuers may significantly affect the value of a bond. These risks are described in more detail in the prospectus.
*Aegon Asset Management US (Aegon AM US) is the marketing name of the sub-adviser. The legal entity name of the sub-adviser is Aegon USA Investment Management, LLC.
Aegon USA Investment Management, LLC is an affiliate of Aegon companies. Transamerica companies are part of the Aegon group.
Transamerica Funds are advised by Transamerica Asset Management, Inc. (TAM) and distributed by Transamerica Capital, Inc. (TCI), member of FINRA.
