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Active managers are working overtime to defend their value proposition in the face of massive capital flows into index funds. Some of their arguments stand up. This article examines one that does not. The takeaway is that only bona fide active management justifies an active management fee.
On a recently televised financial news program a fixed-income manager declared that active management may not generate alpha in large-cap stocks, but it unquestionably adds value in bonds. Three-quarters of the index he is measured against consists of low-yielding Treasurys and related securities. The manager explained that he can outperform his benchmark by adding higher-yielding instruments, such as corporates and emerging markets, to his portfolio.
This approach, the manager contended, beats the index’s total return (including price change and income) in three out of four cases:
1. If the spread-versus-Treasurys on the higher-yielding bonds does not change, relative prices hold steady and the portfolio delivers a higher current income than its benchmark.
2. If the spread contracts, the yield-enhanced portfolio appreciates relative to the benchmark, on top of generating a higher current income.
3. If the spread widens by just a little, the portfolio’s relative price declines, but that is more than offset by its higher income.
The enhanced-yield portfolio loses only in the fourth case, a substantial widening of the spread.
Enhancing the portfolio’s yield in this way does improve returns. The catch is that it does not, in itself, constitute active management. Investors should not pay an active management fee to a manager who does nothing more than this.
I verified the benefit of yield enhancement as follows: For the period 1997-2016, I compared the annual returns of a standard benchmark, the BofA Merrill Lynch U.S. Bond Market Index, and a hybrid consisting of:
75% BofA Merrill Lynch U.S. Treasury & Agency Index
25% BofA Merrill Lynch U.S. Crossover Corporate Index*
*Includes bonds rated BBB or BB
The hybrid beat the benchmark in 12 out of 20 years, a 60% success ratio. Average annual returns over the two decades were 5.64% for the hybrid versus 5.36% for the benchmark. The hybrid was also superior in risk-adjusted terms, based on a Sharpe ratio of 0.91 versus 0.83 for the benchmark.
What Does Justify an Active Management Fee
The manager of a fund similar to the 75%/25% hybrid who beats the BAML U.S. Bond Market Index has not demonstrated any special investment expertise. The performance edge in my simulation was not achieved by active management. Rather it resulted from “going outside the box.”
This term refers to buying classes of securities that are not included in the index—BB corporate bonds, in the present case. Under such an approach, the client’s portfolio and the portfolio that the client signed up for are apples and oranges. A portfolio invested in oranges should not be evaluated against an index consisting of apples. A manager who strives to excel through superior security selection is supposed to pick the good apples and avoid the bad apples. Deciding whether to diversify into oranges is the client’s call.
“Adding value” solely by going outside the box does not merit an active management fee. Clients can replicate the above-described hybrid strategy more cheaply by buying low-cost ETFs.
The higher fee associated with active management is justified only for managers who outperform benchmarks that match the classes of securities they actually hold. Gaming the index by buying an entirely different asset class does not demonstrate ability to exploit market inefficiencies.
The mismatch between performance benchmarks and the actual strategies that managers pursue is hardly a new topic. I, among others, addressed it a quarter-century ago. My 1992 Journal of Portfolio Management article, "High Yield Indexes and Benchmark Portfolios," identified the solution: Create a customized benchmark, matching the portfolio’s asset mix, instead of relying on a one-size-fits-all index.
In the years since that article appeared, BofA Merrill Lynch Global Research made benchmark customization extraordinarily easy. In light of that, it amazes me that managers still present outside-the-box schemes as value-added active management strategies. Given that they do, investors must beware when it comes to active management fees. The rule to follow is, “Pay for what you get, but make sure to get what you pay for.”
