Multi-Sector Fixed Income: Passive Alpha vs Active Cost
- Multi-sector fixed income works; a “pie instead of piece” approach may improve investor outcome.
- Passive investors don’t have to sacrifice performance at a lower cost.
- Passive Multi-sector is an evolution of the “normalization” of the industry.
U.S. investors in fixed income are conflicted on what they want: investment protection, income or diversification, inflation, deflation, or to know when the bull market for fixed income will end. The multi-sector approach answers many of these questions since it owns a larger piece of the pie and can tilt in a balanced and diversified manner towards global outcomes.
Multi-Sector Fixed Income – The Opportunity to Own the Pie, Not Just a Piece
As of June 30 2020, according to Morningstar, the Multi-sector fixed income category is a $252 billion category that is dominated by active management. This means that it only represents about 2% of how investors have allocated towards fixed income. We would argue that investors need to embrace this category more widely because of the measured reward versus risk it offers in global bonds, high yield and emerging market bonds, which is where higher returns may be in the future. Evidence of this risk is documented in Fitch’s July 31 ratings statement. “Fitch Revises United States’ Outlook to Negative, Affirms AAA Rating.” We will not go into the details of Fitch’s comments because the statement is clear. The bottom line is self-evident – if U.S. debt was perfectly balanced on a risk/reward basis, rates would not be going down when conditions are deteriorating just because the U.S. has the most flexibility and creative options.
Multi-sector fixed income allocations make sense because credit opportunities can be isolated, and duration risk is a bad set up when rates are so low. Simply betting that negative rates will come and be leveraged by long or “infinite” duration on free money does not make for a positive economic scenario or investments case to us. Arguably, if broad equity returns are muted on a go forward basis, single digit returns for fixed income opportunities in emerging markets and high yield are compelling.
Passive Investors Don’t Have to Sacrifice Performance at a Lower Cost
The Columbia Threadneedle Diversified Fixed Income Allocation ETF (DIAL), since its inception on October 12, 2017 to July 31, 2020 according to Bloomberg, has outperformed the leading active mutual funds in the category at a substantially lower fee.[1] According to Lipper, the average expense of a Class A share is 1.10% versus DIAL’s expense ratio at 28 Bps. See below chart for details – note that DIAL’s current 12-month yield is 2.86%.
[1] The source for the performance chart with DIAL, PIMIX, FSRIX, LBNYX,NEZYX FKSRX is Bloomberg
Passive Multi-Sector Is an Evolution of the “Normalization†of the Industry
Passive Multi-Sector Is an Evolution of the “Normalization” of the Industry
The ETF industry is advancing, and blurring the lines between active and passively defined dynamic rules. DIAL rebalances every month to a weighting scheme of 30% High Yield, 20% U.S. Dollar denominated Emerging market, 15% each in Mortgage backed and Investment Grade Corporates and then 10% each in US Treasuries and Global Treasuries. No Negative Yielding Bonds are owned in the portfolio, and Credit is well diversified across 478 holdings. Note that while the portfolio average duration is 6.29 years (analytical duration), its sensitivity to US rates moves far less at 2.3 years (empirical duration). This is because much of the portfolio exposure in high yield and emerging market dollar bonds have low or negative correlation to US rates. DIAL is well diversified across different geographies and countries.
The transparent and defined process follows a disciple of defined rules that include:
- High Yield: No CCC or lower rated bonds to reduce credit risk
- EM Debt: Only US Dollar Denominated Sovereign Bonds which historically deliver an attractive Sharpe Ratio
- US Treasury: 7 Year Duration helps to balance High Yield exposure
- Global Treasuries: An equal weighted portfolio towards international countries and away from concentration in Japan
- No derivative exposure
Certain financial advisors are concerned about showing High Yield or Emerging Market Debt in client accounts. It’s not because they don’t agree with the potential risk/reward opportunity, but because of client perceived risks. DIAL offsets this risk with its 50% weighting in holdings in Treasuries, US Agency Global Treasuries which are correlated to U.S. Emerging Bonds, and High Yield by 0.47% and -29%. The Multi-Sector category addresses this issue and a name like Diversified Fixed Income Allocation provides a description of the advantages that clients can embrace.
Conclusion
The Macro-sector fixed income category, as measured by DIAL, provides a diversified stream of income and potential capital appreciation that is at a lower cost than its actively managed mutual peers. The category of Macro-Sector fixed income fits into modern portfolios because it provides a solution that is dynamic and disciplined in its approach to embracing global fixed income. Active Management may work in this area as well, but taking an opportune approach to the category has less transparency, so it is also more difficult to explain when it underperforms relative to the group.
Footnotes
Learn more about the funds listed in this report:
- Columbia Diversified Fixed Income Allocation Fund: DIAL
- PIMCO Income Funds – Institutional : PIMIX
- Fidelity Advisor Strategic Income Fund: FSRIX
- Lord Abbett Bond Debenture Class A Fund: LBNDX
- Loomis Sayles Strategic Income Fund: NEZYX
- Loomis Sayles Bond- Institutional Fund LSBDX
- Franklin Strategic Income Fund: FKSAX
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