SAN FRANCISCO — Core and core-plus fixed-income managers could very well be closet indexers, and institutional investors have yet to realize this, according to research by Fred Dopfel, managing director and senior strategist at Barclays Global Investors, San Francisco.
Mr. Dopfel, in a paper published in the third quarter issue of the Journal of Portfolio Management, said the monthly alphas (managers' returns minus the returns of the Lehman Brothers Aggregate Bond index over the same period) of core and core-plus managers showed a 90% correlation to the Lehman Brothers High-Yield bond index over the five years ended Dec. 31, 2003. Additionally, over the last 15 years of that time period, managers' average alpha showed a 79% correlation. For his research universe, Mr. Dopfel used the 100 largest domestic active core and core-plus managers from the database of eVestment Alliance LLC, Marietta, Ga., benchmarked to the Lehman Aggregate.
Mr. Dopfel argues that both figures suggest investors in active core and core-plus accounts are paying fees for active management but are, on average, only getting returns very close to those of passive indexes. Additionally, his findings suggest the excess returns of active core and core-plus managers come from a persistent bias to high-yield bonds. Active core and core-plus bond managers typically charge 40-50 basis points in annual fees, said one consultant who asked not to be identified, while the fees on a passive core or core-plus account ranges from one to 15 basis points.
"This is not what investors should be paying for," Mr. Dopfel said in his paper. "Investors have asked for and paid for alpha (pure active risk exposure), but they have received beta (systematic exposure)."
What investors should do, said Mr. Dopfel, is invest in an optimal combination of active and passive fixed-income managers. He added that he sees a general misconception among plan sponsors that core-plus managers should be benchmarked to the Lehman Aggregate, and that a more appropriate benchmark should have some exposure to high yield.
"This is not an attack on active managers," Mr. Dopfel said in an interview. "This is an attack on thinking that you can pick a core-plus manager without discerning manager skill."
Active core-plus managers said that active core-plus bond accounts are still worth it, however. Matthew Toms, director of credit portfolio management at Northern Trust Global Investors, Chicago, which manages more than $1 billion in active core-plus bond accounts, argues that active managers have the ability to cut down on volatility by over- and underweighting asset classes in the core-plus universe, such as high-yield and mortgage-backed securities.
"The problem with indexing is that, as an individual investor, you don't have the ability to move back and forth between asset classes," said Mr. Toms. "Another point is that highly active managers can offset volatility. For example, an active manager can invest in mortgage(-backed securities) in anticipation of inflation."
Mr. Toms added that active core-plus managers also can find innovative ways of adding alpha. "For example, an active manager can buy euro-denominated bonds and hedge those back to dollars [with a currency swap]," he said. "The breadth of decisions that an active manager can make are a lot higher than a passive manager."
Steve Johnson, chief investment officer of fixed-income management at INVESCO, Atlanta, said Mr. Dopfel's study shows that institutional investors must place a heavy emphasis on a core-plus manager's investment process, rather than returns. "This really gets back to whether a (core-plus) manager is good at making a suite of active decisions," he said. "How you get the active return is more important than the return itself."
Mr. Johnson also said the study should have broken down different types of core-plus managers. "Part of the problem (with the study) is that there is no one real definition of core plus," he said. "There are a slew of different types of core-plus managers; there's no standard set of active decisions in core-plus accounts."
Mr. Dopfel noted, however, that his research "just looks at the average (performance) of active managers. That's not to say there aren't good active managers out there, but on average, they have not produced alpha."