Chief investment officers and investment committees of pension funds, endowments and foundations should take a fresh look at the level of diversification in their portfolios — it might be less than they think it is, and the portfolios might therefore be carrying more risk than they believe.
That is, a portfolio that is 60% equities and 40% fixed income to provide risk reduction through diversification might not be getting as much risk reduction as plan executives hope because the fixed-income returns have a higher correlation to equity returns than expected.
New research suggests active fixed-income managers in particular are taking more risk than plan executives expect and, in fact, sufficient risk to offset some of the risk reduction benefit of a diversified portfolio of stocks and bonds.
It also suggests the excess return the active managers earn might merely be the result of that risk, not active management skill. Research also suggests some of that benefit is reduced even in indexed portfolios because the indexes are composed of high levels of riskier bonds than in the past.
A paper published in 2016 by Ravi K. Mattu, managing director, global head, analytics at Pacific Investment Management Co. LLC, and three colleagues, found "the active returns of core fixed-income managers are highly correlated to a set of basic risk factors, and in particular, credit." They concluded fixed-income investors were earning a substantial part of the excess returns active managers have provided by taking perhaps "unintended" exposure to those factors.
They also said credit risk exposure has increased in the benchmark portfolios as well, with the benchmark weight in credit almost doubling in the past 25 years, while average maturity has extended and the credit quality declined. For example, the average credit exposure of the Bloomberg Barclays U.S. Aggregate index has risen significantly in the past two decades, to 30% from 17% of the weight of the portfolio.
A new paper by AQR Capital Management, consistent with the PIMCO paper, found most of the risk-adjusted active returns for fixed-income managers "can be explained by exposure to credit markets." The paper continued that if most active fixed-income returns "are as a result of credit risk premium — which is related to the equity risk premium — the resulting diversification loss can dampen the risk-adjusted performance of an investor's overall portfolio."
It went further and found that three categories of active fixed-income managers had positive "active" returns and their risk-adjusted returns were better than for large-cap core equity portfolios in the 1997-2017 period. But it found these returns were highly correlated with high-yield bond exposure. The prices of high-yield bonds, also known as junk bonds, have a higher correlation with stock prices than do high-quality bonds.
In fact, the AQR paper said, the research found that a persistent overweight to high-yield bonds explained the majority of fixed-income manager active returns.
"This is hardly comforting for an investment into an asset class that is meant to provide diversification from equity markets," the authors of the paper commented. In fact: "Active fixed-income strategies may significantly reduce the strategic diversification benefit" of fixed income as an asset class.
The conclusions of the papers might be challenged by active fixed-income managers, but in the meantime the conclusions suggest investment officers should closely examine the holdings of their active fixed-income managers to see if they have unusually high levels of high-yield bonds or similar investments. If they are uncomfortable with the lower level of diversification the active portfolios provide, they should work with the managers to reduce the risk level, or index their portfolios.
