The relatively weak performance of mortgage-backed securities in 1993 distorted the returns of some fixed-income benchmark indexes, making manager performance evaluation for the year more difficult.
For example, the median fixed-income separate account manager in the Pensions & Investments' Performance Evaluation Report returned 10.3% in 1993, 55 basis points greater than the 9.75% return posted by the Lehman Brothers Aggregate Bond Index, a widely used benchmark that includes mortgage-backed securities. But the same manager lagged another widely used benchmark, the Lehman Brothers Government/Corporate Index, by 66 basis points.
It's harder to get apples-to-apples comparisons," said Greg Rogers, associate director of fixed-income research for Rogers Casey & Associates Inc., Darien, Conn., the consulting firm that compiles the PIPER numbers.
"Some of your managers who look good compared to the Lehman Government/Corporate portfolio will look horrible compared to the Lehman Aggregate," he said. While the Lehman aggregate index is about one-third mortgage-backed securities, the Lehman Government/Corporate index has none, he said.
In past years, the difference between the two indexes was much less than it was in 1993. The 10-year annualized return of the Lehman aggregate through 1993 was 11.86%, compared with the Lehman government/corporate return of 11.78%. The two indexes have a high degree of correlation, Mr. Rogers said.
But low interest rates and a subsequent increase in refinancing of mortgages caused unexpectedly fast pre-payments of principal on mortgage-backeds, he said. While the durations of the two Lehman indexes are similar, the faster pre-payments reduced the Lehman aggregate's duration at a time when interest rates were falling - exactly the time when a longer duration usually translates into better performance, he added.
For the fourth quarter of 1993, the differences between the median separate account manager and the two indexes were similar, with the median manager falling in between. The median PIPER manager had a return of 0.2% in the fourth quarter, while the Lehman Aggregate returned 0.05% and the Lehman Government/Corporate returned -0.29%.
Similarly, the median commingled fixed-income fund manager had returns that fell between the two indexes for both the last quarter of 1993 and the year. The median commingled fund had a return of zero for the quarter, and 10.7% for the year.
Another variable that might have affected the returns of money managers in 1993 is the increased use of non-traditional types of fixed-income securities, such as the mortgage-backed securities, international securities and corporate high-yield securities, Mr. Rogers said. As fixed-income managers increase their use of such instruments, the return differences between the top quartile managers and the median manager grows, he said.
For example, in 1993 the difference among separate account managers in the first quartile break and the median manager was 160 basis points, while the difference among 10-year annualized returns for the same group through 1993 is 70 basis points. Moreover, the difference between managers in the third quartile and the median manager, at 220 basis points, also was larger in 1993 than the difference between the 10-year annualized returns, 100 basis points.
All of this translates into an increased difficulty in determining if a manager is adding value, Mr. Rogers said. Although there are four basic ways a manager adds value, there are an increasing number of securities and methods within those four groupings. The four groupings are: duration management, which is essentially forecasting interest rate changes; yield curve management, which is forecasting which maturities along the yield curve will outperform; sector rotation; and security selection. Most managers "are doing a little bit of each of them," Mr. Rogers said.
An example of how strategies can be combined is seen at money management firm Franklin, Spitz & Peters Investment Advisers Inc., in St. Louis. Ken Spitz, a principal, said the firm's managers are "still positive on the bond market." Relative to the rate of inflation, bonds should provide a positive real rate of return, he said.
"We're anticipating that the yield curve is going to flatten more," Mr. Spitz said. As a result, Franklin Spitz' portfolio duration has been lengthened to about 15 years, while its benchmark index is about 5 years, he said.
Portfolio managers for Allegiance Capital Inc., Huntington Beach, Calif., don't attempt to forecast interest rates, but try to find the best value given current market conditions, said Bob Southard, senior vice president.
For instance, after the recent announcement by Federal Reserve Board Chairman Alan Greenspan that the Fed was raising interest rates, Allegiance immediately began to hedge its portfolio of mortgage-backed securities that trade at a discount to par, Mr. Southard said. The concern was that pre-payments for those securities would slow more than expected as interest rates rise, which would in turn lengthen the duration of those securities and cause their prices to fall quicker.
Allegiance's managers hedged the portfolio by purchasing higher coupon mortgage-backed securities that sell at a premium to discount and grouping them with the lower-coupon securities. The resulting portfolio had a duration comparable to the market, but at return spreads 75 to 85 basis points higher.
For Allegiance's U.S. Treasury security portfolios, its portfolio managers gradually moved away from a barbell strategy into a more market-like position over the two-week period following Mr. Greenspan's announcement, Mr. Southard said. A barbell strategy involves overweighting investment in short and long term maturities compared to securities with intermediate maturities, he said.
Some high-yield managers are more concerned with the implications of changing interest rates than the changes themselves. Paul Maguire, vice president and fixed-income product manager for Wellington Management Co., Boston, said rising interest rates could affect the profitability of certain types of high-yield issuers, such as housing builders and banks.
So the recent Fed decision to hike short-term rates didn't cause Wellington's high-yield managers to change the duration of its portfolios, but it did lead them to re-examine which credits it owns could be affected by the shift, Mr. Maguire said.
Another aspect of high-yield investing they examine is the yield spread between issuers with different credit ratings.
Lately, yields have been tight, Mr. Maguire said, meaning high-yield investors are not as "generously compensated" for taking on credit risk as they have been in the past.
Nonetheless, Wellington's managers believe that the economy's strong recovery, and 1993's low default rate, "bode well" for the future of high yield issuers in 1994.