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Diversification may well be a primary reason for including fixed income in your portfolio. The idea is that your fixed income allocation acts as a defence when equities are not performing well. As a result, the overall volatility (risk) of your portfolio should be lower than if you were 100% invested in equities.
Comparison of the simulated performance of a 100% equities portfolio vs. portfolios comprising a combination of equities and bonds bears this out. Over the 19 years from May 2000 – May 2019, both government and investment grade corporate bonds significantly reduced the risk of an Australian equities-only portfolio, with a relatively small reduction in returns (particularly for corporate bonds).
Source: Bloomberg. *S&P/ASX 200 Accumulation Index, **Bloomberg AusBond 5-10 year Treasury Index, ***Bloomberg AusBond 5-10 year non-govt sub Index. Past performance is not an indicator of future performance. You cannot invest in an Index.
A key point here is that the bond performance figures reference two indices.
Indices are not directly investable. Most investors gain their exposure to fixed income via a fund, either a low-cost index-tracking fund or a passive ETF, or an actively managed fund.
The question is: Do these funds provide the same diversification benefits?
Where’s the diversification?
US firm AQR Capital Management (AQR) found that over 5, 10 and 20 years to the end of September 2017, on average active fixed income managers outperformed their stated benchmark.
However, a deeper dive into this performance raises questions.
For fixed income to fulfil its portfolio diversification function, it must show a low or negative correlation to equities. Fixed income is not, however, a homogeneous asset class. Investments range from essentially risk-free Government bonds to sub-investment grade corporate debt. The correlations of these investments to shares vary widely.
On closer inspection it appears that the outperformance of US active fixed income managers is due not to fund manager skill, but to a persistent structural overweighting to high-yield debt – a class of fixed income that is highly positively correlated to equities exposure.
As it happens, this has worked out well in terms of returns. However, it has meant that diversification has become a secondary consideration.
The performance of the benchmark US Aggregate index from 2008 – 2017 had a -0.22 correlation with the S&P 500 index*. That is to say that if the S&P 500 Index declined 1%, then on average that benchmark index would have increased in value by 0.22%. In other words, if you invested in a fund that passively tracked this index, you had fixed income exposure that diversified your equities exposure.
An equally-weighted portfolio of active fixed income managers, on the other hand, had a +0.33 correlation with the S&P 500*. In other words, the ‘always overweight’ allocation of active managers to high-yield debt meant that an investor’s fixed income exposure, instead of providing a counterweight to their equities exposure, was in fact positively correlated.
Source: AQR Capital Management, The Illusion of Fixed Income Diversification, 2017. Past performance is not an indicator of future performance.
The dangers of this are particularly evident during sharemarket downturns. In the last quarter of 2008 when the US sharemarket dropped 24%, the US Aggregate returned +4%, at least partially offsetting the equities drawdown. On the other hand, returns from active managers were flat at 0.3%*. Just when the benefits of diversification were needed most, active managers failed to provide them.
The lesson is clear. As we enter late cycle markets, the diversification benefits of fixed income are more important than ever. Investors whose exposure to fixed income is through an actively managed fund should check carefully what the fund is holding to make sure they are holding something that gives them adequate diversification.
That’s not to say that actively managed funds cannot provide diversification – for example the correlation between the daily returns of Western Asset’s actively managed fixed income strategy (the same strategy used for BetaShares Legg Mason Australian Bond Fund (managed fund) (ASX: BNDS)) and the benchmark Australian shares index (S&P/ASX 200) over the last ten years has been -0.29%, a significant negative correlation demonstrating the strategy’s diversification benefits.
Equally clear are the benefits of getting your fixed income exposure via a passive index-tracking fund. Not only are costs usually lower than active management fees, but they are also transparent, so you know exactly how the fixed income portion of your portfolio is invested.
CRED – performance and diversification
BetaShares Australian Investment Grade Corporate Bond ETF (ASX: CRED) is an index-tracking fund that holds a portfolio of senior fixed-rate corporate bonds, rated investment grade or higher. It has a management expense ratio (MER) of 0.25% p.a.
In the 12 months since inception on 31 May 2018, CRED returned 11.36%, making it the best-performing fixed income fund, exchange traded or unlisted, in Australia among the 218 funds in Morningstar’s database. For context, the median fund return was 5.94%.
Importantly, CRED has provided diversification vs. the S&P/ASX 200. The defensive benefits were especially evident during the sharemarket downturn in the last quarter of 2018.
Source: Bloomberg. Past performance is not an indicator of future returns.