by Matt Tucker, iShares

Lately, I have been field­ing a lot of ques­tions from investors who have been dis­ap­pointed with the per­for­mance of some of their fixed income invest­ments. The basic story is always the same. The investor built a diver­si­fied, multi-asset class port­fo­lio. The investor included fixed income in the port­fo­lio to pro­vide diver­si­fi­ca­tion from riskier asset classes such as equi­ties and com­modi­ties. But now the investor is unhappy with their portfolio’s performance.

Why? On the sur­face, it appears they did every­thing “right.” The fixed income hold­ings were meant to pro­vide an anchor in the port­fo­lio and some sta­bil­ity in uncer­tain times. As we know, this year mar­kets have been highly volatile, Trea­sury yields have declined, and most fixed income asset classes have had strong per­for­mance in 2011.

So, why are investors not get­ting the per­for­mance they expected from their fixed income hold­ings? One rea­son may be that many investors use active mutual funds for their fixed income expo­sure. A stag­ger­ing 95% of active inter­me­di­ate bond funds have under­per­formed year-to-date rel­a­tive to the Bar­clays Cap­i­tal US Aggre­gate Bond Index, the com­mon bench­mark for the Morn­ingstar US inter­me­di­ate term bond cat­e­gory, accord­ing to data from Black­Rock and Morn­ingstar as of Sep­tem­ber 30, 2011.

But Morn­ingstar data as of Sep­tem­ber 30 shows it’s not just a 2011 phe­nom­e­non — over the past 10 years, 68% of active inter­me­di­ate bond mutual funds have underperformed.

A lot has been writ­ten in the active vs. pas­sive debate, and I will address that topic in a future blog. Today, I want to focus on what I see as the trou­bling issue here: the con­flict between an investor’s goal with their fixed income invest­ment and the strate­gies employed by many active fund managers.

As a group, active fund mangers look to add yield to cre­ate out­per­for­mance. The yield that is added typ­i­cally comes from lower qual­ity, higher risk secu­ri­ties. But these higher risk secu­ri­ties tend to under­per­form in mar­ket dis­lo­ca­tions when investors sell riskier invest­ments and move to Trea­suries and other more con­ser­v­a­tive asset classes.

The chart below helps to illus­trate this dynamic. It shows the 3-year cor­re­la­tions for the Bar­clays Cap­i­tal US Aggre­gate Bond Index ver­sus a num­ber of other mar­kets. As you can see, the cor­re­la­tion was low or neg­a­tive to all of the riskier asset classes.

The chart also shows the cor­re­la­tion of the aver­age Inter­me­di­ate term active bond fund in the same period. Their cor­re­la­tion ver­sus these same indices was pos­i­tive in every case. If you looked at a time series of this data you would see that the active fund cor­re­la­tions to equity and com­mod­ity mar­ket per­for­mance actu­ally increased when mar­kets sold off.

(Please see foot­note 1)

This shows that at exactly the moment that an investor was faced with a declin­ing equity mar­ket and was likely look­ing to fixed income for sta­bil­ity, their active fund’s alpha turned neg­a­tive. This is what I refer to as the Para­dox of Active Man­age­ment. The strate­gies employed by many active fund man­agers are designed to add yield when mar­kets are calm or improv­ing, but it can often lead to under­per­for­mance when mar­kets dis­lo­cate and riskier asset classes sell off.

This is counter to the role that many investors expect fixed income to play. They want their fixed income invest­ment to be MORE sta­ble when mar­kets dis­lo­cate, not less. But many investors con­tinue to invest this way.

The ques­tion investors should ask them­selves is not whether active or pas­sive is bet­ter — it’s what role they want fixed income to play in their port­fo­lio. Invest in fixed income asset classes that are expected to per­form in-line with that role, in up and down markets.

If you want lower risk fixed income expo­sure, con­sider US Trea­suries. If you want more diver­si­fied invest­ment grade expo­sure, con­sider the iShares Bar­clays Aggre­gate Bond Fund, AGG. If you want addi­tional yield in return for tak­ing on more credit risk, then buy high yield. But make each deci­sion with aware­ness of the rel­a­tive risks and rewards. Don’t blindly believe all fixed income is the same.

This is exactly what the fixed income ETF was designed for — to pro­vide investors with a vehi­cle they could use to tai­lor their fixed income expo­sure and cus­tomize risk. It is designed to give investors com­plete trans­parency into what they own, and what they don’t own — in short, to avoid the Paradox.

Foot­note 1. Morn­ingstar Direct and MPI Sty­lus, as of 9/30/11. Cor­re­la­tion based on weekly returns. Cor­re­la­tion refers to the degree to which two secu­ri­ties, on aver­age, move together.  A +1 cor­re­la­tion implies they move in lock­step while –1 implies they move in oppo­site direc­tions. Inter­me­di­ate Term Bond Aver­age includes actively man­aged mutual funds in this Morn­ingstar cat­e­gory.  Per­cent­ages are survivorship-adjusted and reflect the fund uni­verse that existed at the start of the analy­sis period (e.g., the analy­sis includes funds that existed at the begin­ning of the analy­sis period but are no longer avail­able due to fund merg­ers or liq­ui­da­tions over the analy­sis period). Analy­sis is based on the old­est share class of active open-end mutual funds to avoid double-counting of mul­ti­ple share classes. Index returns are for illus­tra­tive pur­poses only. Index per­for­mance returns do not reflect any man­age­ment fees, trans­ac­tion costs or expenses. Indexes are unman­aged and one can­not invest directly in an index. Past per­for­mance does not guar­an­tee future results.

Bonds and bond funds will decrease in value as inter­est rates rise. Diver­si­fi­ca­tion and asset allo­ca­tion may not pro­tect against mar­ket risk.

Past per­for­mance is not indica­tive of future results.

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