Many investors today view passive investment strategies as inherently less risky than their active counterparts, often favouring indexed solutions due to their transparency and lower cost characteristics. However, contrary to popular thought, a passive investment approach may not necessarily be the most effective, or low risk, way to access financial markets, particularly with respect to fixed income investing.
The very nature of the way the bond market is structured – together with key differences in the way fixed income indices are constructed when compared to equity indices – means investors can find themselves exposed to a number of unintended risks and consequences in their search for yield.
The following four points highlight some of the limitations inherent in a fixed income index approach:
Index weightings favour heavy debtors: Bond indices are issuance-weighted, meaning the more debt a company or government issues that meet the index criteria, the larger the relative weight it holds in the index as well. Consequently, a passive investor can unintentionally find that they are increasingly exposed to issuers that are expanding their debt load.
Market forces ‘passively’ adjust index composition: A passive product must follow index migration, irrespective of investment merit or market insight. An active manager can proactively respond to market events and changing investment cycles to help mitigate the shifts that may change the risk/reward profile of a portfolio based on their research.
Full replication of fixed income indices is impossible to achieve: Bond indices typically have large numbers of constituents, with multiple bonds issued from the same issuer, some of which may not trade on a daily basis, making it very challenging for passive investment strategies to fully replicate the index. Instead, many use a sampling methodology in an attempt to build a similar allocation, but necessarily deviating from the index itself.
Different buyers lead to differing outcomes: Bond markets have many different buyers, with varying reasons for buying. A significant amount of global fixed income assets are held by central banks and those trying to stabilise foreign exchange rates and adjust money supply, and their goals may share little with those of retail investors seeking diversification, income and/or total return. As a result, bond indices can be shaped and moved by many disparate forces, some of which may be far from supportive for the average investor.
We believe an active approach to fixed income investment can help deliver outcomes that are more in line with investors’ goals and expectations. At Franklin Templeton, we base our actively managed decisions on each investment’s potential for strong risk-adjusted returns, not constraining our choices to the size limitations of the specific index weightings.
And as active managers, we can decide to invest outside the benchmark as well as over/underweight positions relative to the benchmark if our bottom-up analysis dictates. This is particularly important in nascent markets such as the green bond market where any new, large issuance will create a large weight within a green bond index.
By contrast, through active management, our portfolio managers have greater flexibility to continuously benchmark each green bond against its peers and move into issues that offer greater relative value.
Our approach has been tested for over 40 years and Franklin Templeton now manages over $650bn in fixed income assets across the full spectrum of strategies – including core, credit, unconstrained, emerging market and single-country – in a variety of investment vehicles, to help you create the right portfolio for your clients.
Our range of actively managed fixed income ETFs – which offer all the liquidity, transparency and low-cost benefits inherent in the ETF structure – include:
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