Investors wanting exposure to high-quality short-dated corporate credit should consider avoiding passive funds in favour of a more actively managed approach.
With this asset class still an appealing source of income due to its lower sensitivity to interest rate changes, Fidelity International has witnessed passive vehicles underperforming their indices more than their all-maturity counterparts.
“We strongly believe that going passive in this space is sub-optimal,” said Ben Deane, an associate investment director in the asset management firm’s fixed income team.
He believes there are pitfalls via that route, adding that the benefits of an active approach to short-dated credit are often under-appreciated.
Passives underperform
Using the UK market as a benchmark, Fidelity has seen that almost half of the short-dated corporate bond funds are passive, compared with only roughly a quarter of the all-maturity sterling corporate bond market being passive.
Investors’ rationale when it comes to short-dated credit is based on a perception of there being little absolute return or potential excess return on offer given the relatively low risk nature of the instrument. As a result, they don’t want to pay the fees for active management.
However, Deane’s view that this is sub-optimal is based on passive funds generally underperforming their indices on a net basis because of fees and transaction costs.
“We’d argue that this underperformance is more pronounced in the short-dated space because the absolute level of return is more muted than in other parts of the maturity spectrum,” he explained. “Indeed, while some investors look to go passive in the space because the return potential is lower, paradoxically, for that same reason, it may make sense to consider going active.”
Further, Fidelity believes that many passive short-dated funds tend to underperform their indices by more than the fees charged. “We believe [this] is due to the additional costs arising from elevated trading, associated with trying to replicate a short-dated index,” Deane added.
The increase in trading is based on the frequent flow of bonds into and out of the one-year to five-year index – either as they move from six years to five years in maturity, or as they fall below one year in maturity.
Fidelity has seen the impact of this on its own (actively managed) short-dated corporate bond fund. It estimates 41% of the one-year to five-year index (in terms of number of bonds) will move in and out of the index over the next 12 months alone – not even including any potential new issues.
Passive funds cannot avoid trading if they want to replicate this exposure, explained Deane. “They may be forced to buy and sell respectively at either end of the maturity spectrum.”
An active advantage
From Fidelity’s perspective, it will take out-of-index exposure with up to six-year maturity bonds, since it can benefit from forced passive buying.
Similarly, it is comfortable buying bonds with sub-one year maturity to take advantage of forced passive selling. “This paper has additional benefits and can prove to be an attractive hunting ground for active investors, despite being so close to maturity,” added Deane.
