One of the biggest surprises of 2023 has been the resilience of the economy and inflation despite the Fed embarking on the most aggressive rate hike campaign in decades. For fixed income investors, it’s been a challenging environment.
Inflows have been strong and sustained given higher rates and expectations that a recession was imminent. Yet, returns have been mixed especially with there being no change in the Fed’s stance despite some encouraging data on the inflation and economic fronts. Specifically, shorter duration bonds have outperformed, while longer duration bonds have underperformed.
According to Vanguard, it’s simply a case of short-term pain equating to longer-term gains. The selloff in fixed income will lead to higher returns over the intermediate and long-term while generating decent income for investors. Ironically, it’s an inverse of what we experienced over the past decade when bonds were in a decade-plus bull market due to the Fed’s dovish policies. In this environment, there was no value and limited income opportunities in the asset class.
The firm recommends that investors have exposure to a mix of short and long-duration bonds. The factors that resulted in shorter duration outperformance are unlikely to continue especially given that the labor market is rapidly cooling and yields are at historically attractive levels.
Finsum: Fixed income has been particularly challenging in 2023 due to the Fed continuing to hike rates. Here are Vanguard’s thoughts on how to navigate the market.
For Investment Week, Sarang Kulkarni, the Lead Portfolio Manager of the Vanguard Global Credit Bond Fund, shared some thoughts about active fixed income and the current state of markets. Overall, his goal is to identify and invest in the best credit opportunities to generate consistent, risk-adjusted returns over the long-term. He is agnostic in terms of geography, sector, duration, credit quality. Instead, the fund has a bottom-up approach with a bias towards value.
Recently, the fund has been investing in European financials due to favorable valuations and an improving regulatory environment. Additionally, it sees improving credit trends in the consumer discretionary sector and believes there’s upside in the bonds of companies in this sector.
In terms of its edge over other active managers, Kulkarni believes that other funds rely on betting on the direction of the bond market to ‘generate alpha’. Over the long-term, these strategies tend to underperform the benchmarks and can perform poorly in more volatile environments.
In contrast, Vanguard seeks to generate alpha over an entire market cycle in a transparent way. It avoids beta even at the expense of short-term returns. The fund also seeks to replicate the risk-return profile of the asset class which is key to consistent, long-term performance.
Finsum: Sarang Kulkarni, the Lead Portfolio Manager of the Vanguard Global Credit Fund, shares some thoughts on active fixed income and what makes his fund unique relative to its competitors.
A recent challenge for the market and economy has been the surge in long-term Treasury yields. It implies higher costs for borrowers and corporations and if it persists, would certainly lead to a spike in defaults at some point.
Some key factors behind the ascent are resilience in the economy and inflation, rate cut odds in 2023 being priced out, and expectations of increased Treasury supply in the coming months due to large deficits.
Yet, there has been some relief in the fixed income market due to a series of dovish economic data. This includes the August nonfarm payrolls report, jobless claims, inflation, and consumer spending data. In essence, there were some who believed that the economy may have been entering a re-acceleration period as evidenced by the 10-year Treasury yield rising from 3.2% to 4.4% between April and August.
Yet, this week’s economic data undermines this narrative. The August employment data shows that hiring is clearly slowing, wage gains are decelerating, and the unemployment rate ticked higher. The 10-year Treasury yield declined from 4.4% to 4.1% as the breakout gets faded.
Just as those who were confident about a recession have continually been frustrated over the last couple of years, those who are looking for a re-acceleration of the economy are likely to be as well.
Finsum: There was some relief for the fixed income market this week due to a series of dovish economic data which support the notion of continued economic deceleration.
The landscape for financial advisors has shifted rapidly over the last decades. And, these shifts are only accelerating in terms of frequency and impact. Thus, advisors also need to update their strategy and approach to thrive in this new environment.
A major change is that advisors have to work harder to get and keep clients, especially given that many other money managers are likely competing for clients' resources, time, and attention as well.
For Financial Planning, John Guthery discusses why advisors should start embracing model portfolios to align their business with this new environment. Increasingly, the most value that an advisor brings is through quality time spent communicating with their clients to understand their needs and plan appropriately. This is true for both parties.
Too many advisors are spending too much time managing portfolios and researching investment ideas, when they could instead be focused on tasks that will actually grow their business. Most long-term research shows that advisors fail to beat the market over long periods of time.
With model portfolios, this function is effectively outsourced so that advisors can spend more time on the tasks that actually move the needle in terms of building and operating a thriving practice.
Finsum: Financial advisors tend to feel like they are not spending enough time with clients. Model portfolios are one solution as it frees up time for advisors.
For Vettafi’s ETFTrends, James Comtois shares his thoughts on the major differentiator for direct indexing vs the traditional strategy of investing in index funds. Over the last couple of decades, it’s become accepted wisdom that investing in passive funds is the best path to retirement given their diversification, history of long-term gains, and low costs and fees.
However, there is one drawback to this strategy. Investors are unable to capitalize on tax losses to offset gains to lower their year-end tax bill. Direct indexing addresses this weakness while still retaining the major benefits of passive index investing. In addition, it also enables investors to customize their holdings to reflect their personal values and beliefs.
Still, the key advantage for direct indexing is the boost in returns due to tax-loss harvesting. This can result in additional performance between 1 and 2% and is more potent in years with greater volatility. It can be particularly beneficial for investors who have gains in other parts of their portfolio.
With direct indexing, the portfolio is scanned regularly to sell losing positions. These are replaced with stocks that have similar factor scores to continue tracking the benchmark.
Finsum: Direct indexing has several benefits for investors but its key advantage is that it can help them reduce their tax bills and boost performance in more volatile years.
Active fixed income ETFs are seeing strong inflows and a slew of new launches to capitalize on its increasing popularity. Some major drivers of demand are growing awareness and comfort from advisors and institutions, elevated yields, and outperformance on longer timeframes.
In addition to these secular drivers of demand, the asset class is benefitting from the current uncertainty around the economy and Fed policy. Active managers have more discretion in terms of duration and quality when selecting securities. This creates more alpha especially in a sideways market.
The latest entrant in the active fixed income ETF space is Madison Investments which just launched the Madison Aggregate Bond ETF which invests in all types of bonds to generate superior long-term risk-adjusted performance. It believes that the fund will have lower risk than benchmarks in addition to income through risk-conscious investing.
The ETF has an expense ratio of 0.40% and marks its third ETF launch and first fixed income ETF. It will be co-managed by Mike Sanders, the Head of Fixed Income, and Allen Olson, Portfolio Manager. The fund will hold between 100 and 500 securities with up to 10% in non-investment grade credit. Currently, it has an average duration of 6.3 years.
Finsum: Madison Investments launched the Madison Aggregate Bond ETF which is an active ETF that aims to have lower risk than benchmarks.