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Active Management and Risk Adjusted Returns

Executive Summary

Passive management or active?  We believe in both, but not universally.  In order to achieve the best of both worlds, a blended approach is what we offer to deliver the best risk-adjusted after-tax returns, and this post explains why.

At Centura Wealth Advisory we believe we can add alpha to both stocks and bonds, although the path to do so is very different. With equities, it is all about taxes, and with fixed income it has to do with economics and math.

In prior work we have discussed our philosophy to source alpha in equity markets (see our tax harvesting whitepaper), so in this post we dive deeper into fixed income and the rationale for why we believe in active management for bonds. Our research shows that fixed income markets are uniquely suited for active management, particularly when it comes to mitigating downside risk, and as a result we can often provide enhanced value for investors currently indexing the fixed income side of their portfolio.

We specialize in portfolio risk management, designing our fixed income portfolios to optimize risk adjusted returns against the index and to mitigate key fixed income risks over time (e.g., rising interest rates and inflation). We leverage industry and academic research paired with rigorous quantitative analysis to do so. If you currently use index funds for your bonds, continue reading to understand:

  • Why you should consider actively managed bond funds
  • Why it is important to hold them in portfolio,
  • What is required to identify the few actively managed funds that can outperform on a net-of-fees basis over time.

Introduction

Active versus passive management is a long-standing debate that tends to divide rooms of investment professionals. Active management offers the potential to outperform passive indexing but has become increasingly hard to do on a consistent basis. Recent research has called into question the merits of active management, but it should be noted that not all markets (i.e., stocks, bonds) are created equal. This post will outline our active vs passive management philosophy at Centura and utilize a recent study by Standard & Poors to evaluate the merits of our beliefs. We will also conduct a quantitative analysis to test our firms’ holdings and challenge our own beliefs.

Investment Ethos at Centura

At Centura Wealth Advisory we believe in both active and passive portfolio management, however which tactic is employed and on which asset classes, matters. For example, when constructing diversified portfolios, we usually take a passive approach to equities unless we are actively managing taxes via index replication and tax harvesting.   Regarding fixed income, we typically utilize a diversified active and passive approach due to the favorable economic backdrop that fixed income markets provide as related to active management. But, are these philosophies rooted in sound economics and does current quantitative research support our thesis?

Fund Selection Criteria

We believe that actively managed funds (equity or fixed income) must meet the following mandate(s) in order to be selected over an index:

  • Funds held in portfolio, must add statistically significant alpha versus their respective index*
  • Funds held in portfolio, must be accretive to risk adjusted returns (i.e., Sharpe Ratio)

To determine whether funds outperform their respective index, net of fees, we employ Fama-French Regression Analysis using a variety of factor returns for both equity and fixed income markets.  Then, we analyze the portfolio of funds over different time periods to assess their return/volatility profile as compared to the appropriate index (or blended index) in order to garner an apples-to-apples comparison.

Economic Backdrop: Equities vs Fixed Income

In breaking down equity and fixed income markets by themselves, we find that they are very different in their structure, policies and participants. Thus, keen understanding of the subtle nuances is paramount to understanding why the opportunity for outperformance may or may not exist.

Equity Markets

Equity markets are fiercely competitive and well covered by highly skilled analysts, traders and various media outlets. This level of competition and sophistication creates an environment that has democratized information, access to markets, and technology.  For reasons like these and others (e.g., algorithmic trading), we feel that actively managed equity funds underperform their respective indices on a risk-adjusted, net-of-fees basis most of the time.

Given our belief, we typically look to access market beta for equities as cheaply and efficiently as possible through use of large, liquid, low cost index ETF’s. This passive, low cost, approach to indexing equities ensures that we will participate in market returns but reduces the risk of underperforming on a net basis due to fee drag.

As alluded to earlier, equities are not typically an area of the market where we look to source alpha; unless we do so through tax management. Tax harvesting through an index replication strategy using individual stocks is a way to pair active and passive management in a way that outperformance (alpha) can be generated on a net of tax (and fee) basis. At Centura we specialize in advanced tax planning and leverage the use of sophisticated software to optimize tax harvesting in taxable accounts . For more on this approach, see our tax harvesting whitepaper.

Fixed Income Markets

When it comes to fixed income, we believe bond markets are different than equities and actively managed fixed income funds offer more opportunities to outperform based on the following considerations (including, but not limited to):

  • Fixed income investors have different objectives and may have mandates and/or other incentives when making investment selections
  • Bond market(s) are dynamic in that thousands of issuers constantly issue new bonds, which provides ample supply of both primary and secondary issues of
    various yields and maturities
  • Bonds are generally held to maturity and therefore trade infrequently
  • Trading occurs via over the counter (OTC) transactions and not on exchanges
  • Infrequent, over the counter trading, across thousands of different issues can lead to mispriced assets, negotiated trade prices and opportunities for outperformance (alpha)
  • Return profiles of individual bonds are far more skewed

For these reasons, and more, we utilize actively managed fixed income funds in our fixed income portfolio whereas with equities we generally rely on passive strategies alone. That said, we still retain a portion of our fixed income portfolio in the respective index as we recognize there are periods where indexing will still outperform, and it allows us to create a blended portfolio that meets our mandates specified earlier.

Qualitative and Quantitative Testing

Now that we have outlined our general philosophy and economic rationale supporting it, we will test whether a sample fixed income portfolio that we utilize at Centura Wealth Advisory meets our specified mandate(s).

Test: Part 1 – SPIVA Results

To begin our test we will utilize the 2018 year end Risk Adjusted SPIVA scorecard provided by S&P Dow Jones Indices. The Risk-Adjusted SPIVA Scorecard measures the performance of actively managed funds against their benchmarks on a risk-adjusted basis, using net-of-fees and gross-of-fees returns. Risk adjusted performance in SPIVA is measured by the Sharpe Ratio (i.e., higher = better) and evaluates results over 3 distinct time periods: 5 years, 10 years and 15 years. For purposes of our study, we will utilize these SPIVA findings to evaluate our philosophy on active vs passive fund selection.

For detailed results, please reference the SPIVA research report for year end 2018. Key highlights relevant to our analysis include:

  • Benchmarks outperformed US Equity Funds 81%-95% of the time, depending on whether looking at 5, 10- or 15-year periods
  • Unlike their equity counterparts, most fixed income funds outperformed their respective benchmarks gross of fees.
  • However, when using net of fees returns, most actively managed fixed income funds underperformed across all three investment horizons on a risk adjusted basis
  • This gross vs net performance divergence highlights how the role of fees in fixed income fund performance was especially critical

These findings corroborate our thesis and support our rationale for taking a passive approach in equities and a diversified active/passive approach to fixed income. We believe we have sourced active managers that deliver alpha, net of fees, but careful analysis and ongoing monitoring is recommended.

Test: Part 2 – Quantitative Analysis

Next, we will evaluate the actively managed funds (held in portfolio) that we utilize in our fixed income model(s) at Centura. Our goal is to determine:

  1. If our fixed income portfolio adds statistically significant alpha
  2. To see if our fixed income portfolio has outperformed the bond index on a risk adjusted, net of fees basis over the recent 1, 3- and 5-year periods.

To assess whether our fixed income portfolio produces statistically significant alpha we run a Fama-French multi factor regression which includes term and credit
fixed income factors in addition to the traditional 5 Fama-French factors. We run this regression over the longest common period which is 4 years. The result is a statistically significant (p-value = 0.000) model with an adjusted Rof 73.2% and annualized alpha of 1.22%. These results confirm our first mandate that our fixed income portfolio must add statistically significant alpha.

Table 1 – Regression Results

Turning to risk adjusted returns in a portfolio backtest, we find diverging results between the actively managed funds we have selected and the index itself. Fortunately for our portfolio, we use a blended active and passive approach, however we recognize that there are periods where results may differ.

For example, in the tables below we see that the index has outperformed on a risk adjusted, net of fees, basis over the 1-year period. However, over the 3- and 5-year periods, the actively managed funds are preferred. While insightful, these results help support the notion for holding both active and passive funds together in portfolio.

Table 2 – Risk Adjusted Returns 

Note: returns are net of expense ratios however AUM fees are not included.


Test: Part 3 – Stress Testing

Last, we will evaluate our portfolio (versus the index) under simulated stress test scenarios including rising interest rates and inflation; risks paramount to fixed income markets. We seek to understand how different types of portfolios behave under different types of “stress” conditions. The stress tests conducted include:

  1. Rising Interest Rates
  2. Inflation

Table 3 – Stress Test Results: Potential Downside

As is clear from the table above, there is a marked difference between the potential downside risk of unconstrained actively managed bond funds versus the index alone. Thus, we believe active management decreases portfolio risk in ways that may not be -captured through returns and volatility data alone.

Conclusion

In summary, at Centura Wealth Advisory we believe in active fund management for specific markets at specific periods of time. This philosophy is reflected in our portfolio construction and validated in our research and quantitative analysis. We acknowledge that there are periods of relative out performance between one strategy or the other, but we caution readers not to try and time these swings. Rather, skillful portfolio construction and prudent risk modeling can help build a diversified, actively managed fixed income portfolio that leverages a strong economic backdrop which favors such an approach.  If you have been indexing your fixed income investments, chances are you can do better. Contact us for a portfolio evaluation and stress test to see if our fixed income solutions could improve your portfolios risk adjusted returns.


References

  1. Cumberland Advisors
  2. S&P Dow Jones Indices
  3. PIMCO
  4. Fama-French


Disclosures

Centura Wealth Advisory ("Centura") is an SEC registered investment adviser located in San Diego, California.  This brochure is limited to the dissemination of general information pertaining to Centura's investment advisory services.  Investing involves risk, including risk of loss.

Centura Wealth does not make any representations as to the accuracy, timeliness, suitability or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein.  All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.

We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting or tax advice.  We recommend that you seek the advice of a qualified attorney and accountant.

For additional information about Centura, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).   Please read the disclosure statement carefully before you engage our firm for advisory services.