Morningstar Magazine - August/September 2018 - 38

Spotlight: Fixed Income

Raising the Bar for Active
Bond Managers
There's more than meets the eye when
assessing funds' performance.

MANAGER SKILL

Alex Bryan

Active managers in the intermediate-term bond
category have fared much better against
their Morningstar Category index over the past
decade than their counterparts in most
U.S. equity categories. That's largely because the
category benchmark, the Bloomberg Barclays US
Aggregate Bond Index (commonly called
the Agg), does not adequately represent the depth
and breadth of the pond where active
managers in this category fish. The Agg skews
heavily toward low-yielding U.S. Treasuries
and agency mortgage-backed securities, or MBS,
which have little credit risk.

It doesn't take a genius to take greater credit risk
to boost returns, as many active managers
do. These managers shouldn't get credit for
beating their benchmarks by simply taking greater
risk, especially because investors can do so
more cheaply on their own with exchange-traded
funds that cover riskier segments of the
bond market.
Because there are often differences between the
amount and types of risk active managers
take and the risk in the Agg, it isn't necessarily fair
to compare their returns. It is necessary
to raise the bar to assess whether an active
fund is delivering a differentiated source
of return that can justify its fee. That is the aim
of this article.

EXHIBIT 1

Factor Definitions Our regression model attempts to explain a fund's return as a
function of credit, duration, and residual market risk. Anything left over is attributed
to manager skill.
Factor

Definition

Intermediate Duration

BBgBarc US Treasury 3 -10 Yr Idx - Rf

Long Duration

BBgBarc Long Term US Treasury Idx - BBgBarc US Treasury 3 -10 Yr Idx

IG Credit

BBgBarc US Corp Bond Idx - BBgBarc US Treasury Idx

HY Credit

Markit iBoxx Liquid High Yield Idx - BBgBarc US Corp Bond Idx

Residual Market

BBgBarc US Agg Idx - Interm Duration - Long Duration - IG Credit - HY Credit

Source: Morningstar.

A Better Way to Assess Performance

To determine whether active managers are doing
more than earning compensation for building
exposure to common risk factors, I constructed
a regression model. This model attempts
to explain each fund's return as a function of
credit, duration, and residual market risk. Anything
left over is attributed to manager skill, or alpha.
The payoff to credit and duration risk is often not
linear. To address this, the model includes
two duration and credit-risk factors. The duration
factors break the yield curve into two, accounting
for the payoff to intermediate-term and longterm interest-rate risk. Similarly, the credit factors
control for the payoff to investment-grade
corporate credit risk and high-yield credit risk.
While credit and duration risk are the primary
return drivers in the bond market, they don't
capture everything. To account for bond
market returns that aren't attributable to the credit
and duration risk factors in the model, I added
a residual market risk factor, which strips
out the returns from those other factors from the
Agg.¹ This factor may pick up convexity and
interest-rate and credit risk that the other factors
don't fully capture. The residual market factor
was negatively correlated with the Agg and had
a negative return over the sample period.
The factor definitions are shown in EXHIBIT 1 .
The ETFs listed in EXHIB IT 2 either track or
offer very similar exposure to each of the indexes
used to construct the factors.
Formally, the regression model is expressed as:
Fund Return - Rf = + ₁(Intermediate-Term
Duration Risk) + ₂(Long-Term Duration Risk) +
₃(Investment-Grade Credit Risk) +
₄(High-Yield Credit Risk) + ₅(Residual
Market Risk)
Where:
Rf = the risk-free rate, as proxied by the return
to 1-month T-bills
= estimated return to manager skill

1 This term slightly reduced most funds' alphas, though its inclusion didn't significantly affect the results. Its inclusion has the benefit of giving the Agg an alpha of 0 and rescaling that
benchmark's other risk coefficients to 1, making it easier to compare the results of the other funds.

38

Morningstar Augsust/September 2018



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