Active Bond Portfolio Management
It focuses on maximizing returns from the bond portfolio
What is Active Bond Portfolio Management?
Active bond portfolio management is a bond portfolio management strategy that focuses on maximizing returns from the bond portfolio. The major approaches are classified as active, passive, or a combination of the two.
A portfolio manager in an active bond portfolio takes an active part in operating, organizing, and managing the portfolio.
Portfolio managers have an active part in selecting the bonds that will be included in the portfolio. This is chosen based on the market's best-performing bonds, which are expected to outperform the benchmark index over time.
The ultimate aim is for the bond portfolio to outperform the index. Managers will frequently locate and invest in undervalued bonds to accomplish this.
Purchasing bonds may also be used to hedge against market fluctuations.
In comparison, passively managed funds, also known as index funds, are managed by a manager who chooses and invests in a basket of bonds that are expected to reach the performance of a benchmark index.
This indicates that the portfolio manager is unlikely to modify the bonds in the portfolio after they have been chosen. The aim is not to outperform the index but to reach the stated benchmarking index.
Because the goal of active bond portfolio management is for the manager to play an active role in exceeding market expectations, the portfolio manager will take on greater risks than a passive approach.
Passive Bond Management Trends
In comparison to the active technique, investors have been more receptive to passive bond portfolio management solutions over time.
Funds that have consistently used active methods have lost market share as a result of the lower expenses that passive mutual funds and exchange-traded funds (ETFs) incur.
This is due to the fact that investors are constantly seeking strategies to diversify their bonds, which are typically provided by passive funds and ETFs.
The Vanguard S& P 500 index is one of the most popular passive funds. The iShares Core US Aggregate Bond ETF (AGG) is another popular passive bond ETF.
While passive funds and ETFs have performed well, active funds have had a net outflow of more than $500 billion as investors shift their capital to passive funds. This is related to a shift in investor risk tolerance, where passive funds can provide two benefits.
The first advantage is exposure to diverse markets through diversification. An early investor, for example, may obtain exposure to a range of markets just by owning Vanguard and iShares funds.
In addition to diversification, passive funds provide investors with reduced transaction and operation expenses. This is due to the fact that passive funds require less analytical assistance and so have lower overhead costs.
Investing with passive funds, on the other hand, frequently exposes you to unrecognized risks.
Credit risk and interest rate risk are examples of this sort of risk.
Unlike active strategies, which can forecast and analyze numerous situations for buying and selling bonds, passive techniques will be unable to build portfolios for varying market conditions.
Tools for an active strategy
The basic idea is that active managers have the ability to modify certain important aspects of the portfolios they manage, as well as gain from trading opportunities.
Because of the volatile nature of an active bond fund or ETF, active managers should use a range of tools to enhance the total return of the portfolio. Taking advantage of the uncertain market environment is also crucial in enhancing the portfolio.
In particular, fund managers will use:
1. Changing position
As the bond yield approaches maturity, the manager's position on the 'yield curve' will shift.
This is called a roll-down since investors will often want higher yields when lending money for a longer length of time to cover their risks and opportunity costs. A roll down in bond yields indicates that prices are rising as the yield falls.
As a result, the active manager will profit by selling the bonds that have grown in value as a result of the roll down.
Changes in the general level of interest rates or the form of the yield curve can also have an impact on total return. This is due to the fact that bond values fluctuate when interest rates change.
The active manager will take advantage of rate changes by hedging or protecting the fund with other investments. Interest rates may generate significant market volatility.
Therefore, this method will frequently need substantial study and trading resources to maximize the trader's position.
3. Credit spreads
Some bond yields contain a credit spread similar to a yield premium for government bonds in the U.S. This is designed to represent the bond issuer's greater level of risk.
For example, compared to government bonds, the market nearly always demands a greater yield from corporate bonds, mortgage-backed securities, and asset-backed securities.
However, because the private market is vulnerable to subjective fluctuations, the active fund manager might benefit from a roll-down in credit spread.
Advantages of Active Bond Portfolio Management
Some of the advantages are:
1. Boost the tax-exempt income
Municipal bonds (bonds issued in the client's home state) are free from federal taxes. Municipal bonds, also known as debt securities, are issued by local governments and states in order to raise funds for forthcoming budgets.
As a result, municipal bonds are effectively loans given to local governments, which are repaid in interest when the bond is cashed in.
The local government is rewarding you for actively investing back into society through the loan, which is why it is tax-free.
This is especially enticing for high-income workers in California, where the income tax is among the highest in the country.
As a result, although appearing to yield substantially less than corporate bonds, it is feasible to earn more on an after-tax basis.
When municipal bonds are used in an active strategy, it is used to hedge against gains and losses in other areas of the portfolio.
2. Control the holding period of bonds
An active approach allows the portfolio manager to control the number of bonds held in the portfolio at any given period. This tool is used to sell off bonds that have a low yield before they mature.
Interest rate risk is frequently studied in order to understand how bond prices vary in response to current interest rates.
Interest rate fluctuations, both short-term and long-term, can influence different types of bonds differently.
Because of the inherent risk that investors must accept in their portfolios, interest rates tend to rise as the period to maturity lengthens.
As a result, when interest rates are high, selling bonds might enhance the portfolio's total yield. This is referred to as the cash flow timing of a bond.
For example, if market participants feel that inflation is strong, interest rates will likely rise so bond yields will climb. This is to compensate for the loss of purchasing power in all future cash flows.
In comparison, a passive fund would let the bonds reach maturity regardless of their yield performance and effects on the overall portfolio.
3. Downside protection
While passive funds seek to replicate the performance of an underlying index, active management seeks to shield investors from the risks of a failing market.
Portfolio managers, for example, might hedge against certain investment risks or sell specific bonds and assets in advance of market weakness or volatility.
Hedging allows the portfolio manager to increase the portfolio's value while it declines due to external factors.
Fund managers can safeguard investors' funds against increasing inflation, policy changes, or falling liquidity through hedging. When done correctly, hedging can assist in decreasing uncertainty and limiting losses without significantly lowering the rate of return.
As a result, it is critical for active funds to capitalize on market conditions and emerging market trends.
Although passive funds have performed well in the last ten years, they may not perform as well in the ten future years. This is due to the prevailing valuations in the fixed income and equity markets.
To outperform traditional markets, it is critical to examine alternative assets for diversification and risk reduction.
Risks of Active Bond Portfolio Management
Some of the risks are:
1. Cost
Because several transactions must be completed in a short amount of time, active investing may be highly costly. If the fund manager is constantly buying and selling equities, the commission costs can quickly add up.
This can have a major influence on the overall return on investment.
Investors who go through a hedge fund typically have to pay a management fee ranging from 0.1% to 2%. Active money managers may also charge a fee between 10%-20% of the profit they are able to generate for the investors.
There is also a minimum investment amount for prospective investors.
E.g., A hedge fund may require the investor to have a minimum net worth of $1 million or more and earn at least $200,000 per year.
2. Difficult to outperform the market
Although the goal of active bond portfolio management is to outperform the index, doing so is difficult. Because of the hefty transaction costs, trading eats away the gains.
Typically, active investors' portfolios are not as diverse as planned, which implies that many opportunities for portfolio managers to profit from diversity are lost.
Active managers also keep more cash than passive funds, which reduces returns because this money is not used to create returns. Furthermore, putting your faith in investment managers implies that you are putting your trust in them.
However, human error is unavoidable, and mistakes like misjudging the market or selecting a terrible bond to invest in can occur.
Choosing the right active bond fund or ETF
For many investors, selecting the appropriate fund or ETF to invest in is crucial. Because past success is no guarantee of future performance, it is critical to undertake your study for the appropriate investment approach for your requirements.
Several factors should be considered by investors, including:
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Which vehicle should you use: a mutual fund or an exchange-traded fund (ETF)? Each has its benefits and may not be suited for all investors.
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The manager's research and trading resources - Investors must conduct extensive research on the fund manager to verify that they have sufficient and reputable sources to analyze the credit risk of various bonds. Managers should also be able to identify and capitalize on market inefficiencies in order to obtain lower trading expenses through skilled trading.
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The benchmark of the strategy - Each fund manager, should have a precise and unambiguous benchmark plan that matches the demands of investors. For example, if the major rationale for investing in a bond fund is to diversify an investor's portfolio, which is already heavily weighted in equities, investors may prefer a strategy with fewer correlations to equity returns.
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The overall level of risk within the portfolio - Fund managers should evaluate the risk they are incurring in relation to the fund's return and if this risk is comparable to index benchmarks. If active fund managers earn significantly more than the benchmark by investing in riskier bonds, it may be reasonable to examine whether the higher risk is justifiable.
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The sources of risk within the strategy - This includes credit risk and duration. For an active bond fund, the credit risk and duration can be manually altered by the portfolio manager.
Researched and authored by Freida Lee | LinkedIn
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