This edition of On the Trading Desk® discusses low-cost options for fixed-income management. We’re talking about this because investors are fixated on finding products that offer the lowest operating costs when deciding to invest in mutual funds or exchange-traded funds. However, there may be considerable opportunity cost associated with a seemingly low-cost, passive strategy.
Discussing this topic is Danny Sarnowski, Portfolio Specialist for the Wells Fargo Asset Management Global Fixed Income Platform and Noah Wise, Senior Portfolio Manager on the Multi Sector Fixed Income – Plus and High Yield Team.
Danny Sarnowski: I’m Danny Sarnowski and you’re listening to On the Trading Desk®.
This edition of On the Trading Desk is about understanding the low-cost options for fixed-income management. The reason this topic arises is because many investors are focused on finding products that offer the lowest operating costs when deciding to invest in mutual funds or exchange-traded funds (ETFs). As we’ll discuss, there may be considerable opportunity cost associated with seemingly low-cost, passive strategies. I’m Danny Sarnowski, Portfolio Specialist for the Wells Fargo Asset Management Global Fixed Income Platform and I’m joined today by Noah Wise, Senior Portfolio Manager on the Multi Sector Fixed Income – Plus and High Yield Team, to discuss. Thanks so much for being here, Noah.
Noah Wise: Happy to be here, Danny, and thank you. This is a topic that I am very passionate about, as you know, so excited to dive into the details here. This is one of those things where common knowledge is in one direction, but I think that reality is actually quite a bit different. So I think it’ll be really, really fascinating to shine a light on an area that investors maybe have certain preconceived notions about that are likely not true.
Noah: So as you know, we talk about low-cost strategies, it’s really been interesting to me to see the flows, which is where investors have been putting their money in an attempt to get the lowest explicit fees.
Danny: For sure, yeah. I mean, if you’re saying that investors vote with their wallets, they’re certainly telling us that costs do matter, right? If you think about at the end of the first quarter of 2021, nearly 42% of all mutual fund and ETF assets—now that’s excluding money market funds—was invested in passive solutions. In 2011, that number was 21%. So that means the proportion of assets invested in passive strategies has doubled in the last decade. And if you look at just the fixed-income side of the house and if you look over just the last 12 months ending 3/31, meaning March 31 of 2021, $358 billion dollars was invested in passive fixed-income mutual funds and ETFs. So investors are looking for lower cost solutions. They’re voting with their wallet, but investors really, they’re only considering part of the story.
Noah: That’s exactly right, and that’s why this is so interesting.
Investors in fixed income are really fixated on explicit costs and they are important and there’s a good reason for it. There’s the old saying that a bird in the hand is more valuable than two in the bush, and there’s a lot of good reasons that that saying is so well-known. But I really think that this is a question of a bird in the hand versus maybe nine in the bush in fixed income.
And when we look at it, we believe investors are better served by taking a more holistic approach to weighing costs and really especially true in fixed income because of some unique aspects of the fixed-income markets. There’s really two big reasons for this.
One is the difference in management fees between active and passive fixed-income are so much lower than they are in most other asset classes. And it’s really both sides of that equation. The passive fixed-income fees are a lot of times higher than other passive fees in other strategies, and you can kind of look at some the biggest fixed-income sectors and assets in some passive ETFs and they charge 40, 45, maybe 50 basis points in some instances. They’re not all that high, but some of the biggest ETFs out there do charge that much. Whereas, if you look at something like large cap equities, there are a number of ETFs that aren’t charging anything for their fees. So it’s a pretty interesting difference in dichotomy just on the passive fee differential.
But then you look at the active fees, as well, and active fixed-income managers charge lower fees. I’ve seen estimates that put it about 20 basis points less in active fixed-income fees than in your comparable equity actively-managed strategies. So you have a lower explicit cost differential in active fixed-income than you do in a lot of these other asset classes. But that’s probably a smaller part of the story. It’s really important, but that bird in the hand that you get in fixed income, that’s even a smaller bird compared to some of the other ones.
But the other thing is the opportunity costs, and that’s where we’re going to focus on a lot of our discussion. The opportunity costs in passive fixed income are just so much higher than they are in active fixed income and I think that’s a really interesting part of this story.
Danny: If you don’t mind, Noah, let’s take a quick step back, because I think you said a number of things there that are really important and maybe it’d be helpful to sort of set the stage or have some definitions. When you’re talking about opportunity costs or total costs, walk us through how you view those different terms.
Noah: Yeah, absolutely. So when we’re talking about costs associated with investing, we are talking about it a little bit more holistically. I think everybody takes the shorthand and says what is the management fee? And that’s certainly the place to start, but it’s only part of the equation.
The total costs encapsulate the explicit management fees, but they also need to account for opportunity costs, and we really believe in fixed income, the opportunity costs are arguably a bigger factor in that total cost equation. So we talk about total cost as equaling fees plus opportunity costs.
But really, what do opportunity costs mean? Opportunity costs in investing really have to do with flexibility and where and when flexibility is valuable. Opportunity costs are associated with a strategy’s ability to take advantage of inefficiencies in the marketplace.
And so what we would argue is explicit fees are really important, much more important in that total cost equation where opportunity costs are low—or another way of saying that there aren’t a lot of inefficiencies, right? In really efficient markets, there isn’t much on the opportunity cost front, so fees are really, really important. In markets that have really significant inefficiencies, like fixed-income markets, then the balance shifts quite a bit and you start to see opportunity costs becoming much more important.
And when you think about where these inefficiencies come from, that helps you answer this question of why, right? Why are these securities in fixed income uniquely mispriced? And there are couple of main reasons for that.
The first one really has to do with benchmark construction, I think, is a big factor. So you have benchmarks within fixed income that have allocations to different sectors and risk exposures, and those risk exposures and what’s driving those allocations may not be because of purely economic reasons.
But passive strategies will have a structural bias to match those exposures, even if those exposures are non-economic from a risk/reward standpoint.
So investors that are saving for retirement, that want to generate some income, that want some ballast in their portfolio, they’re kind of getting carried along by some of these benchmark exposures when they may not really be appropriate for them.
So that’s really the second factor that I want to talk about, which is why these exposures there in the first place, right? And I think that has to do with some of these kind of structural supply and demand types of imbalances that are a little bit unique to the fixed-income market.
And I’ll highlight a couple. One is a factor that all investors are very, very attuned with, but maybe have not thought about how that ties into this discussion, and that is monetary policy and central bank behavior and really how that’s changed over the last 10 or 15 years.
We have a $100 trillion plus global fixed-income market. And a couple of decades ago, central bank balance sheets were a tiny fraction of the size that they are today.
After the Global Financial Crisis and then now following COVID, we’ve seen obviously an explosion of activity and involvement in central banks in global fixed-income markets, in particular, and specific spots within global fixed-income markets with a heavy emphasis on government treasury bonds but also in some unique areas. Europe, a little bit more focused on corporate bonds. The U.S., a little bit more focused on agency mortgages. But when you add up the size of those large global central banks, you’re talking $20 trillion dollars plus in assets.
Well, that’s one in every $5 of global fixed-income assets, and that is a big demand factor. And so you have to think about what is driving that decision? Is it economic? And we would argue that it’s not economic at all, right? They’re trying to manage to an inflation mandate or a labor market mandate or something like that. Maybe control a currency movement. But it’s not what is the right risk/reward.
Well, those decisions ultimately impact that benchmark construction and then those passive investors are following those benchmarks, even if it’s not the right risk/reward profile. So what are we seeing over the last couple of decades?
We’ve seen large increases in specific sectors, more recently, lots of issuance in treasury government bonds. We’ve seen an extension in duration, which is the interest rate risk that investors bear as a result of that benchmark.
And so you’re getting more interest rate risk, more exposure to a lower yielding asset class, like treasury or government bonds, and you’re getting paid less for it with a lower yield. And we look at that and say is that efficiently priced? Are you getting a risk/reward that’s attractive for those types of exposures? And we would argue that is not the case and it’s because of some of these structural supply/demand imbalances that are really unique to the fixed-income marketplace.
Danny: So as an active manager, you’ve got all these different tools in your toolbox. What can you do to offset some of that opportunity risk or that opportunity cost?
Noah: It’s really how we navigate those different environments—rates rally, a credit selloff, a credit rally, and a rates selloff. We don’t do the same thing all the time. It’s dictated by this cost-benefit analysis. Where is the risk? Where is the reward?
Doing the same thing is a passive strategy. It really locks you into those same characteristics of the index, and as we discussed before, there’s some serious issues with the index construction in terms of whether or not it provides that income, that total return, that ballast that investors necessarily are looking for because of some of these outside influences that are really non-economic and how it impacts these indices.
Danny: So would you say, Noah, that some fixed-income investors are missing the forest for the fees?
Noah: Very nice. Yes, yeah, that’s exactly right.
Yeah, we think really the best way to implement this and build a better strategy is by utilizing an unbiased approach. You really don’t stake out a specific set of biased positions and then just hope that they’re going to work in every environment.
Instead, the way that we think it leads to a better outcome is that we look at market, we look at the risks, we look at the opportunities, we look out for the next six months, and we’re always asking ourselves what is priced in? What is our view? And if there is a discrepancy between the two, there very well may be an inefficiency available that we can take advantage of to deliver superior risk-adjusted returns and really reduce the opportunity costs that our clients are facing in these markets.
So if we believe spreads are going to be tighter in six months, then we will utilize that flexibility to increase credit exposure and, therefore, reduce some of the opportunity costs in that type of area. But if we think that spreads are going to widen out, then we can lighten up on credit. The same thing with yields. If we see yields rising, as we have seen over the last two to three quarters, we can favor a shorter duration posture, so taking less of that interest rate risk so that it can help shield the client experience.
If we think that the yield curve is going to steepen, then we can adjust for that. But conversely, sometimes yields are declining and maybe you want to have more interest rate risk. So we can pull a lot of these different levers, and that is really helpful because it leads to a more diversified and, I think, consistent and better total return stream while generating more income and, ultimately, being a better experience for our clients.
So it’s really a lot of these smaller decisions, diversified across a broad set of exposures, but not keeping them the same all the time. Instead, really focusing on that relative value and where the risk-adjusted opportunities are best at any given moment in time.
Danny: Yeah, as I’m listening to you, and as our listeners are hearing all those different decision planes and all those factors that you and your colleagues on the team are taking into consideration at all times, if you just sort of stacked each one of those up and associated a cost with each of those decisions—think of all that opportunity cost. Think of all those decisions that you’re making that a passive strategy just is precluded from making.
And so then, yeah, fees are important, but if you’re looking at sort of the total return and the risk-adjusted return picture and trying to find ways to efficiently drive alpha in the fixed-income markets, it just seems like there is a lot of opportunity cost that passive investors are taking on or not thinking about when they’re sort of equating total cost with fees.
Noah: Yup, that’s exactly right.
Danny: Well, I appreciate your time. Any other final thoughts for our listeners?
Noah: Yeah, so I think you really summed it up really well. There is this fixation on explicit cost for a very good reason. But also recognizing that oftentimes a bigger driver of outcomes is actually those opportunity costs. And really highlighting both those differences, both from an explicit cost standpoint—the differential in active versus passive on the fixed-income side in explicit fees is much lower, which favors active fixed income—but also that the opportunity costs are much higher for passive fixed-income, as well, which also favors active fixed-income.
And therefore, the total costs when you combine those two factors really tilt the balance in favor of active fixed-income.
Danny: Great. Well, thanks so much, Noah. I really appreciate your time.
Noah: Yes, thank you, Danny.
Danny: For our listeners, if you’d like to read more market insights and investment perspectives from the fixed-income teams at Wells Fargo Asset Management, you can find them at www.wellsfargoassetmanagement.com.
And to stay connected to On the Trading Desk and be able to listen to both past and future episodes of the program, you can subscribe to the podcast on iTunes, Stitcher, Overcast, or Google Podcasts. Until next time, I’m Danny Sarnowski. Thanks for listening.
Originally Posted on July 2, 2021 – Finding A Low-Cost Option for Fixed-Income Management
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