Why Vanguard does active fixed income in-house
24 November 2020 | Portfolio construction
By Kunal Mehta, CFA, senior investment product manager, Vanguard Europe
In the last blog, we shared our thinking around when and why we often combine managers on a single equity mandate. In this post, we explain why our approach to active fixed income is different.
Fixed income – particularly investment-grade credit – can play a vital role in a balanced portfolio, providing reliable risk-adjusted returns, a dependable source of income and liquidity, as well as sensible diversification from equity markets1.
Generating alpha from credit markets has, however, become more difficult in recent years as bond yields have fallen2. In fact, only 18% of surviving active bond funds over the past 15 years were able to beat their benchmark, compared with 43% of active equity funds3.
This low-yield environment has encouraged many active fixed income strategies to invest in lower-quality assets or make large tactical asset-allocation decisions to try to generate extra return. These decisions in the hunt for yield often result in some form of compromise – whether it’s reduced diversification against equity market downturns or worse yet, underperformance when tactical decisions fail.
Our approach to active fixed income is different. We believe firmly that individual security selection is one of the best ways of adding alpha in fixed income, as opposed to large tactical bets on interest rates and markets. It’s about hitting singles, not sixes – to borrow a cricketing analogy.
So why does Vanguard feel that its in-house team is best placed to deliver active fixed income, particularly in this challenging environment?
Vanguard’s Fixed Income Group
Our active fixed income funds are run by Vanguard’s Fixed Income Group (FIG), which has managed active mandates since 1982 and currently oversees around £350 billion globally in active fixed income assets. This makes us one of the largest active fixed income managers in the world4. This size and scale means we benefit from being one of the largest liquidity providers to the market, which enables us to purchase bonds that many other managers are not able to access, at very favourable costs.
On top of that, our global team of more than 100 highly experienced investment professionals provide us with a research edge when it comes to identifying the right bonds from across the fixed income spectrum – whether its government bonds, corporate bonds or emerging market securities.
Excellent research is only one part of a successful active fixed income strategy. FIG abides by a disciplined investment process that incorporates a top-down macroeconomic outlook with the team’s focus on bottom-up fundamental credit research and relative valuations (driven by specialist sector teams based in their local respective markets). We aim for our funds to behave similarly in terms of risk to the asset class they represent, so that investors can feel confident that what they invest in matches their expectations for risk.
The investment process is highly collaborative and the team is further assisted by our Risk Management Group around the clock. This cooperation makes us different from many competitors and is reflected by something that isn’t present: a star manager. There’s no one key individual calling all the shots, no one person whose eventual absence may leave investors vulnerable.
Above all, FIG strives to achieve consistent alpha generation over the market cycle rather than on any single big trades that can work in your favour sometimes but not in others.
Beating a benchmark is one thing, delivering net excess returns consistently is another – made all the more difficult if active managers charge high fees for their services. And as yields have fallen, often it is the case that more risk must be taken to maintain returns. This behaviour can generate high returns in a bull market but is likely to be painful in a bear market. Our analysis of index and active fund types over a 10-year period found that as expense ratios increased, net excess returns tended to decrease5. That’s why we believe fees are so important – high fees pressure managers to take unattractive risks which ultimately eat into clients’ market returns.
So keeping costs low is vital to improving the likelihood of outperformance when investing through an active fixed income manager. By keeping our active fixed income strategies in-house we are able to offer strategies that are firmly in the lowest cost quartile vs their peers6, which provides a genuine advantage to our clients.
So how have our active strategies performed?
The first active fixed income fund we made available to investors outside the US was the UCITS Vanguard Global Credit Bond Fund, which was launched in 2017 to provide a moderate and sustainable level of current income by investing in a diversified portfolio of global credit bonds. As with many Vanguard active fixed income solutions, the fund is designed with consistency and lower-than-average drawdowns in mind, allowing the fund to be used as a ‘core’ fixed income allocation.
Led by senior portfolio manager Sarang Kulkarni, the fund intends to provide diversification from equities as well as aiming to protect investor returns in weak markets. Being true to its label, the fund will be primarily invested in global investment-grade bonds (core credit), although the managers do have a remit to seek opportunities elsewhere in a risk-controlled manner.
Since inception, the fund is the best performing in its Morningstar sector whilst outperforming its benchmark, the Bloomberg Barclays Global Aggregate Credit Index, by 4.1%7. The fund’s focus on generating alpha from bottom-up security selection and relative value has rewarded investors, with more than 75% of the fund’s return coming from security selection8 – supporting our bottom-up focus at a time of increased macroeconomic and geopolitical uncertainty.
Meeting the needs for higher yield
For investors seeking the higher-yielding and alpha possibilities of lower quality credit, FIG’s other active mandate in Europe is the Vanguard Emerging Markets Bond Fund, which is number one in its Morningstar peer group since inception9 – like the Global Credit Bond Fund.
The fund was launched in 2019 – though the strategy in the US was launched in 2016 – to address chronic underweighting of emerging market debt in most global bond indices. It seeks to provide total return with a moderate level of income by investing primarily in bonds of issuers in emerging market countries.
Regardless of the mandate, FIG’s risk-controlled approach seeks to avoid exposing clients to unnecessary risk, which is achieved via credit diversification and idiosyncratic credit selection.
At Vanguard we are fortunate to have one of the largest fixed income managers in the world10 (including index funds) within our ranks. So addressing the original question, why do we run active fixed income in-house? Put simply, our unique combination of size, scale, cost advantage and world-class research puts us in a position to deliver the desired results for our clients.
In future blogs, we will dive deeper into the Global Credit Bond Fund and speak to the people behind the impressive numbers at FIG.
1 Vanguard, ‘The role of global credit in a diversified portfolio’, 2018. 2 Bloomberg, data as at 31 July 2020. Historic average yield of Barclays Global Credit Index and average dividend yield of S&P 500. 3, 5 Vanguard calculations, based on data from Morningstar. Data as at 31 December 2019. 4, 10 Bloomberg, 30 September 2020. 6 Morningstar, Vanguard, as at 20 October 2020. KIID Ongoing Charges vs relevant Morningstar category peer groups. 7 Morningstar category Global Corporate Bond – GBP Hedged, data from 14 September 2017 to 30 September 2020, net returns in GBP. 8 Vanguard calculations, data from 14 September 2017 to 30 September 2020. 9 Morningstar category Other Bond, data from 3 December 2019 to 30 September 2020, net returns in GBP.
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