How to Choose the Right Fixed-Income Strategy

The fixed-income portion of retirement portfolios is just as important as the equity allocation, yet far less research has been devoted to it. Advisors must decide whether to pursue active or passive strategies and which types of bonds to recommend. I'll address those strategic choices and argue that the best approach is the simplest, lowest-cost one.

Active versus passive

Data availability is different for stocks versus bonds. For stocks, there is good historical information on the performance of active versus passive funds, persistency of performance (i.e., do good funds repeat?) and whether those selecting funds, such as pension fund managers, are able to successfully choose funds that beat the indices.

For fixed income, there is less to go on, and the research that is available is subject to interpretation.

Each year, S&P publishes the "S&P Indices Versus Active Funds (SPIVA®) U.S. Scorecard," which provides detailed comparisons of fund performance versus indices for the past one, three and five years. The scorecard runs 28 pages and provides a lot of detail by specific categories within both equity and fixed-income investments.

But despite the level of detail, there are problems of interpretation for fixed-income investments. Here's an example. For the five years through the end of 2013, 63% of investment-grade intermediate-term active funds outperformed the Barclays Intermediate Government/Credit benchmark (AGG), and active funds produced an average annual return of 5.81% versus 3.96% for the index. These results might be interpreted as solid evidence favoring active management in this fixed-income category.

However, let’s we dig into the numbers a bit deeper. The AGG index uses a mix of fixed-income investments reflecting the size of different segments of the bond market. The bond market is dominated by Treasury bonds and government-backed mortgage pass-throughs, so the AGG holds mostly these types of bonds.  Many investors have been attracted to the higher yields offered by corporate bonds. This Vanguard report shows that, at the end of 2012, the AGG index consisted of 23% corporate bonds, while funds benchmarked to the index held an average of 44% corporate bonds. This discrepancy raises the question, discussed in the Vanguard report, of whether the funds' investment mix represents manager skill in tilting toward corporate bonds or whether it represents investors’ desire for higher yield.