Rick and Jacob examine why 2017 provides a seemingly unlikely source of evidence for the effectiveness of an active approach to fixed income.
At first blush, late 2017 may seem to be a curious time to be writing about the advantages of active management in fixed income. For much of the past year, markets have felt incredibly quiet and there has been little price volatility. In fact, market participants could almost hear the proverbial pin drop during this period. Looking at realized volatility, there have been few times as quiet as what we’ve seen this year. Of course, this isn’t to say that there haven’t been periods of uncertainty, risk and market movement over the past several months; but stepping back, this has been a very docile period. To highlight how low volatility has been this year, we’ve frequently seen both realized rate and equity volatility resting in the bottom decile relative to a long history (see first graph).
Markets Have Been Quiet
One might be tempted to think that this kind of low volatility environment isn’t favorable for active fixed income strategies of the kind that we outlined in March 2017; if volatility creates opportunity, one could ask whether there has even been enough of an opportunity set available. In short, we think there has been. In our view, a lot has been going on under the hood in markets over the past several months, and we think there have been plentiful prospects for active strategies to function well and generate returns. This point is crucial—if these strategies can find the raw material needed to generate returns above that of the market in environments that are as quiet as this one, we think it’s possible to create durable and consistent active returns across varying market regimes.
However, we can see clearly that there has been opportunity in this environment when we uncover the thematic drivers of markets utilizing Principle Component Analysis (PCA, see second graph). It’s easy to think that markets have been on a steady grind higher during this period of low volatility, but when we look more closely, we find that there have been distinct, dynamic and evolving trends in place. Indeed, these trends could serve as a fertile opportunity set, particularly for dynamic active strategies, which generate return from evolving macro trends.