Current market uncertainty is prompting advisers to de-risk portfolios, which for many means reallocating away from riskier equity assets in favor of fixed income. In fact, we've seen a lot of flows into traditional bond exchange-traded funds (ETFs) this year. Unfortunately, this traditional derisking strategy comes with little income opportunity in today's low interest rate environment.
Now Is The Time For Multisector Strategies
There is still income opportunity in fixed income today, but finding it isn't as simple as investing in an ETF that tracks a traditional benchmark, such as the Bloomberg Barclays U.S. Aggregate Bond Index ETF (Agg). Although the Agg is a well-known, established benchmark, it's not a comprehensive bond index. In fact, it's almost entirely composed of U.S. government-backed debt and some investment-grade corporates — which, based on Bloomberg data from June 2020, means it's only capturing 40% of the global yield opportunity and missing out on the strong income potential of sectors such as credit and emerging markets debt.
I believe the current rate environment demands a more comprehensive approach — and that broader multisector funds that are intentionally constructed and balanced across the major fixed-income asset classes offer better diversification and enhanced income potential than traditional benchmark products.
Fortunately, there are options that can give investors that thoughtful multisector exposure. Multisector ETFs with proven track records offer advisers the opportunity to enhance their clients' income opportunities while keeping portfolio expenses down.
Strategic Beta: Bringing Cost Efficiency And Portfolio Manager Insights Together
The cost efficiency of traditional benchmarks is well established. But in the current environment, it's time for advisers and investors to move away from benchmark investing and look to options with a more thoughtful design. There's value in combining cost efficiency with portfolio manager insight.
Consider the basic continuum on which every investment solution sits. On one end are pure index funds that track conventional benchmarks — by definition, all beta, no alpha and less expensive. And toward the other end of the continuum are active mutual funds, which are designed to deliver more alpha and are inherently more expensive. Strategic beta sits in the middle of the continuum, benefiting from both sides: the pursuit of alpha at the lower expense of beta.
The process of constructing strategic beta solutions in fixed income isn't about re-weighting an existing benchmark or screening factors to isolate trends. It's about starting with active portfolios and finding ways to offer passive, distilled versions, which can be offered at attractive prices. Multisector strategic beta ETFs are informed by a firm's investment insights and active management expertise. For these reasons, these types of funds can be a good option for passive investors looking for value.
Sector Diversification And Credit Selection Key To Driving Outperformance
But which sectors are most likely to deliver income in 2021? No single sector of the market currently stands out as incredibly cheap. A diversified approach to sector allocation may yield better risk-adjusted results than a narrower focus.
Based on my conversations with colleagues, the factor I believe is most likely to drive outperformance in fixed income this year is credit selection. Advisers in search of income for their clients should consider balancing their interest rate exposures by focusing more on credit-centric areas of the bond market. Credit selection is also a key lever for downside protection, and in 2021 — with low yields and credit spreads — mitigating downside risk is also important for outperformance.
A good strategy may be to diversify credit risk across corporate, consumer and sovereign balance sheets, all of which have experienced fundamental improvement since the depths of the most recent crisis. For example, corporate high-yield bonds with upside potential could be one way to diversify. While interest rates are expected to stay relatively low for the next couple of years, exposure to shorter duration bonds could be more appealing versus longer duration bonds in anticipation of an eventual rate increase.
Regardless of which investment vehicle advisers and investors choose, their decision should be based on strong credit research that identifies which trends are most likely here to stay. This is an indispensable tool to successfully navigate today's fixed-income market because we believe better insights lead to better outcomes. Who and what is behind each fund, whether passive or active, can be the difference between achieving clients' income goals and coming up short.
This article originally appeared on Forbes.
