Investor allocations to traditional active fixed income managers do not give the level of diversification to 60/40 equity/bond portfolios they are supposed to provide, according to a new research paper from AQR.

In the report, the alternatives specialist firm — well-known for factor investing — said it found that returns generated by active fixed income can be attributed to a structural overweight allocation to high yield credit.

Because of this overweight to high yield, much of the return generated by active fixed income strategies was derived from exposure to credit risk premium, AQR said, which is correlated with equity risk premium.

It acknowledged the possible influence of survivorship bias on its findings, saying “we cannot completely rule out that survivorship bias may account for some of the observed correlation between active returns and credit”.

In its paper — The Illusion of Active Fixed Income Diversification — the investment manager said active fixed-income managers had had a good run from 1997 to 2017 and especially in recent years.

“Active fixed income strategies may significantly reduce the strategic diversification benefit of fixed income as an asset class”

“This has prompted some to suggest that active fixed income management is easy — at least in a relative sense,” it said.

But active fixed income strategies may significantly reduce the strategic diversification benefit of fixed income as an asset class, AQR warned in the paper.

“Given the strong performance of high yield over the last 20 years, the effective structural credit overweight embedded in active returns of global aggregate, core-plus,
 and unconstrained bond managers has improved the standalone performance of these strategies, but it has reduced their diversifying characteristics,” AQR said.

These diversifying characteristics were, it argued, a central motivation for holding fixed income within a strategic asset allocation, because they had historically mitigated equity risk.

“Given the high correlation between high yield and equities, by being overweight credit risk, fixed income managers are inducing positive correlation to equities relative to the benchmark,” the manager said.

In its conclusion, AQR said it found that across active fixed income categories, managers were choosing to be overweight in credit or hold exposures that were highly correlated with credit.

“This importantly suggests that average active returns overstate the true ‘alpha’ in active fixed income management,” the report’s authors wrote.

‘Systematic approaches’, on the other hand, might allow investors to generate outperformance relative to fixed income benchmarks that was not correlated to credit or equity markets, the firm said.

This, it said, would therefore enhance, rather than detract from, overall portfolio diversification.

The full AQR paper can be found here.

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