Active management techniques can exploit "structural flaws" that exist in the composition of fixed income benchmarks and the volume of assets passively tracking such benchmarks to maximise returns for investors, according to BlueBay Asset Management's Mark Dowding.
The chief investment officer, in a post on the company's website dated 5 October, sets out why, with fixed income offering yields at unprecedented lows, "return generation needs to be maximised through proactive approaches that look to utilise the opportunities the asset class offers beyond simple benchmark tracking".
Dowding, in comparing equity indices and bond benchmarks, writes that the greater number of fixed income securities makes benchmark replication more challenging in comparison to equities.
He also wrote that "as bonds don't routinely trade on formal stock exchanges, price discovery can be opaque", therefore the market structure "may be seen to lead to pricing anomalies" that can also "potentially be exploited".
BlueBay's Dowding referred to studies having shown fixed income to be an inefficient asset class "by means of the identification of observed premia attached to term structure, credit, volatility and liquidity".
However, he argued in the post that active investors in particular can "enjoy a theoretical over-compensation" by exploiting these premia through carrying out credit analysis to avoid those issuers whose credit metrics are on a deteriorating trajectory and are most likely to default.
He also explained how active investors can exploit the "rigid rules" that govern inclusion and exclusion in bond indices, by anticipating moves from third-party credit rating agencies, "which will flag their intentions to the market in advance of making formal rating adjustments".
"Arguably, the greater the volume of assets passively tracking such benchmarks, the greater the distortions around such index-rebalancing events will occur, creating potential market inefficiencies for active investors to exploit," Dowding stated.
In his post, he pointed out that while equity indices are constructed to reward the "success stories" whose stock prices increase over time, bond benchmarks are constructed based on those entities that issue the largest volume of debt and that "one could make the argument that this intrinsically favours struggling names rather than success stories".
Dowding added that it could be argued "bond issuers can exploit their understanding of benchmarks to their benefit".
"Put simply, bond issuers have the potential to exploit passive fixed income investors given the understanding of which bonds will be bought and at what times, based on index composition rules.
"This can be viewed as a further source of market inefficiency and one which active fixed income investors may also benefit from," the BlueBay CIO wrote.