Why active fixed income in DC plans
When it comes to defined contribution (DC) plans, it is critical for plan sponsors to offer a diverse selection of investment options covering a full range of asset classes. However, it is also important to understand the differences between active and passive strategies, especially for fixed income.
Whether you are looking at core menu options or target date strategies for your plan, it is important to understand how the fixed income investments you choose to offer participants are managed.
While some plan sponsors (and participants) may opt for passive fixed income investments, they may not always deliver the outcomes participants expect from their fixed income allocations, including diversification and potential return enhancement. In addition, passive investors are vulnerable to the changing investment characteristics of fixed income indices and could miss out on the benefits of exposure to securities and sectors that are not represented in a given index, especially in volatile interest rate environments.
Actively managed fixed income investments can help participants construct strong, well-diversified portfolios. Skilled and experienced active managers have the tools to inform security selection, identify return-enhancing opportunities and manage duration and risk – as well as the flexibility to respond to ever-changing markets.
The case for active fixed income
In our view, passive fixed income strategies can attempt to mimic an index, but on their own they may not lead to all the outcomes that investors traditionally expect from their fixed income allocations, including enhanced returns, lower volatility and diversification. As a reminder, the largest holdings in a fixed income index are those that issue the most debt. Do investors inherently want their largest holdings to be the largest borrowers? In an environment of rising rates in conjunction with increased market volatility globally, active, flexible decision-making is even more critical to portfolio performance in a changing economic environment.
While the S&P 500 Index captures more than 80% of the U.S. stock market, bond indices are less reflective of the markets they seek to emulate. The benchmark for U.S. investment-grade bonds, the Bloomberg US Aggregate Bond Index (also known as “the Agg”), captures only 49% of the U.S. bond market. Diversified core fixed income investors need to be aware that the Agg remains highly concentrated in U.S. Treasury and agency mortgage-backed securities (MBS), which represent almost 70% of its underlying assets. The index’s rule-based construction, designed in the 1980s, excludes many securities that investors prefer to deploy in a modern, well-diversified portfolio: certain agency mortgage securities, most asset-backed securities and approximately 40% of all corporate bonds.
The Agg excludes large parts of the U.S. bond market
Investors seeking broader market diversification need to look beyond the rigidity of the Agg for exposure to a more complete set of opportunities – and access to sectors such as asset-backed securities, high yield bonds and emerging market debt – to potentially generate additional income and return.
Ability to make active decisions
The current interest rate environment is an excellent example of why flexibility to make active decisions is critical. Since passively managed funds are designed to track an index, there is no opportunity to make active decisions, such as making tactical allocations as well as managing duration and risk.
Last year when rates were rising, active investment managers had the flexibility to lower duration versus the Agg to mitigate declining bond prices. Depending on the fund’s objectives and guidelines, managers may have also had the flexibility to upgrade credit quality, increase liquidity profile and capture yield by allocating to other sectors of the fixed income market.
Active fixed income management has shown its ability to deliver excess returns net of fees – a fact that may surprise some staunch advocates of passive investing in equities. Within each of the two largest bond fund categories – core bond and core-plus bond – the JPMorgan Core Bond and Core Plus Bond Funds outperformed the Agg as well as the average passive core bond fund over various economic cycles.
In addition, not only do active fixed income managers outperform their passive peers net of fees over the long term, they have also outperformed on a risk-adjusted basis, meaning lower volatility with higher Sharpe ratios.
Within the largest bond categories, active management has added value
Excess annualized return (%) over the Bloomberg US Aggregate Bond Index
Building stronger retirement plans
With the crosscurrents of volatile rates and the possibility of persistently higher inflation combined with a slowing economy, active fixed income managers continue to see ample opportunities to enhance portfolio returns and mitigate risks.
Plan sponsors and advisors have the freedom to choose from an expanding array of both active and passive fixed income approaches – from core strategies that provide diversification to equity exposures, to complementary strategies that reduce overall portfolio risk, to sector strategies that enhance income and total return. The key is to understand what is really beneath the hood of both an active or a passive strategy – or a blended approach, in the case of target date funds – and whether that strategy has the ability to flexibly navigate changing market conditions.
Within our SmartRetirement target date funds, leveraging active managers for our underlying fixed income strategies – specifically JPMorgan Core Bond Fund and JPMorgan Core Plus Bond Fund as well as our high yield and emerging markets debt strategies – can help us generate more efficient risk-adjusted returns with the potential to both mitigate volatility on the downside and lead to better income replacement outcomes.
With increased sensitivity to fees, we understand providers are looking for lower cost alternatives in the target date space. The JPMorgan SmartRetirement Blend Funds combine both active and passive strategies, while leveraging the same glide path, asset allocation expertise and risk management process used for our actively managed target date funds.
Core Bond Fund (R6 shares)
Core Plus Bond Fund (R6 shares)
Performance quoted is past performance and is no guarantee of future results. Investment returns and principal value will fluctuate, so shares, when sold, may be worth more or less than original cost. Current performance may be higher or lower than returns shown. Call 1-800-480-4111 for most recent month-end performance.