Do Active Fixed Income Managers Actually Beat the Benchmark?
Book: Systematic Fixed Income: An Investor’s Guide Author: Scott A. Richardson, Ph.D. ISBN: 9781119900139 Publisher: John Wiley & Sons, 2022
This is Chapter 4 of the book, and honestly it might be the most eye-opening one so far. Richardson basically takes apart the entire active fixed income industry and shows that most of what managers call “alpha” is really just exposure to risk premiums you could get way cheaper.
What Active Bond Managers Actually Do
Before getting into the data, Richardson lays out five types of investment decisions that active fixed income managers typically make:
- Avoiding bad selling practices - things like not panic-selling when bonds get downgraded or fall out of an index. Just being patient can earn you money.
- Asset allocation / duration timing - trying to predict interest rates. As we saw in the previous chapter, this is really hard.
- Out-of-benchmark tilts - reaching into high yield, emerging market debt, loans, and other sectors not in the benchmark.
- Liquidity provision - making money by being willing to buy and sell when others can’t or won’t.
- Security selection - picking specific bonds that are more attractive than others.
Here’s the thing about those out-of-benchmark sectors. Richardson shows that loans, emerging market debt, US high yield, and equities are all highly correlated with each other (0.80 or higher). They’re low correlation with treasuries, so they feel diversifying. But they don’t diversify beyond the credit premium. This becomes a running theme.
US Core Plus Funds: The 65% Haircut
Richardson looks at 142 US Core Plus funds from the eVestment database. The average active return was 1.18% per year with a Sharpe ratio of 0.54. Sounds great, right?
But when you run a regression against traditional risk premiums (term, credit, emerging market, currency, volatility), the picture changes fast. The average correlation between these funds’ active returns and the credit premium is 0.72. That’s huge. These managers are basically just loading up on credit risk.
After stripping out passive beta exposure, that 1.18% “active” return drops to just 0.41% alpha. That’s a 65% reduction. Most of what looked like skill was just credit beta in disguise.
Global Aggregate Funds: A Better Story
The 94 Global Aggregate funds tell a slightly better story. Average active return of 0.77% drops to 0.57% alpha after removing beta, only a 25% reduction. The credit beta correlation is lower at 0.29, which makes sense since these funds have a broader mandate.
Still, the pattern is the same. A chunk of “active” returns comes from tilting toward credit risk.
Unconstrained Bond Funds: The Worst Offender
This is where it gets really interesting. The 103 unconstrained bond funds had an average return of 4.09% over cash with a Sharpe ratio of 0.74. Sounds amazing.
But the credit beta correlation is 0.63, and when you remove passive risk premium exposure, that 4.09% collapses to just 0.57% alpha. That’s an 85% reduction. Richardson calls this category one where “the repackaging of beta as alpha is both very large and very pervasive.”
So you’re paying active management fees for what is mostly credit beta you could get much cheaper through an index product. Not ideal.
Emerging Market Bond Funds
The 117 emerging market funds show a moderate pattern. Average active return of 1.04% drops to 0.54% alpha, about a 50% reduction. The credit correlation is lower at 0.26, but the beta capture pattern is still there.
Credit Hedge Funds: Even They Do It
Richardson then looks at 51 live credit long/short hedge funds from the HFR database. These are net-of-fee returns, so any alpha here is more impressive.
The average return was 8.66% with a Sharpe ratio of 1.09. But there’s survivorship bias since these are all live funds. The average correlation to the credit premium is 0.66 (median 0.79). The full-sample correlation between the average credit hedge fund return and US high yield excess returns is 0.83.
After removing beta exposure, the 8.66% drops to 3.85% alpha, a 55% reduction. And this is for the survivors. Richardson asks the obvious question: “Is that worth a 2/20 fee?”
To be fair, the remaining 3.85% alpha is still meaningful. But more than half of those impressive hedge fund returns are just passive credit beta, which has been great over the last decade.
The Big Picture
The pattern is consistent across every category of active fixed income management. Managers are systematically reaching for yield through credit exposure. Asset owners probably know this happens but might not realize how pervasive it is or how much it affects returns.
This sets up the rest of the book perfectly. The challenge for systematic fixed income investing is clear: can you generate excess returns that are actually diversifying? Returns that don’t just come from loading up on credit beta?
The next few chapters tackle security selection for government bonds, corporate bonds, and emerging market bonds. The goal is attractive returns with low correlation to traditional risk premiums. That would be genuinely valuable for investors.
Previous: Tactical Asset Allocation and Timing Bond Markets | Next: Security Selection for Government Bonds