Investors tend to enjoy talking about stocks; they’re exciting, easy to buy and sell, and can produce high returns. But fixed income is just as important as your equity allocation, and sometimes even more so.
Bonds are often the quiet cornerstone of many portfolios. However, managing a bond portfolio can quickly become a lot more complex than simply looking at the quality of each bond. Discussions of bonds tend to revolve around terms like duration, maturity, credit risk, and yield. The result is that many investors avoid the issue entirely and turn to a “set-it-and-forget-it” formula for their bond allocations with a laddered or stagnant portfolio. Unfortunately, this approach can put you at a significant disadvantage as an investor.
The Cost of Inactivity
Stagnant portfolios don’t change over time to reflect changes in the world, and laddered portfolios can be a great example of this. A bond ladder is simply the purchase of several bonds with different maturity dates. Often, advisors who are not focused on fixed income will recommend a laddered portfolio, investing for one client at a time and managing several such portfolios at once. While the strategy is well-intended, the result is not only inefficient pricing but difficulty in keeping track of the big picture when it comes to each client’s bond strategy.
For example, while an actively managed portfolio can capture gains, make use of losses for tax purposes, and strategically reinvest in appropriate sectors, laddered portfolios miss out on these opportunities because they’re not being watched on an ongoing basis. This lack of attention means that over time, a laddered portfolio won’t evolve to reflect shifts in the market or your holdings. It’s very possible that if you set up your bond ladder years ago, it looks a lot different now in terms of its overall characteristics than it did when you started out!
Sticking to the Strategy
Active management, on the other hand, means that a specialized team is consistently evaluating the credit risk, sector diversification, maturity, and duration of your portfolio in light of changes in the overall investing environment. This means that your strategy will be the guiding principle of the portfolio, and that your holdings will change over time to reflect that strategy. Where a laddered portfolio will begin to lose its integrity as the yield curve shifts or as bonds mature, active management will keep your portfolio in line with your objectives over the long term and help you access to undervalued sectors and outperforming bonds.
Ensuring this consistency of strategy is part of a professional manager’s expertise and can help you avoid overvalued sectors or issuers with potential credit problems, as well as realizing tax losses when appropriate. An active manager will also seek to maximize the total return of your portfolio by generating income both through interest payments and through capital appreciation. These techniques can help smooth your portfolio’s returns over time and help you to outperform relative to stagnant portfolios.
The Cost Savings of Active Management
Another benefit to active management is the manager’s greater ability to aggregate trades and pass along institutional trading prices to individual investors. In other words, advisors buy retail, while bond managers buy wholesale. Institutional pricing can make a big difference to your bottom line as managers have the ability to buy in large blocks at more efficient prices. Institutional managers can also generally access a broader range of potential investments, helping you craft a more diversified portfolio.
Someone who recommends the laddered portfolio approach may try to build the case that professionally managed bond portfolios are at a disadvantage because they come with annual management fees. However, between cheaper institutional pricing, a total return approach to your investment, and an ongoing focus on credit quality, diversification, and due diligence, I would argue that the price is well worth it. Stronger and more consistent long run returns are, in my opinion, worth the investment in active management.
Individual Bonds vs. Mutual Funds
In an environment of rising interest rates, it is my opinion that individual bonds have important advantages over bond mutual funds. Investors of individual bonds can ensure that their holdings are analyzed carefully and have the option of holding their bonds to maturity or selling at an opportunistic time while bond funds have no concept of maturity as you don’t actually own the individual bonds. This added flexibility can help enhance long run returns.
Investors in bond mutual funds can also be adversely affected by the actions of other investors in the fund. During challenging times, price volatility can make investors nervous, resulting in increased withdrawals from the mutual fund. In the face of such pressure, funds may be forced to sell their highest quality bonds at lower prices in order to meet redemption requests. The result is a further reduction in the share price and an unfavorably restructured portfolio.
However, in general, mutual funds, despite their drawbacks, are still a good way to gain exposure to the fixed income market at a lower level of investment. Just remember to look closely at the investment strategy and how well the fund has been able to adhere to it while providing consistent returns over the long run. I recommend that you seek professional advice before choosing an investment, and keep in mind that these investments are not for everyone. A good advisor will help you to determine what is best for your particular situation.
Conclusions
In addition to an active manager adjusting your portfolio to reflect changes in the investment environment, maximizing total return, and getting better pricing and inventory, it will also give you the peace of mind that your portfolio is consistently reflecting the strategy that you expect it to.
Investing in bonds isn’t simple, and in my opinion active management is a great strategy to ensure that your portfolio is getting expert guidance. I say it all the time, but it really is true: knowledge is power. The more you’re empowered to make your bond allocation an active part of your portfolio, rather than a stagnant and overlooked one, the more secure you’ll feel as an investor.
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Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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