Latest / The Issue at Hand by Madison Investments / Benchmark Illusion: When Managers Deviate from the Index
Transcript
- speaker-0: If you go through life assuming the worst is gonna happen, you get s surprised on the upside. speaker-1: We're all gonna get depressed if we continue to listen to Hello and welcome back to another episode of The Issue at Hand. I'm Chris Aleman and I'm joined by head of fixed income Mike Sanders. Tough loss for both of our teams, I'd say, huh, Mike? speaker-0: Not a good week. Not a good week. speaker-1: You didn't lose with seven seconds left on the clock. speaker-0: No, the Packers are just bad the entire game. So speaker-1: Well, that's fair. That is fair. All right. Well, enough about our teams because I think we'll get a little too too off topic. So let's stay let's stick with fixed income. Now we've already talked about risk, credit, duration, liquidity structure, active versus passive. We've already covered a lot of that in our previous episodes. But I think I we need to take a step back and talk about where does an advisor start to have that conversation with their client about fixed income in general? Where do we start? speaker-0: Yeah. I mean, I think it really comes down to defining the objectives for your client and then trying to find a benchmark that kind of best reflects ⁓ those risks and the returning possibilities, right? I mean, if if if you if you have, you know, a certain client that wants, you know, was okay with more or less interest rate risk, you that's gonna push you into a specific index. And then, you know, the objective really is is that hopefully the manager or the strategy you select kind of follows that return pattern because that's you know you're choosing an index based upon, you know, your clients' risks and the returns that they would like to make sure that's kind of what's getting invested in. speaker-1: But wait a minute, I thought ⁓ you mentioned index and benchmarking. I think one of the things that you need to point out again was there is a difference between an equity index and a bench and a fixed income index. So what is that key difference? speaker-0: Yeah, yeah. I mean it's it's the biggest difference from how how we look at it it would be or how I look at it is really, you know, in in in equity land, right, the the companies that have better performance, their stock price goes up, and then that's gonna be over time become a bigger and bigger portion of the index. So for bonds and bond indices, it's kind of the opposite. Not the opposite, but it's it's more and more debt gets you a larger percentage on in the index, which may or may not be what you want. Right. Think about treasuries today or maybe mortgages back in the crisis or corporates, whatever the whatever the index is, the more you issue, the bigger representation you're going to have in the index. And again, that's not necessarily good or bad. It's just, you know, you you're going to choose a manager then to assess those risks. Again, ideally in a framework that's going to have performance patterns roughly in line with the index. Hopefully beat the index, but then not take so much risk you're swinging one way or the other. speaker-1: Well hang on, let's focus on the last point. Because what you're saying is not taking all that risk. So what are some of the things that we should factor in? I guess something that's maybe embedded in the index or maybe even like a false sense of security. I don't know. Where what are some of those things that we should be looking for? speaker-0: Yeah, so you know, you know, let's take the ag, which is probably the most well known index. It's, you know, six years, give or take. A lot of treasuries, corporates, and mortgage securities for the most part, right? I mean, you could have managers that have durations massively different than the benchmark, half half the duration of the benchmark or more of the duration of the benchmark, way more treasuries, way less corporates, whatever the combination is. ⁓ and Depending on the market, you're going to have vastly different performance versus the index. Now, again, I think ideally you kind of want to have the return stream somewhat similar to the benchmark you're choosing. Cause again, it's going back to your clients' risk ⁓ preferences, if you will. ⁓ and so you just gotta make sure the you know you're when you're looking at the levers that can get pulled, if you will, the sources of alpha. That it's not so dissimilar than the index. speaker-1: Well, I think some of the things that you point out doesn't seem like n to your point, it's not necessarily a bad thing. So is an index flawed or is it how we're thinking about it flawed? speaker-0: You know, I don't know if it's flawed is the right word to use. Right. I think it it's a it's a representation of the fixed income market, right? The ag is the the representation of investment grade US bonds, right? Whatever they are. ⁓ now it's it you you can have preferences within that universe of of possible ⁓ fixed income or possible bonds, but again, it's Yeah. If you want a representation of the entire fixed income market here in the United States, you should hopefully the you're you're investing in securities that are similar to that, that have kind of the same return pattern. If if you don't care, then choose a different index or a different manager. But but you really if you're choosing an index, you should have some similar performance patterns. Otherwise you're not you you have no idea what you're gonna get. speaker-1: Okay. Well, I want to touch on that one just a little bit because when I'm saying I think it the flawed that I I agree with you. I don't think it's flawed. And I go back to the financial crisis like ⁓ eight. The index was overweight the financial sector, which was completely distressed at the time, right? Which was getting exposed. Is like what are we looking at today, whether it's AI issuance, hypershalers, industrials, or anything like that. What is the current makeup today, I guess, so people understand that again, it's not flawed. It's just what the reality of the issuers are today, right? Yeah. speaker-0: Yeah, a hundred percent. Right. You have a lot of treasury issuance, right? We have massive, you know, amount of government spending. You have the hyperscalers that are issuing a lot of different debt. And again, there's no there's no bad bonds, just bad bond prices. And so, you know, you you could you can still hire a manager that can assess those risks, but still provide you some performance that should be similar to the benchmark and outperform the benchmark without investing in stuff that's not a anywhere in the benchmark. It's not really a fair comparison. To own a bunch of bank loans and you compare yourself to the ag. That's not really the advisor's not looking and trying to compare an ag performance versus a bank loan portfolio. It's not really what you should you be looking at. You know, buy just then buy a bank loan manager and know that that's what they're investing in. Hopefully they're not saying, well, you know, it's in it's they're they're exposed to the ag and therefore I should have performance similar. You're not going to get the same. So just making sure. You understand your risks and the possible outcomes for performance. I think that's the biggest key. speaker-1: Well, one of the things I think that you just said it understanding the risk is I get questioned a lot is what happens when an issue gets downgraded? Is the price movement, is a risk, et cetera? Like what exactly happens either with the issuer's debt when it's issuer's debt is downgraded, what happens to the makeup of the index, that sort of thing. speaker-0: Yeah, so it gets booted on the index, right? And so that creates opportunities possibly to own it, you know, after it gets downgraded, maybe it's still attractive relative to other securities and you can still own that and then still benefit from performance. Ideally, indexing in fixed incomes a tough a tough road to do that because you have some of those rules that, you know, are you're having bonds in and out that necessarily reflect value on when they come in and out. But I think that's the part where again, you can still have a broad exposure to securities that kind of make up the ag, but still have the opportunity to make these small investment decisions at the at the at the edges to generate the performance while still having kind of the integrity of the portfolio act like how it should. speaker-1: Well, I I think that makes sense. And I think you've d I think we've beat the makeup of the index. I guess ⁓ as far as we could go. So I guess let's start with index sele selection when it comes to managers. Why does it matter so much that managers in the asset class have different benchmarks? I guess why does it matter when evaluating them if they one manager says I want this index, the other one wants a different index? Why does it matter? speaker-0: I think it matters so you can properly judge how well the manager does, right? You can game an index and prov have a completely different asset class and it'll do well sometimes and it'll do poorly other times. And so if if you're gonna properly assess whether a somebody's good at investing in fixed income, I think you have to have the the compare it to what it really is investing in. And so that's the biggest, that's the biggest key, right? At certain points in time a specific asset class will do really well or really poorly. And there's nothing this great for that to happen. Yeah. But if you're not comparing that manager to the correct index, you're gonna get signals that aren't going to really match with maybe what you want that portfolio to do. And, you know, a lot of those misrepresentations, if you will, shows up when you don't want it to. It shows up when volatility really hits. It shows up, you know. COVID happens and spreads massively widen out and your bonds are negative performance at the same time your equities are down. I mean, that that's not really why you you own fixed income. You wanted bonds to help when rates fell and there was uncertainty. Instead, you have managers that owned everything but what's in the ag, if you will. And that's, you know, you have this massive swing in performance. So You know, it it it's just so you understand what you're investing in and you understand kind of the possible outcomes that you can get. And again, there's no issue with not owning what's in the index and owning other securities. But then I think as the advisor, you have to understand why that's the case. Is it consistently the case? And if so, then maybe it needs to be a different portion of your client's portfolio. It's not really a good representation of the broad fixed income market. It's a representation of a of a smaller part of it, which doesn't mean it's good or bad. It's just you're not gonna get what you think you're gonna get. I think that's really the biggest speaker-1: I think one of the things, sorry to interrupt you for a second, is when I get questions sometimes when I look at manager performance, a lot of the times it's how liquid am I? Do they have leverage? Cause when they actually look at the holdings, sometimes it's not exactly what they were supposed to own. So I always think that's always that's always an interesting thing to to to look at. So let's stick with the financial advisor theme. So if I'm an advisor sitting across from a client or pros or prospect s looking at their bond allocation, I I think we've covered some of them, but Can you lay out what are the questions that they should be asking? Maybe four or five points. speaker-0: Yeah, I mean, first of all, what's what's the benchmark? You know, what does it own? You know, the the flaws, if you will, of the of the index, you know, does it own too much of certain securities that were just not necessarily a positive more debt? You know, how does the portfolio itself differ from the benchmark? You know, if you have a like kind of going back to the ag, you have an ag strategy and the portfolio doesn't own any treasuries at all, then that's should be a red flag in reality because it's not really gonna be anywhere close to the performance. of the egg. And then, you know, kind of from that, you know, where is the manager taking its active risk? Right? Credit, duration, liquidity, etc., structure. And then, you know, how is that historically kind of played out in terms of performance? And so what's the downside if it doesn't work out? Because again, that's I think the best investors are risk managers first. And I think that's again how you should be looking at it. Cause bonds, you know, you get A hundred cents, if you will, back and you get a lot less if it doesn't work out. So you have to always look on the downside. speaker-1: Well, one of the ones you just mentioned, the Barclays ad, I always to when I talk to FAs, I've dealt with this before and they see the Barclays ad and they assume that the manager is similar to that, that they're gonna be investing very similar, exactly what you're laying out. So you're saying don't just stop there when you see it. You need to do a little bit more, right? speaker-0: Hundred percent. Yeah. You you you really need to understand where the money's getting invested and don't assume that because a benchmark is on the prospectus or whatever they're stating, that that's what kind of what you're more or less are investing in. There's, you know, a lot of ⁓ a lot of different securities out there and they don't have to necessarily own the benchmark ish type bonds and that's what you have to be w afraid of when it does 'cause because again, it might not work out. speaker-1: Well I think those are good questions, Mike, but I guess how as an advisor, how do they actually understand what any of that means? How do they go about looking at some of these things? speaker-0: Yeah, I mean, I think in fixed income, I think a great place to look could be just in credit, in your credit exposure. And you know, like I had mentioned, the ag is investment grade fixed income in the United States. Well, if you look at, you know, a a lot of managers out there, a lot of ⁓ other strategies that supposedly follow the ag, you know, have ten, twenty, thirty percent high yield in it. And there's nothing wrong with that. But Is that really what you're getting when you are outperforming in against the ag? You're just getting high yield exposure, and that's going to be correlated to the equity market. And so it's those are the kind of clues I think when you're looking at managers' allocation and then performance patterns that should be, and I and not even say it has to be a red flag. It just has to be something that you're aware of that, you know. The last thing you want is to buy an an ag manager that has twenty five percent high yield, and then all of a sudden you want to allocate more to a specific high yield manager. And next thing you know, your supposedly safe fixed income portfolio is a bunch of high yield bonds. Nothing wrong with that. Just make sure you know what that's the that that's the case. speaker-1: Yeah, even if they use that index, you gotta make sure, read the fine pred, see if they actually say it. Cause that might be what they're doing, but you need to actually be able to see those things. All right. Well then I guess let's end let's wrap it up there. ⁓ I want to thank everyone for joining us today. Mike, thanks for your insight. And one of the things I always tell people, please don't forget to click subscribe. If you want to hear more information about the issue at hand, insights, additional disclosures, or even some of the questions and characteristics you should be looking for out of your manager, please visit. Madisoninvestments.com. Thanks again. Take care.