Building better blends: Part 2 Balancing fixed income allocations

Containing investment costs is a top concern among many target date investors. To address this, some look to passive investment options as the solution for the fixed income building blocks in their target date portfolio. This may overlook some limitations of a purely passive approach.

Deciding where to go active in fixed income is crucial. Active approaches can help target date investors avoid—or more effectively manage—some of the common limitations of passive fixed income. Selecting the right combination of active and passive fixed income building blocks has the potential to contain cost, target opportunities with the best potential to generate positive returns, and improve diversification. Striking the right balance is key to helping investors along their journey to feeling retirement certain.

Careful targeting of passive fixed income

Passive fixed income can be a useful tool to gain exposure to discreet segments of the asset class and help to limit the costs associated with doing so. But the choice needs to be made carefully to ensure the cost containment doesn’t unintentionally limit growth opportunities or introduce undesired risk exposures.

Some passive fixed income approaches within target date strategies feature inherent limitations of the underlying index used to track the sector. Simply put, benchmarks or indices in some sectors may be hard to replicate and difficult to track. In such indices, bonds may have extremely small market capitalizations and/or are infrequently traded.

New issuance, maturating securities, credit downgrades, and redemptions can also continuously alter the makeup of a fixed income index. This increases potential tracking error for passive strategies seeking to replicate such indices.

Even accurate index tracking can produce unfavorable unexpected or undesired risk exposures if the benchmarks in question have potentially unattractive qualities. Examples include:

• High yield credit—index representation tends to skew toward the most highly leveraged issuers. This can expose investors to greater default risk or produce undesired sector concentrations.
• Emerging markets debt—some indexes only include sovereign issues, reducing the opportunity set for passive strategies that track those benchmarks.
• International developed market bonds—indexes tend to be heavily concentrated in issuers from a relatively limited number of countries, increasing idiosyncratic risk.

Selective passive exposure to limit costs is viable. But we believe the key is for target date strategies to allocate to core fixed income segments where benchmarks can be replicated relatively easily and tracking error is less of a risk.

Where to go active in fixed income

We believe the best options for actively managed building blocks are in market sectors that offer stronger opportunities to generate excess returns and improve diversification. This includes high yield and emerging market bonds.

Conversely, we think that the best options for passive building blocks within a target date glide path are for U.S. Treasury and U.S. investment‑grade allocations.

An additional advantage of using passive building blocks for the core fixed income allocations is that it can free up room within the tracking error budget for an overall target date portfolio. This means active approaches can be employed more intensely in the equity allocations while maintaining the same overall risk profile.

Conclusion

Our focus is on delivering investment outcomes that help investors on their path to feeling retirement certain. That means understanding the respective challenges and opportunities for passive and active allocations for fixed income within target date portfolios. The sheer size and complexity of the indexes in some key return‑seeking sectors, or unintended risk exposures for some benchmarks, mean that decisions need to be made carefully.

Our target date strategies seek to deliver the best of both worlds, combining active and passive building blocks in a cost‑effective way. A blended approach can add value by giving portfolio managers the tools to efficiently provide market exposure while targeting the potential benefits of active management to address different risk exposures, navigate varying market dynamics, and add value over the long term.