Tied to the agg?

December 4, 2018

Uncaging fixed income opportunities

Market cap-weighted benchmarks rose to prominence in the decades following the 1950s, when the concept of market ‘beta’ (representing the ‘fully diversified market portfolio’) was developed as part of modern portfolio theory [1]. Benchmarks are now the common proxy for beta. Originally, these benchmarks were used as a guide to help measure a manager’s performance. However, over time, market participants became fixated with analyzing every difference between a portfolio and its benchmark, potentially tying investors closer to them and away from their core objectives.

With the rise of benchmark-aware investing, either explicitly (through passive mandates) or implicitly (via ‘closet’ indexing active portfolios) much of the industry has appeared to lose sight of this income-oriented objective, focusing instead on price moves in a market where the instruments redeem at par.

In our view in the credit markets, this obsession with benchmarks raises four key problems: indices are structurally-biased towards the most indebted issuers, market weights can lead to concentration risks, passive funds are prone to forced selling and ‘closet’ indexing can tie active funds to flawed benchmarks.

In our view, being more benchmark-agnostic, through looking for the most compelling credit opportunities, maximizes the potential to capture beta and alpha more efficiently. In turn, we believe flexible strategies can help investors exploit the artificial barriers created by benchmarks.

Gautam Khanna and James DiChiaro, senior portfolio managers. Insight Investment – a BNY Mellon Company

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[1] Source: Portfolio Selection, Harry Markowitz, The Journal of Finance, 1952. 3 Bloomberg, Bank of America Merrill Lynch, Insight, as at June 2018

All investments involve risk, including the possible loss of principal. Asset allocation and diversification cannot assure a profit or protect against loss.

Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Municipal income may be subject to state and local taxes. Some income may be subject to the federal alternative minimum tax for certain investors. Capital gains, if any, are taxable. High yield bonds involve increased credit and liquidity risk than higher rated bonds and are considered speculative in terms of the issuer's ability to pay interest and repay principal on a timely basis.

Investing in foreign denominated and/or domiciled securities involves special risks, including changes in currency exchange rates, political, economic, and social instability, limited company information, differing auditing and legal standards, and less market liquidity. These risks generally are greater with emerging market countries.

Investors cannot invest directly in an index. Indices are unmanaged and have no fees.

Investment advisory services in North America are provided through two different investment advisers registered with the Securities and Exchange Commission (SEC), using the brand Insight Investment: Insight North America LLC (INA) and Insight Investment International Limited (IIIL). The North American investment advisers are associated with other global investment managers that also (individually and collectively) use the corporate brand Insight Investment and may be referred to as "Insight" or "Insight Investment."

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark.

Modern Portfolio Theory is an investment theory based on the idea that risk-adverse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

Views expressed are those of the authors stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This material has been distributed for informational purposes only and should not be considered advice for investments or a recommendation of any particular investment, strategy, investment manager or account arrangement. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. No part of this material may be produced in any form, or referred to in any other publication, without express written permission. The Dreyfus Corporation, Insight and MBSC Securities Corporation are companies of The Bank of New York Mellon Corporation.

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MARK-42930-2018-11-26