Superior returns do not happen by chance all the time, so it is relevant to identify active strategies to help achieve them. We focus on the three broad investment strategies used by most fixed income managers: duration management, sector rotation, and credit selection.
- Excess return potential from active duration management can be sizeable, between 2.47% and -1.51% annually over the past 10 years.
- A hypothetical strategy of sector rotation returned annualized 2.80% and -1.65%, respectively, over Treasuries during the past 10 years.
- Our hypothetical methodology of the best credit selections each month produced 0.65% higher annual returns than simply staying in A-rated corporate names. Conversely, bad bets on credit could have resulted in 0.64% annual return disadvantage over the safe AAA group over the past 10 years.
When presented with an investment with seemingly attractive return potential, it helps to ask how much duration, sector, or credit risk is involved.
Active duration strategies have the potential of producing the largest excess returns, although they may also have the highest volatility. Meanwhile, little return potential, both positive and negative, often comes from credit selection.
When it comes to investment strategies, cash assets often garner less attention than other asset classes. In the context of investing for safety, liquidity and yield objectives, the topic of active investment strategies is even less discussed and understood, by the treasury community. Nonetheless, when it’s time to evaluate manager performance, returns often show up at the top of the agenda. Superior returns do not happen by chance all the time, so it is relevant to identify active strategies to help achieve them.
In this paper, we will focus on the three broad investment strategies used by most fixed income managers in one form or another: duration management, sector rotation, and credit selection. As “there is no such thing as free lunch”, an investor’s ability to deliver peer-beating returns usually comes as the result of taking measured risk in one of the three areas. Although more exotic strategies exist, cash managers tend not to use them as often given the safety, liquidity and yield objectives of cash investing.
In presenting each of the three “pillars” of investment strategies, we will use historical return data in the last 10 years to illustrate the impact of different strategy choices. Specifically, we will focus on three scenarios: a) the most conservative approach as a base scenario, b) the best outcome where 100% of the portfolio is shifted into the most profitable investment at the beginning of each month, and c) the worst outcome where an investor makes the worst decision consistently each month. As a matter of methodology, we will deal with one type of risk and remove factors that may involve the other two types of risk to achieve apples-to-apples results.
The objective of this hypothetical exercise is to demonstrate the double-edged nature of investment strategies. One can expect returns to improve by increasing certain measured risks, however, investment strategies may result in undesirable to disastrous consequences if not executed well.
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