While intended and unintended risk is a constant concern across asset classes, perhaps the hardest hit area is fixed income.
Fixed income is often “assumed” to be a safer asset class, but upon closer inspection, it becomes clear that the growing variety of investment options in the space do not always act like more “traditional” fixed-income asset classes. While the proliferation of new categories in recent years has created opportunities for participants to meet their goals in a low-yield world, this situation also requires deeper analysis to understand how new investment styles can prudently be made available within defined contribution (DC) plans.
In a research partnership with the Plan Sponsor Council of America (PSCA), Janus Henderson found that equity options outnumber fixed-income options in plans by approximately three to one. Furthermore, the average number of fixed-income options recommended to plan sponsors is three, total.
These findings prompted a deeper analysis of the risk and reward of fixed-income investments in plan lineups, a project that ultimately identified four areas that are the most crucial to consider to avoid the complications of intended and unintended risk.
In fixed income, overlap presents itself in two critical categories: core and core-plus. These categories form the basis for the traditional fixed-income exposures of a plan lineup; they are portfolio anchors that are intended to diversify and mitigate equity risk.
It makes sense, then, that many lineups have both a core and a core-plus option, but upon further investigation, there is a risk of redundancy by having both a core and a core-plus manager present. Despite the greater flexibility of the core-plus category relative to the core category, the risk and return statistics are extremely similar. Research shows that the Morningstar U.S. Fund Intermediate Core Bond and Intermediate Core-Plus Bond categories have a trailing 10-year monthly correlation of 0.96.
To address the overlap challenge, evaluating potentially duplicative exposures created by the inclusion of both a core bond and a core-plus bond fund in a plan lineup is a good starting point. Understanding a fund’s correlation to equities is also critical; it is important to consider funds with a reasonably low correlation to equities as acceptable and those with very high correlations to equities as unacceptable.
The heavy focus on government-related securities in core and core-plus means the trade-off between yield and duration is currently at its weakest. This potentially exposes plan participants to too much rate risk (duration) without proper compensation (yield), compared to historical norms.
While the categories face the challenge of decreasing value in the trade-off between duration and yield, the analysis shows it is still necessary to include one—but not necessarily both—in DC plan investment lineups. Furthermore, the evidence shows core-plus provides greater flexibility within a single line item. And, while their necessity cannot be denied, it must also be observed that core or core-plus may no longer be adequate as the sole fixed-income options in a plan. These should be complemented with strategies that may have greater yield or return potential.
Understanding Specific Risks
Categories such as multi-sector bond and world bond offer opportunities for diversification, but they come with their own challenges, including the potential for more volatility because of risk exposures not commonly found in core or core-plus categories. This can potentially expose participants to unnecessary risk despite the diversification benefits. Therefore, it’s important that DC-focused financial professionals have the necessary tools and resources to obtain a firm grasp on the specific risks these new categories may introduce.
Failure of Benchmark-Driven Risk Assessment Methods
The categories that contribute the most potential diversification for plan lineups were created to be intentionally different from the traditional categories, making them a challenge to judge using traditional benchmarks and their standard statistics of risk and return. This creates a conundrum for investment committees as they attempt to provide these diversifying options to plan participants.
While Modern Portfolio Theory statistics are generally helpful, it is important to note the shortcomings of benchmark-driven statistics in the evaluation of categories that were explicitly constructed to look very different from their benchmarks. To overcome this hurdle, one may isolate discrete time periods of particular risk/reward stress and compare and contrast manager success during those periods.
In sum, these insights can ignite new conversations that help plan sponsors and advisers construct the best lineup possible for participants. Lineups that harness all four elements presented here are likely to be well-positioned to meet participants’ ever-changing needs.
About the author:
Adam Hetts is the global head of portfolio construction and strategy at Janus Henderson Investors. In this role, he leads the portfolio construction and strategy team that is focused on delivering actionable investment strategy and thought leadership to help clients in all aspects of the investment management process.
The opinions and views expressed are those of the author(s) and are subject to change without notice. They do not necessarily reflect the views of Janus Henderson and no forecasts can be guaranteed. Opinions and examples are for illustrative and educational purposes only and should not be used or construed to be legal or fiduciary advice or a full representation of all responsibilities of any financial professional.
This feature is to provide general information only, does not constitute legal or tax advice and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.