Let's examine some of the typical mistakes we make in our fixed-income portfolios, and then we'll turn to best practices in this sector.
Given the extraordinary efficiency of the bond markets, especially on the taxable side, it's surprising to observe how many bond managers claim to have outperformed the indexes. Closer examination almost always discloses, however, that the managers have exposed their clients to significantly more risk than was embedded in the index, and it was the added risk that explains the outperformance, not the managers' skill. Adjusted for risk, these managers will usually be found to have underperformed.
Let's look at how a typical taxable bond manager “outperforms,” by observing the fictional firm of Wily Bond Management.
Wily manages taxable bond accounts for institutional investors and for families who have private foundations or large IRA accounts. Its typical benchmark is the Barclay's Aggregate bond index, a very broad long-intermediate index. Over the past 10 years, Wily has outperformed the Barclay's Agg, and this fact is naturally trumpeted in its marketing materials. Looking at this record, many investors have hired Wily, and Wily's business is growing and profitable.
But a closer look at Wily's performance discloses what is not disclosed by the firm's sales staff: Wily has subjected its client accounts to considerably more risk than is contained in the index, and it is that increased ...