INVEST LIKE AN INSTITUTION by Michael C. Schlachter

Author:Michael C. Schlachter
Language: eng
Format: epub
Publisher: Apress, Berkeley, CA

Active versus Passive Management

In Chapter 3, I made a pretty strong case for why most pension plans invest a large fraction (sometimes even 100%) of their equity allocation in index funds and why individual investors should generally do the same. I will not repeat that advice here! Very simply put, in contrast to my thoughts about indexing stock investments, I am not a fan of indexing fixed income, and I know of very few pension plans that use index funds for bonds. Why? The answer is simple. Unlike in equities, where the sum of all market participants equals the stock market index, the sum of all fixed income funds does not equal the bond market index.

How is this possible? Unlike in equities, the fixed income industry has plenty of participants with different interests or guidelines than the average investor has, which thereby skews how funds are actually invested. Insurance companies, for example, largely invest in government and highly rated corporate bonds, typically disdaining mortgage bonds and anything rated below AA. Sovereign wealth funds, the national investment companies of countries with positive national trade flows, tend to buy mainly government bonds in the United States and maybe a few highly rated corporate bonds. Meanwhile, central banks looking to manipulate exchange rates or manage international cash flows exclusively buy government bonds.

Lower rated corporate bonds and mortgage bonds are therefore more the domain of pension plans, investment managers, and retail investors. As a result, the sum of all the bond holdings of retail and pension plan investments looks nothing like the market as a whole. With insurance companies and sovereign wealth funds buying a disproportionate share of the government issuance, the investment funds that you and pension plans invest in will be heavily skewed toward the riskier corporate and mortgage bonds in most environments.

The question for you, the investor, then, is whether you are okay with that bias. Are you investing in fixed income for the perfect long-term safety of government bonds, or are you simply looking for a way to reduce and balance your stock market risk? If you are looking for the latter, then considering funds who take advantage of the long-term systematic outperformance (with the occasional major hiccup) of corporate and mortgage bonds over government bond returns is completely appropriate. Do you want a core or total return product that employs all sectors but usually underweights governments, or do you want to go full out and invest in a corporate-only portfolio?

The decision really boils down to what you view as the role of fixed income in your portfolio, your time horizon, and how well you can absorb the periodic corporate bond return collapses. As the charts in Chapter 5 have shown, anyone with a 10- or 20-year time horizon, or longer, would have done much better in a risky asset-biased portfolio over time, assuming they could have stomached the periods when corporate bonds and other risky assets fell off the proverbial cliff. Figure 6-1 compares the entire universe of institutional,

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