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Aon Retirement and Investment Blog

Improving Fixed Income Portfolios Benchmarked Against the Barclays U.S. Aggregate

Aon Hewitt Investment Consulting (“AHIC”) recently completed its most comprehensive research in several years on fixed income portfolio construction, focusing on ways to improve portfolios typically benchmarked against the Barclays U.S. Aggregate Index (as opposed to those customized to hedge liabilities).  
 
We started this project by reviewing what academic and other finance researchers have published on this topic and trying to understand the various dynamics in the fixed income market. One of the recurring themes we saw throughout the research highlights that many submarkets highly segment the fixed income market because a significant proportion of participants buy and sell based on idiosyncratic factors (which differ from fundamental value) – regulatory requirements, liquidity needs, liability hedging, taxes, as well as monetary and fiscal goals. These investors tend to have highly customized mandates and only engage in certain segments of the fixed income market. Examples include: 

  • Insurance companies
  • Central banks
  • Private banks
  • Liability-driven investors (particularly pension funds in the private sector and insurance companies)
  • Stable value and money market funds
  • Investors with varying tax situations
  • Investors with significant liquidity needs
The collective actions of these various market participants may impact prices, even though their motivations are not exclusively based on total return. When one of these investor types is stressed and requires changes to the amounts or types of fixed income needed, it may put disproportionate pressure on the specific segments of the fixed income market in which they operate and create sustained deviations from fair values. As a result, passively investing in a broad market-weighted benchmark is rarely optimal. Investors can do better than simply act as passive price-takers of broad market-weighted fixed income benchmarks, which behave based on factors other than pricing fundamentals largely driven by the collective forces of investors with unique characteristics. This segmentation in fixed income is different from, or at least more extreme than, the equity markets. 
 
AHIC recommends that investors carefully consider how to best construct their fixed income portfolios through exploiting persistent market dislocations by customizing their target exposures to sectors, credit qualities, and durations, paying (or getting paid) for liquidity when it is most appropriate, and allowing skilled active managers to invest across a broad opportunity set where they see the greatest value. The solution investors implement should be based upon the level of portfolio sophistication that they are comfortable with while maintaining the portfolio’s target split between return-seeking and risk-reducing assets.
 
Our full research is in our white paper, Flexibility in a Rigid Market: How investors may be able to improve on market-cap weighted benchmarks in fixed income
 
 
Eric Friedman is an Associate Partner in Aon Hewitt’s Investment Policy Services group, based in Chicago.  
 
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