Portfolio perspectives

Building fixed income portfolios for today’s market

As we enter a new phase in Fed policy, many of our engagements continue to focus on fixed income portfolio positioning. In our last Portfolio perspectives, we discussed duration positioning, but credit exposure is another lever that we feel warrants careful consideration. While we see the benefits to capturing the credit risk premium, advisors’ general preference for active management, specifically in categories with broad and/or flexible mandates, has led to more portfolio complexity. This has resulted in portfolios with higher expense ratios, greater overlap, and higher levels of credit risk—making it harder for advisors to attribute risk/returns.

Given this dynamic and the dramatic repricing we’ve witnessed, now, may be an opportune time to reassess if you need the same level of credit risk and complexity with your client portfolios. In short, we believe you no longer need to stretch for yield; you are in a better position to simplify your fixed income portfolios and improve their diversification to equities.

One way you can simplify is by evaluating how your selected funds fit together. Are they complementary to each-other, or are they creating complexity and overlap? Our trends analysis found that many fixed income portfolios had significant overlapping exposures. In roughly 25% of these portfolios, clients used multiple core and core-plus holdings as their centerpiece. In many instances, these pairings did not provide meaningful diversification. Further, we found these portfolios also had overlap with their satellite allocations. For example, nearly 75% of an advisors’ exposure to high yield comes from outside their dedicated high-yield funds, such as core-plus, multisector, and emerging market bond (source: Vanguard advisor trends, as of June 30, 2024). This can make controlling for credit and duration exposures more challenging and potentially dilutes the impact of a favored manager.

To gain better control, reduce overlap, and improve diversification to equities, consider a low-cost, true-to-label (that is, less manager drift) core fund or ETF as the foundation of your fixed income allocation (see Figure 1). This can create a more scalable and efficient base to layer in your favorite credit- or duration-tilted funds for specific client or model needs. This approach also frees up a meaningful portion of your fee budget to redeploy to highly active satellite funds, such as multisector, high-yield, or emerging market bonds.

How to decide between core and core-plus?

While both core and core-plus are great centerpieces of a fixed income portfolio and play similar roles as a stabilizer, a core-plus strategy gives the active manager greater flexibility, limiting the need to allocate as much to satellite positions. That can make them a great all-in solution. As shown in Figure 2 below, core-plus strategies can typically invest up to a third of the fund in high-yield bonds and up to a fifth in emerging markets. On the flip side, a core bond can be a better stackable solution, limiting overlap with more credit-sensitive satellite positions, and allow for better control.

Next steps to consider:  Look into building out the core section of your fixed income portfolio

In a recent paper, Considerations for active fund investing, we found that there is a negative relationship between expense ratios and excess returns, highlighting the benefits of low-cost active strategies. If you would like to better understand the risk and areas of overlap in your portfolio, please consider partnering with our Portfolio Solutions team. In the meantime, here are some products to consider:

• Active core: Core Bond Fund (VCOBX), Core Bond ETF (VCRB), Core-Plus Bond Fund (VCPAX)*, Core-Plus Bond ETF (VPLS).
• Index core: Total Bond Market ETF (BND), Intermediate-Term Bond ETF (BIV).
• Active satellite: Multi-Sector Income Bond Fund (VMSAX)*, High-Yield Corporate Fund (VWEAX), Global Credit Bond Fund (VGCAX), Emerging Markets Bond Fund (VEGBX).

* Will achieve a 3-year track record on October 12, 2024, for VMSAX and October 25, 2024, for VCPAX.

Considerations when tilting portfolios toward factors

When financial advisors send their portfolio to the Portfolio Analytics & Consulting team, our consultation often covers style factor tilts in the equity allocation of the portfolio. Though not all, most advisors tend to have a preference toward a factor, such as value versus growth, small-cap versus large-cap, or higher quality versus lower quality.

Our team dives into the nuances of style tilts through a factor score and a traditional 9-box analysis, both which look to measure style factor exposures in different ways. Vanguard’s views on style factors acknowledges that investor behavior and biases about risk taking have historically delivered return premiums attributable to various factors; however, not all investors agree on the reasons for factor premia or whether they will continue to exist into the future.  There are also portfolio construction observations our team can share should they choose to lean into their preferred style factors.

Vanguard’s model portfolio franchise starts with market-cap-weighted models that already provide the investor exposure to all factors. The next step is to determine what factors investors want to systematically tilt toward. Of course, predicting factor performance is difficult, and Vanguard has found no clear economic or market signal that would indicate a factor return premia is imminent.

Figure 3 illustrates the inconsistency of factor active performance versus market-cap weighting, highlighting the variability investors experience each calendar year.

However, our capital market projections consider valuations, earnings growth, and other variables that indicate factors like value and small-cap have a higher probability of outperforming their opposite factors over the next decade. Ultimately investors need to determine if they also have conviction that factors are over-/undervalued and want to tilt portfolios accordingly, as the greater the tilt away from market-cap, the greater the potential active return that needs to be explained to clients. 

Indeed, advisors who have tilted their model toward value have experienced very long periods where growth has led the market year over year. As our team helps advisors measure the magnitude of their tilts, we assist in either increasing or decreasing those factor exposures based on a mosaic of impacts to the rest of the portfolio, such as historical risk and return, forecasted risk and return, or sector tilts.  Based on the judgment of the advisor, factor tilts that are sized too small might need to be dialed up, while in other cases, significant factor tilts may have led to uncomfortable performance deviations from the market and may need to be dialed down. Factor tilts can be implemented in a myriad of ways via market-cap-weighted indexes, active products, or a combination of the two.

Beyond factor sizing, another common portfolio construction mistake we see includes products canceling out intended factor tilts. For example, advisors who use products that tilt toward higher quality companies (such as firms that have a combination of stable earnings, low accruals, low debt ratios, zero or low recent equity issuance, high ROE, and positive gross profitability) may find that overweights to international equities or small-cap value stocks contribute lower quality metrics than the U.S. market. The net effect is that this cancels out the intended quality factor tilt at the portfolio level. Also, complex portfolios with too many products create greater difficulty in managing factor tilts as every product has a different factor profile that may lessen or strengthen the factor impact from other products.

Lastly, the market and investment products have factor exposures that fluctuate over time.  We recommend checking your portfolio factor loadings once or twice a year to gauge how they have changed, and whether any adjustments need to be made.

Next steps to consider: Assess your factor exposure

Factors are just one way of expressing active tilts, and our team has the tools and the products to make sure you are expressing factors as you desire. For more information on how you can get a factor diagnosis on your portfolio, contact your Vanguard representative.