CONTRIBUTORS
Josh Lohmeier, CFA
Portfolio Manager, Investment Grade
Franklin Templeton Fixed Income
United States
Introduction
In the investment world, everyone is fallible, including professionals. Investment managers are vulnerable to behavioral biases that can oversimplify complex decisions and lead to suboptimal outcomes. In the investment grade credit space, active managers exhibit a range of emotional and cognitive biases, as evidenced by their trades, portfolio positioning and strategy performance.
To better understand the behavioral biases present in the investment-grade market, we segmented the pertinent peer universe into five categories:
- Yield Hoarders
- Gloom Boomers
- Value Timers
- Macro Elephants
- Closet Indexers
In this paper, we explore the shared attributes of each group as well as the anticipated outcomes in different market environments. We also highlight a sixth approach (Structural Advantage), which avoids the five common biases and seeks to exploit inefficiencies in the benchmark.
Key points:
- We found that investment grade credit managers generally fall into one of five categories, each with its own behavioral bias that may unintentionally influence portfolio construction.
- Understanding how these biases may influence or impact performance in different market environments can help investors think about their holistic asset allocation.
- We argue that a sixth approach—one which avoids these common biases and looks to exploit inefficiencies in fixed income markets to create a structural advantage—may result in more consistent return outcomes across different market environments.
Our conclusion
Our analysis of active investment-grade credit managers reveals many investment managers employ certain styles that result in common, well-studied behavioral biases. That said, institutional investors shouldn’t view a strategy that lands in one of the categories outlined above as inherently bad. For example, Yield Hoarders have historically been able to generate outperformance relative to the benchmark during periods of falling rates and risk-on sentiment. However, it is crucial for institutional investors to understand how different credit strategies tend to perform in different market environments: An unduly large amount of exposure to strategies falling victim to the same biases can compound underperformance in adverse environments.
In our view, investors stand to benefit from strategies designed to identify and, to the greatest possible extent, mitigate the structural and emotional biases that constrain credit managers. We believe investors can achieve their desired outcomes of outpacing the relevant benchmark while reducing unwanted volatility by taking a different approach to generating alpha, building portfolios designed to provide resilience during down markets and utilizing quantitative tools to provide visibility to different types of risk.