The Issue at Hand by Madison Investments
In fixed income, as in all investing, returns are generated by assuming some level of risk. Selecting a fund manager that outperforms similar managers or a benchmark index can feel satisfying, but how do you know if the level of risk that manager took on to achieve those returns was appropriate for your clients’ objectives?
In this episode, Chris and Mike discuss how advisors can evaluate fixed income managers beyond headline returns. They break down concepts like alpha, beta, tracking error, and information ratio that you can use today to make more informed client portfolio decisions, while offering a practical framework for understanding where a manager’s performance comes from, how much risk was taken to achieve it, and whether that approach fits the role fixed income is intended to play within your clients’ portfolios.
Key Takeaways
- Performance should be evaluated alongside the risks taken to generate it, not in isolation.
- Information ratio measures how efficiently a manager converts active risk management into alpha (or excess return).
- No single performance metric tells the whole story; understanding a manager’s investment process and sources of return is more important.
- Ask four key questions: Where did performance come from? What risks generated it? How consistently has the manager delivered results? And how has the strategy performed during periods of market volatility?
The Discussion
Chris Aleman: Welcome back to The Issue at Hand. I’m joined again by Mike Sanders. How are you doing, Mike?
Mike Sanders: Doing good.
Chris Aleman: So, before we get started today, I wanted to quickly recap the first two topics that we have covered at The Issue at Hand. And of course, I encourage you to go back and always listen to those episodes.
First, what we covered were the major risks of fixed income and how you and your clients should have those conversations, what you should be looking for.
In the second episode, we covered active versus passive – that great debate. How they differ in the types of risks, and what considerations you and your clients should work through when evaluating what is best for them. So now let’s transition to what we’re going to talk about today.
Today we’re going to cover how you evaluate that manager. What do you look at when you’re looking at an active manager? So what we’re going to do today is, and Mike’s going to help me cover this, we’re going to cover the risk and return metrics, and hopefully we’re going to come up with a step-by-step process for understanding why a bond manager performed the way that they did. So, Mike, I guess with that backdrop, how about you set up the first topic?
Mike Sanders: I think it just comes back to risk management. And I think to be a good investor, I think you have to be a good risk manager – they go hand in hand. And what we really want to discuss is how managing risk can translate into performance. And then how there’s specific statistics that one can look at that allow you to assess the risk management and the performance. And why just looking at performance alone maybe doesn’t tell the whole story when you’re evaluating what type of manager you want to use.
Chris Aleman: Well, I think you threw in the good one – when you’re not just looking at performance. I think what that means is, or at least how I’m interpreting it, is we should dig into the why. How did the manager generate this alpha? Are they using low-quality credit? Are they using derivatives? What are some of the things that we should be looking for then?
Mike Sanders: There are a lot of different ways that a manager can generate performance, like you said, high-yield allocations, duration management, and derivatives. There are a lot of levers a manager can pull – those fixed income risks that we discussed. And again, each one of those securities or asset classes has its own risks in a way. And then generating that performance translates into all those statistics that we want to discuss. Volatility, alpha, tracking error, information ratio – all of that can be derived based on the risks these managers want to take. And I think the overarching decision from an investor’s perspective, is the risks that the manager is taking in your fixed income portfolio – how is that relating to risks you’re taking in other places in your asset allocation? I think it has to go hand in hand when you’re evaluating what kind of manager you want to use.
Chris Aleman: Alright, well then let’s dig in. A couple of things that you just mentioned in there, I think that we need to explain to people, and one of the ones that I want to focus on, is information ratio. I also want to talk about tracking error. And then I think we need to also touch on – in one of the past episodes we talked about the differences in the benchmarks between equity benchmarks and fixed income benchmarks, and I relate that to how people think about beta. So, let’s start there on beta. How should advisors be talking to their clients about beta when it comes to fixed income portfolios?
Mike Sanders: The easiest way to think about beta in the time and construct of a fixed income portfolio is to think about an entire corporate bond portfolio. In theory or in reality, a lower quality or high yield, when spreads are tightening or the market’s doing well, will move a lot better than what maybe an A-rated or AA-rated corporate bond would be. So in theory, they have more beta. It’s the same concept as a more volatile or maybe a little more volatile stock versus the rest of the market in broad terms. And so, when you think about taking on beta risk, a way to think about it in fixed income is allocation to lower quality credit versus the overall corporate bond market. Or you could relate that to mortgages or other securitized products as well. That’s the best way to think about it, at least from our perspective, beta.
Chris Aleman: It makes sense. I think again, when we’re talking about exposure to the market, we need to know: are we going on the lower credit quality side, or are we going on the higher credit? I don’t want to get in the weeds too much because the one I do want to focus on, what I think most active managers focus on, is information ratio. Can you touch on what that is and how clients should be looking at that?
Mike Sanders: I think from our perspective, I really do think that’s one of the more important ones to focus on. It really is a way to describe or view the amount of excess return a manager is achieving. Which again is the goal of active management – to outperform whatever benchmark you’re against. But also to measure that against how much risk you’ve taken to outperform that benchmark. So, you generate a hundred basis points a year in an excess return or alpha, but there’s obviously a risk associated with that excess return. And information ratio balances those two numbers out to give you a statistic that says, “well, for per unit of alpha, every basis point of alpha it costs you this much in risk”.
Chris Aleman: I think if I want to break it down – give me the formula. Essentially, it is, what is your active return over your active risk. How my return is to the benchmark versus what the risk is that I’m taking with regard to the benchmark. Is that fair?
Mike Sanders: Correct. If you put numbers into it, if it’s a hundred basis points of alpha, but you took fifty basis points of active risk, you’d have an information ratio of two. And that’s how I think about it.
Chris Aleman: Perfect. And when we’re looking at this as a skill or something that we should be looking at, this is just another tool that a client or a financial advisor should be utilizing to evaluate managers in their portfolios.
Mike Sanders: Correct, because again, generating excess return and alpha is doable when you take a lot of risk. But if you have to take a lot of risk to achieve performance, you might be taking risk that’s really correlated with other parts of your portfolio. And so that’s why I think it really does matter. Information ratio is one singular number, but you do have to go a little bit deeper in thinking about what the manager owns or how they manage those four risks in fixed income. It’s a combination of everything.
Again, just looking at alpha, you can get in trouble by doing that. If you just look at information ratio, you can get in trouble by looking at that. I think it’s really a combination of looking at everything and seeing how the process that a manager uses to generate performance relates to an overall asset allocation.
Chris Aleman: At the end of the day, it’s not going to be one thing that solves everything. You need to have a combination of things. Now I want to break it down to “how do I want to evaluate manager A versus manager B”. Let’s try and put terms on this. So, if manager A is generating high returns one year, negative returns the next year, but has an information ratio of about .1, versus a manager not as high up, not as low down, but has an information ratio of .5. How should I go about evaluating manager A versus manager B?
Mike Sanders: There’s no right or wrong answer for this. If an investor is comfortable with maybe more expected excess returns, but having more volatility, that’s fine. If they want more consistency, that’s another decision to make. Going back to it being a good or bad number, I mean you think about private credit and firms being able to mark to market their own portfolio, which dampens their volatility. So, you have better performance and an artificially high information ratio, if they quote that number, because they’re marking to mark, there’s less trading. That’s a way that you could have a really high information ratio and it’s not really a true representation of a manager’s skill or the amount of risk that they’re taking. So again, it’s how you value alpha in terms of your overall asset allocation, what you’re trying your goal is, and what you’re trying to achieve.
Chris Aleman: I think you just also made a great point. When we’re looking at information ratio, yes, you want to go with the higher information ratio, but you also need to understand how was that information ratio achieved? I think that’s a nice point to put. I want to use some real-world examples. So, if I am still in this phrase of manager A versus manager B, how would they do in 2008? How would they do 2020 when rates started to come up? How should we evaluate those two managers during those periods?
Mike Sanders: If you were truly trying to assess the two different managers, looking at periods of volatility and seeing the manager’s up/down capture ratio would be a great way to do that. Performance in good markets, performance in bad markets. Those are other levers that you can pull in terms of assessing a manager’s performance. Most likely, a lower information ratio, when volatility hits, the standard deviation of their alpha probably widens significantly. It could be down a lot versus a benchmark, versus the higher information ratio, most likely, not all the time. But it probably would have a much tighter performance pattern versus the benchmark.
So I think that’s, again, it’s a broad statement. But in general, these are maybe the ways to think about that. But again, other ways to look at manager performance. And I think really the key is to make sure you understand how they’re generating that performance, and are you comfortable with the generating of the performance, and then how that relates to the actual performance statistics and all the different ways that you measure it.
Chris Aleman: Well, that’s a good point. I think let’s just put a ribbon on that. I think what you’re saying is that some of the questions that we should be asking are: where did the performance come from? What risk generated that performance? Is there consistency to that performance – are we looking at long periods of time? Is it short term? How does that manager perform in difficult markets? And then I guess does the manager’s views align with what’s going on with my client’s risk tolerance?
I think those are some of the things that when I’m listening to you talk, I think that’s the framework that people should walk away from. What do you think?
Mike Sanders: Yeah, a hundred percent.
Chris Aleman: I think that’s a great place to end. So, for more information and disclosures, please visit MadisonInvestments.com. If you haven’t already, please subscribe to The Issue at Hand. You can find us on YouTube, Spotify, and Apple Podcasts. Thank you for tuning in. Take care.