t’s an ongoing debate: Are investors better off using passive or active strategies? On one hand, proponents of active management have argued talented managers can outperform their benchmarks over full market cycles while positioning portfolios to avoid large risks that passive managers cannot. On the other, passive management advocates often point to limited tracking error, greater tax efficiency and lower costs.
Since the recent financial crisis, opportunities for active management have become even more robust. Pervasive rating agency downgrades, accommodative monetary policies and re-regulation of the financial industry have led to even larger inconsistencies between asset prices and fundamental value. As a result, passive investors have been exposed to material downside risks and have been unable to capitalize on some of the most attractive risk-adjusted return opportunities across fixed income markets in recent years.
This has been especially true in the securitized mortgage market, including mortgage-backed securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae (agency MBS), non-agency MBS, and commercial mortgage-backed securities. In total, securitized assets represent approximately $9 trillion and make up nearly 33% of the Barclay’s U.S. Aggregate Index, which serves as the benchmark for over $1 trillion of public mutual fund assets.
Below, we highlight three recent examples of the value of active management in the securitized mortgage market, but PIMCO believes that dislocations in value stemming from unprecedented central bank actions, re-regulation of the financial sector and rating agency dysfunction will continue to present attractive opportunities for active managers for the foreseeable future.
Capitalizing on out-of-index opportunities for non-agency MBSNon-agency MBS currently represent a $943 billion market in the U.S. and have historically been excluded from traditional bond benchmarks. In addition, other forms of residential structured credit, including home equity ABS and manufactured housing ABS, were once parts of the Barclay’s U.S. Aggregate Index. Given widespread rating agency downgrades, home equity ABS and manufactured housing ABS were eliminated from the Barclay’s U.S. Aggregate Index in 2007 and 2009, respectively.
As losses mounted on residential mortgages during the financial crisis, rating agencies downgraded most of the outstanding universe of residential structured credit. At its peak, the non-Agency MBS sector totaled nearly $2.1 trillion. Beginning in 2007, rating agencies began to downgrade these securities as home prices began to decline and mortgage credit performance showed signs of deterioration. Securities would fall out of investment grade even if they took a principal loss of just $0.01. Ultimately, nearly 91% of originally AAA-rated non-agency MBS were downgraded to below investment grade, decimating the demand base for these securities and pushing prices down by as much as 70% (see Figure 1).
As a result, massive forced selling of the sector by ratings-constrained and levered investors brought prices to levels that were far below fundamental value. In PIMCO’s view, our expected return of principal relative to the price for these securities was far more important than the credit rating that any rating agency assigned.
Ultimately, active management and the ability to operate outside of the confines of traditional bond benchmarks and ratings constraints allowed PIMCO to increase exposure to non-agency MBS at historically cheap levels.
Not only were investors in passive investment strategies unable to capitalize on the outsize returns available in the non-agency MBS market over the past several years, but many index-tracking investment strategies exposed investors to unnecessary risks prior to the financial crisis. For example, passive strategies constructed to track the performance of the Barclay’s U.S. Aggregate Index were forced to hold exposure to both subprime home equity ABS and manufactured housing ABS, which together made up nearly 0.5% of the index at their peak. The sectors were finally removed from the index just as prices had dropped precipitously. As a result, many passive investors were forced to sell holdings at the least opportune times, resulting in large realized losses just before the securitized sector rebounded from record-high yields (see Figure 2).
Actively overweighting and underweighting agency MBS within their benchmarks
Agency MBS represent a $5.4 trillion market and one of the most widely traded bond markets in the world. In addition, they represent approximately 29.7% of the Barclay’s U.S. Aggregate Index. Fannie Mae and Freddie Mac MBS represent nearly 22.3% of the index, while Ginnie Mae MBS accounts for 7.4%.
During the depths of the financial crisis, when yields on agency MBS reached record highs relative to U.S. treasuries, PIMCO maintained a firm belief that the U.S. government would continue to honor the outstanding obligations of Fannie Mae and Freddie Mac and that spreads had widened without a material change in the fundamentals of these securities. As a result, active management allowed PIMCO to establish a material overweight in the agency MBS sector, which proved to be extremely beneficial to investors as the Federal Reserve announced its Agency MBS Purchase Program in November 2008 and MBS spreads tightened by approximately 120 basis points.
The Fed once again reaffirmed its willingness to target the agency MBS market in response to economic weakness in September 2011, when it announced it would be reinvesting paydowns on its agency debt and MBS portfolios back into agency MBS. As economic conditions remained fragile during the early months of 2012, PIMCO began to believe that it was highly likely the Fed would once again turn to the agency MBS market as a means of injecting liquidity into the financial system by suppressing mortgage rates and forcing investors into riskier assets.
While a passive investor would have been unable to express this view by overweighting the agency MBS sector, PIMCO was not only able to overweight the sector as a whole, but was able to employ active management to target securities we believed most likely to benefit from the Fed’s purchases of production agency MBS coupons. As a result of active management, PIMCO sought to provide investors with exposure to securities with the greatest risk/reward profile in the event of additional Fed purchases of agency MBS.
Not only would a passive investor not have been able to actively position a portfolio in anticipation of the Fed’s activity, but index-tracking investors also were forced to hold exposure to agency MBS coupons that did not benefit from Fed involvement and actually exhibited flat to slightly negative price performance in 2012.
Gaining access to the most efficient means of exposure to CMBS, whether in cash or synthetic form
The CMBS market currently stands at $694 billion and constitutes approximately 1.8% of the Barclays U.S. Aggregate Index. CMBS have exhibited robust spread tightening across the capital structure over the past two years, as investor demand for yield and limited new issuance have resulted in extremely high demand for a limited supply. However, synthetic indexes that track CMBS, called CMBX, have lagged the rally in cash bonds, as many investors are unable to use derivatives for regulatory reasons, while others receive more favorable accounting treatment for cash bonds. In addition, a combination of natural hedgers (dealers and origination pipelines) and speculators (macro hedge funds, dealers) often results in material distortions in value between cash bonds and synthetic exposure for the exact same credit risks.
While the theoretical (and historical) relationship is for synthetic CMBS to offer lower compensation than cash CMBS because of the advantage that CMBX has over cash in implied funding costs, the recent cheapening in CMBX relative to CMBS has created attractive relative value opportunities for the active investor (see Figure 4).
An active manager had the flexibility to maintain exposure to the CMBS sector, greatly improving the risk/reward profile of its positions through rotation out of CMBS cash bonds in favor of synthetic CMBX exposure. Active management allows investors to gain access to the most efficient means of exposure to certain sectors represented by a benchmark, whether in cash or synthetic form.
Over the past year, PIMCO has opportunistically added CMBX exposure across a variety of strategies versus sales of equivalent cash securities that have rallied to levels that no longer justify the downside risks. In addition to cash versus synthetic exposure, active managers can also employ detailed security selection across the CMBS sector to identify opportunities that are not included in traditional bond benchmarks. For example, interest-only and floating-rate CMBS have historically not been included in the Barclay’s U.S. Aggregate Index.
The importance of active management in today’s mortgage market
PIMCO believes that active management can help investors navigate the dislocations in value across the securitized mortgage market, particularly in an investment landscape which continues to be heavily influenced by ongoing policy initiatives, rating agency dysfunction and structural changes to the mortgage finance system. As valuations and fundamentals change, active managers can adjust their portfolios accordingly.