Fixed income - frequently asked questions
Why do some fixed income index funds have annual portfolio turnover of 100% - 200% in some years? This appears inconsistent with a passive strategy.
Our fixed income approach is “passive” in one sense – it involves no interest rate or economic forecasting – but is “active” in implementation. Research conducted by Eugene Fama at the University of Chicago, Booth School of Business, suggests a shifting-maturity strategy that targets segments of the yield curve with the highest expected return can add value relative to a conventional indexed approach. The optimal maturity targets are constantly reviewed using information provided in the yield curve, and transactions are made if the increase in expected return exceeds the cost of making the trade. Annual portfolio turnover in excess of 100% is not unusual. An important element of the shifting maturity strategy is a focus exclusively on short-term instruments with the highest credit quality. These issues are very liquid, and can be traded at very low cost.
Why does Dimensional offer a global fixed income strategy but no international-only fixed income strategy? Shouldn’t the allocation decision between domestic and international fixed income be made by the advisor?
Dimensional’s global fixed income strategy reflects our view that the sole purpose of fixed income in a balanced account is to dampen the volatility of equities. Returns for a Canadian investor in non-dollar denominated securities are determined by a combination of changes in foreign currency exchange rates and the return on the underlying fixed income securities. The return component attributable to fluctuating exchange rates frequently exceeds that of the fixed income securities by a wide margin. The additional volatility attributable to the currency fluctuations defeats the purpose of holding fixed income securities.
If one could predict future changes in foreign exchange rates, it would be possible to engage in selective hedging activity in an effort to improve the reward-to-volatility characteristics. There is little evidence, however, that active managers are able to extract excess returns from foreign exchange trading with any consistency.
As a result, Dimensional employs foreign currency forward contracts to hedge exchange rate risk at all times. High-grade securities from eight major international bond markets (Australia, Canada, Denmark, Euro, Japan, Sweden, U.K. and U.S.) are placed in competition with each other. Non-dollar denominated assets are purchased only when their expected returns (net of all hedging costs) exceed those of comparable U.S.or Canadian instruments. No more than 30% of portfolio assets can be invested in any single country outside the U.S. It is not unusual for the portfolio to own issues from major multinationals such as G.E., Freddie Mac, or Toyota Motor Credit in several different currencies.
By eliminating both the potential profit and loss from currency movements, the strategy eliminates the greatest source of risk in a global bond portfolio. The increased diversification provided by owning securities in multiple bond markets suggests it is appropriate to consider using Dimensional’s global strategy as a substitute, not just a companion, for a Canadian-only approach.
Why doesn’t Dimensional offer portfolios investing in mortgage-backed securities, convertible bonds, high yield debt or Income Trusts?
Dimensional believes that five factors explain the vast majority of returns in diversified portfolios (market, size, and value for equities; term risk and default risk for fixed income). They also appear to explain the behavior of hybrid asset classes such as high yield bonds or convertible securities or income trusts. In general, the behavior of these asset classes can be captured more reliably and at lower cost by using some combination of structured equity strategies combined with high-grade short-term fixed income securities.