Predicting future interest rates is a favorite activity among economists and strategists, but Dimensional Fund Advisors takes a unique stance. “Forward rates are the best guide when positioning bond portfolios for higher expected returns,” they assert, dismissing the predictions of journalists and other ECB/Fed watchers.
Even the Federal Open Market Committee of the Federal Reserve, responsible for setting the American target interest rate, cannot predict market interest rates with certainty. Still, asset managers continue to offer their own estimates.
Douglas Longo, head of fixed income portfolio strategists and vice-president at Dimensional Fund Advisors, emphasizes that there’s “no reason” to believe they can predict better than the market itself. “We believe that all available information is already reflected in current prices, which can offer information to outpace market returns,” says Longo, speaking to Investment Officer from Dimensional’s headquarters in Austin.,” says Longo, speaking to Investment Officer from Dimensional’s headquarters in Austin.
Efficient market hypothesis
After four decades of offering only mutual funds, Dimensional, with 618 billion dollars under management, is now the world’s fastest-growing provider of active ETFs. Their strategy is a dogmatic application of the efficient market hypothesis by Nobel laureate Eugene Fama, a director at Dimensional and a member of the investment research committee.
“Unless you as an investor know something the market doesn’t, there’s absolutely no reason to think that the price reflects an incorrect prediction of future interest rates,” says Longo, pushing back against contrarian predictions frequently offered by traditional active managers.
Random good predictions
If markets operated differently, opportunities would constantly arise for investors to identify “price errors” and convert them into higher returns. However, more than fifty years of academic research shows that the vast majority of active managers consistently underperform.
“Looking at the average performance of all active managers combined, you see the market average, minus their fee. Those who manage to generate outperformance can never consistently maintain it,” says Longo. “Statistically, good predictions are random, and any outperformance is not due to the predictive ability of the asset manager.”
This doesn’t mean that outperformance of the fixed-income market is impossible. Dimensional uses the shape of the yield curve to calculate expected returns, varying the duration of a given portfolio to target areas of the curve with higher forward rates.
Sweet spot opportunities
In the current fixed-income markets, Longo sees the greatest opportunities for clients in Europe in American, Australian, European, and New Zealand government bonds. Within corporate bonds, products rated from A to BBB currently offer the highest expected returns.
“The sweet spot is currently between zero and three years of duration. The longer end of most curves is still very inverted,” explains Longo, who systematically utilizes the roll-down return, the increasing price as the bond “shortens.”
“In an inverted curve, as is currently the case for bonds with a duration of longer than three years, the yield on your bond will increase as time progresses, and the price will decrease.”