Recent volatility in equity markets and the stellar performance of bonds in 2000 have reminded institutional investors of the importance of fixed-income components in their portfolios. But the same dynamics that helped fuel the tremendous growth in equity values before 2000—an increasingly global financial market and a generous credit cycle—also created subtle and not-so-subtle shifts in the ways fixed-income funds have been managed.

Over the last decade, bond fund managers have felt pressure to sustain the easy excess returns of the early 1990s, when falling interest rates raised bond prices dramatically. As interest rates settled into a narrower range, some bond managers methodically expanded their investments beyond the traditional investment-grade corporate and government debt offerings that are the staple of traditionally managed bond portfolios.

Although these "plus" investments are more sensitive to credit risk, they also offer far more opportunities for skilled managers to find potentially high-returning securities.

These "Core-Plus" portfolios still focus on a traditional core of high-quality fixed-income securities—treasuries, mortgage-and other asset-backed securities, representing 60–85 percent of total assets.

But the riskier investments in Core-Plus—high-yield bonds, emerging markets and convertible and non-dollar securities—are what separates these portfolios into "quasi-equity" sectors. Although these "plus" investments are more sensitive to credit risk, they also offer far more opportunities for skilled managers to find potentially high-returning securities.

"In theory, Core-Plus is a more efficient investment strategy," says Brian Hersey, a senior consultant with Watson Wyatt Investment Consulting. "The idea is that giving fund managers a broader mandate lets them generate excess returns, both by taking advantage of higher-return asset classes and by identifying a broader universe of securities that may be underpriced. Our research suggests that typically this has been the case over the last decade—but not always. What is less clear is whether the higher returns of Core-Plus strategies are different on a risk-adjusted basis from plain-vanilla Core mandates."

Hersey notes that Watson Wyatt's investigation of 72 Core-Plus managers over the past decade shows that their additional returns have been accompanied by higher risk and volatility—notably during the credit crisis of 1998. "This isn't necessarily a problem if investors know what they are getting into. Investors have to weigh a number of important issues when considering Core-Plus." For instance, "Do the expanded asset classes represented in Core-Plus mandates overlap with other parts of the portfolio and expose the investor to unwanted (and unrewarded) additional risk? Do the mandates meet the liquidity requirements usually associated with the fixed-income asset class? Is Core-Plus the appropriate area for part of an investor's risk budget? And finally, do the excess returns pay for the extra fees and governance costs that come with active management?

These caveats aside, Hersey believes that Core-Plus can be an important component in an investor's portfolio. The Core-Plus mandate allows fixed-income investments to serve both their traditional capital-preserving role and a more return-oriented, quasi-equity role in today's complex global financial markets. The critical test, which Hersey sees playing out over the next several years, is whether managers can realize the theoretical efficiency of the Core-Plus mandate. "If not," he says, "investors really shouldn't expose themselves to additional risk without being rewarded."