Today, let’s explore a popular question: Is active bond management dying or are there factors that make it attractive?
At the core of the argument against active investing is the basic assumption that it’s a zero-sum game – for every winner, there must be a corresponding loser. However, we believe there are strong arguments in favor of active bond management and reasons why the simple zero-sum math may not work out so cleanly — especially since the bond markets could have some tricky years ahead with changes in the interest rate environment.
Many active shorter term, intermediate-term bond investment grade and national municipal funds have done well consistently compared to their passive benchmarks over the one, three and five year periods ending June 2014, according to S&P Dow Jones Indices (SPIVA Scorecard, June 30, 2014). Having shared those statistics, we have no desire to discredit passive investing – we believe indexes and ETFs have their place in the portfolio. Not all active managers beat their benchmarks, and not all have a coherent process for doing so.
In the spirit of caveat emptor, here are five considerations we believe are important when comparing active bond management to passive bond indexes.
1) The shortcomings of bond index construction
The most common bond index is the Barclays Capital Aggregate (AGG), while the S&P 500 is arguably the most influential stock index. Let’s take a look at how each is constructed.
The S&P 500 Index is weighted more heavily toward large, well-established, and financially-strong companies such as Apple. This construction enables investors to own a larger share of companies that are mature, while still offering a compelling growth or value proposition. By contrast, allocations in fixed-income indexes are based on issuance; the more debt an entity issues, the larger its allocation within the index. To put that in perspective, the largest issuers in the country are the U.S. Treasury and other government-sponsored entities, and thus make up the largest segment of the Barclay’s U.S. Aggregate Index.
In the index, the largest constituents are those issuers that keep increasing their debt. So if you invest in a bond index like AGG, you’re investing with frequent issuers of a lot of debt.
Active bond managers aren’t bound by those construction rules. Increased issuance perhaps should be met with reduced allocations, not increased allocations. Active managers can weigh that factor among others in making decisions about which bonds to buy. Passive index investors have no such opportunity.
2) Bond index sensitivity to interest rate movements
As it now stands, the Barclays Capital Aggregate Index holds a significant stake in bonds that may be highly sensitive to interest rate movements given their low coupon and longer maturity. An active manager can be more nimble to the evolving changes that might affect the bond market. Active bond managers attempt to outperform the bond market’s returns through analysis of bond prices in relation to creditworthiness and by anticipating changes in interest rates.
3) Is the Aggregate really an aggregate?
There is a broad range of fixed income opportunities that are not included in the Barclays index. Investing in indexes limits your exposure to different sectors, which could prevent passive investors from getting a fully diversified bond portfolio. While there are bond indexes available that mimic the missing parts of the bond market, investors would have to decide which sectors to pick and when, and ironically, that would require them to have an active, disciplined and bottom-up index and sector selection process to manage their passive bond portfolio adequately. Many investors choose passive investments not only for their lower fees, but because they want to “set it and forget it.” And even if they’re willing to make these decisions, how many investors have the expertise to do so?
4) Bond markets are inefficient
While the stock market claims market efficiency, the bond markets, especially the municipal bond market, is fragmented, localized, and could pose liquidity concerns. 2008 imparted many lessons, not the least of which is the need for investors to have a safe, liquid pool of assets they can access for rebalancing purposes. These same fragmentation and liquidity issues bedevil the corporate bond market as well, especially the junk (high yield) bond sector. In periods of volatility, some municipal ETFs could trade differently from the municipal bond index. We believe an active bond manager has the better opportunity to mitigate the disparity in the not-so-efficient bond markets and help protect investors’ liquidity.
5) Meet or beat the benchmark?
Typically, bond indexes are created with the objective of earning total return. Index investors earn index returns (net of fees), but that’s the best they can expect to do. Active managers seek to outperform the index; they aim to achieve above-market returns. Setting the bar to meet, rather than beat, the benchmark means accepting index returns rather than aiming higher. Of course, there’s no guarantee that active returns will be higher in future.
Consider too a recent Morningstar report in which Jeffery Ptak shared data suggesting that investors are willing to pay for active management, at least in taxable bonds. In the last five-year period ending in July 2014, passive index taxable bond funds raked in about $315 billion, a figure that pales in comparison to actively managed taxable bond funds, which took in $743 billion in net new monies, more than twice the net inflows to passive indexes. If there’s enduring wisdom in keeping costs as low as possible favoring passive bond management, then why didn’t that rationale hold true for taxable bonds?
A key question we ask is whether we have compelling reasons to believe that active managers will add value in excess of their fees. We understand that the key risk associated with active bond management is underperformance of the manager at a higher cost.
There’s still a lot of work to be done in the ongoing active versus passive debate, and it’s too early to conclude that a flight from active to passive makes sense for all areas of bond investing. We generally believe that active bond management remains a prudent strategy for fixed income investors, especially in the current environment, and that active management has the potential to achieve higher returns and greater diversification while providing the desired level of liquidity.