Active vs. Passive Management in Bond Funds

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Investors in bond mutual funds and exchange-traded funds (ETFs) have the choice between two types of portfolios: actively managed funds and passively managed funds.

What are Passively Managed Funds?

Passively managed funds – also called index funds – invest in a portfolio of bonds designed to match the performance of a particular index, such as the Barclays U.S. Aggregate Bond Index. Index funds simply hold the securities that are in the index, or, in many cases, a representative sample of the index holdings.

When the composition of the index changes, so do the fund’s holdings. In this case, the managers of the funds aren’t seeking to produce returns greater than the benchmark – the goal is simply matching its performance.

What are Actively Managed Funds?

Actively managed funds are those with portfolio managers who try to choose bonds that will outperform the index over time and avoid those they see as likely to underperform. In general, their goal is to find bonds that are undervalued or to position the portfolio for anticipated changes in interest rates. Active managers can adjust their funds’ average maturity, duration, average credit quality, or positioning among the various segments of the market.

See the complete and updated list of actively managed bond ETFs here.

The Key Differences Between the Two Management Styles

Fees: Since actively managed funds incur more trading costs and need to devote greater resources to research and portfolio management than passively managed funds, they tend to charge higher expense ratio.

Sometimes this is worth it, but very few actively managed funds can sustain outperformance relative to indices over an extended period of time. Over time, the higher fees of active managers tend to eat into returns – particularly in the current environment of ultra-low interest rates.

Turnover and taxes: Since actively managed funds are steadily shifting their portfolios in response to market conditions, they have a much higher turnover than index funds, which only change when the underlying index changes.

This can result in a higher tax bill at year-end, which reduces investors’ after-tax returns.

Performance variability: One of the most important reasons investors would choose an actively managed fund is the notion that the fund will be able to beat the market over time. That may in fact occur, but along the way even the best funds can have off years. Whereas passively managed funds produce returns that are in line with the market, actively managed can experience wide annual swings around the index return. And when a fund underperforms, investors run the risk that they will be correct in their initial choice (for instance, to invest in high yield bonds), but they won’t receive the full benefit of their decision.

Performance results: This is the most important difference between active and passive management. While there will always be a good number of actively managed funds that outperform in any given year, over time index funds tend to come out on top. One reason for this is the fees – the gap between the two types of funds is large enough that the difference compounds over time. Also, the market is so efficient – i.e., analyzed by such a large number of investors – that it’s extremely difficult for a manager to deliver consistent outperformance over the long term.

The numbers bear this out. The investment manager Robert W. Baird & Co. published a paper in June 2012 in which it analyzed the results of active managers over the previous 15 years. Only 16% of high-yield funds outperformed over the full-time period, while 18% and 37% of taxable investment-grade bond and tax-exempt managers beat their benchmarks, respectively. In all cases, investors would have been better off in index funds. Separately, the investment consultant DiMeo Schneider & Associates calculated that as of the end of 2011, the median intermediate-term bond fund had underperformed its benchmark by 0.3 percentage points, the median high yield fund had lagged by 3.3 percentage points, and the median international bond fund by 1.6 percentage points.

The takeaway: in theory, active management should enable the managers to add value through security selection, avoidance of losses, or the anticipation of ratings changes to the bonds they hold in their portfolios.

In reality, however, the numbers don’t show this to be true.

The Bottom Line

Passively managed funds have their drawbacks, as outlined in the index funds link highlighted above, and some managers – such as PIMCO’s Bill Gross, DoubleLine’s Jeffrey Gundlach, and Daniel Fuss at Loomis Sayles, to name three – have excelled at adding value for their investors. However, picking which manager will outperform in the next five to ten years is much more challenging. Keep this in mind as you’re selecting funds for your portfolio.

Next: How to Choose an Actively Managed Bond Fund