Passive funds are often described as a cost-efficient way to gain exposure to a specific market. Yet, passive bond funds carry a range of risks which means that they might not be suitable for every investor. As for active bond funds, their mandated risk-management means that many might struggle to generate alpha in certain market environments.
Below, wealth managers discuss when to go passive or active with your bond exposure.
When passive works best
Hoshang Daroga, investment director at Elston Consulting, said some sectors within the fixed-income space lend themselves better to passive investing than others. This is mostly the case for “vanilla” exposures such as government bonds.
Yet, an important distinction between passive equity and bond funds is the way bond indices are structured. They usually give exposure to poorer quality companies, which can not only hinder performance but also not meet the objectives of investors seeking exposure to bonds for their defensive properties.
Moreover, it is difficult for a passive bond fund to replicate a bond index, with sampling being often used instead.
Jim Rowley, global head of investment implementation research at Vanguard, said: “Bond indexing is very much based on systematic risk factors. Bond index funds assemble a portfolio of bonds based on their characteristics rather the individual names. Those broad risk characteristics have to match those of the indices.
“From that standpoint, equity trackers tend to be able to fully replicate an index, fixed income trackers don't.”
Peter Dalgliesh, managing director at Parmenion, noted that bond index trackers might be more suitable for investors who are cognisant of their tolerance for risk, volatility and drawdown.
He said: “With a tracker, you'll typically find that the duration tends to be higher and the credit quality further out the curve of the risk spectrum. As a result, the volatility is likely to be higher.”
Yet, investors might have arguably been better off with a passive bond fund in the decade following the global financial crisis, as many active managers were constrained by the risk management required in their mandate.
Dalgliesh said: “In aggregate, we can observe that the overwhelming majority of active managers have adopted a much more cautious approach to duration management and credit risk management since the global financial crisis.
“That was to their detriment until around 2018 when the Federal Reserve started to move up interest rates. It wasn't until that point that shorter duration started to generate a bit of alpha for the active managers. So, for a number of years, investors had the luxury of leaning into those passive instruments because of the lower cost and the longer duration as interest rates were at or near zero.”
Dalgliesh added that the new environment of higher interest rates has been a game changer for managers of active funds.
However, if central banks around the world manage to get inflation under control, it is possible that they cut them back down, which could benefit passives.
When active makes a difference
Managers of active funds can make a difference thanks to their ability to manage portfolio risk while trying to enhance returns.
Tom Hopkins, portfolio manager at BRI Wealth Management, said: “Using in-depth research, active managers can screen issuers who they believe may not repay their debt or may experience financial hardship that causes their bonds to decline in price before maturity. They also add value since they can tilt, reduce, and increase the portfolio’s sensitivity to changing interest rates.
“Active sector rotation, bottom-up security selection and active interest rate (duration and yield curve) management can all create opportunities for investors to add value that are simply not available in passively managed strategies.”
This ability to manage risk and take risks tend to come to fruition in less efficient markets such as high yield and emerging markets, as well as in markets where the respective index introduces unwanted biases.
Daroga said: “For example high yield bond indices are skewed towards more heavily indebted companies. So a selective, actively managed approach makes more sense.”
Those benefits will, however, depend on the skill of the manager, with the risk that the manager may underperform.
What should investors consider before taking a decision?
Before buying a bond fund, whether it is an active or a passive one, John Moore, investment manager at wealth manager RBC Brewin Dolphin, suggested investors should ask themselves what they are allocating to fixed income for.
He said: “Liquidity? Relative safety? A step up from bank accounts and similar? A search for higher or attractive yields? Once this has been decided, they should decide on what is a reasonable output for this – government bonds offer liquidity and relative safety but don’t offer a yield pick-up, in fact returns might be below interest rates to reflect the forward curve.
“On the other hand, the yield may look attractive at the headline but where is it generated from today, what risks and costs are involved and how sustainable might that (and the investment process) be?”
Daroga added that investors should look at how broad a mandate the manager has, as a narrow process severely restricts active management and the fund ends up looking like a “closet tracker”.
As for passives, Daroga said investors need to look at the inherent biases of the index exposure and methodology, tracking error, tracking difference and other efficiency metrics for index funds.