Bond Markets Favour Active Management
In an ever-changing market, we’ve covered a variety of subjects in these commentaries over the years. Some recurring themes include our thoughts on active versus passive investment approaches, the likely path of interest rates, and the fact that, in practice, finance is trickier than academic theory would lead us to believe. Given the current market environment, it seems appropriate to revisit these topics.
The debate regarding active versus passive investment strategies has raged for more than a half-century. Through the ebbs and flows of market cycles, compelling academic studies come out to justify either side’s point of view. As we wrote in March 2013, “For every fund with a strong track record, there are numerous studies that call into question the efficacy of active investment approaches…This sentiment has undoubtedly played a role in the rising popularity of low-cost, passive ETFs [exchange traded funds].”
That sentiment is even more applicable today. Closing out the last year, Vanguard Group – which has literally been the vanguard in its elevation of index funds – benefitted from record inflows. Attracting $243 billion (in USD) in 2014, Vanguard helped boost passive strategies to 35% of all U.S. mutual fund investments. Two decades ago, index funds were just 2% of assets!
As you receive those familiar quarterly reports in the next few weeks, you will likely see that some of your actively-managed bond investments slightly lagged the index over the past year. If investing was a scientific theory, these recent outcomes would conclude that passive investing is the clear winner. Given that investing is instead something of an art, we have confidence that superior active managers will add value over time. As it relates to the bond market in particular, we believe it is an inopportune time to passively invest in the index.
It is true that both in theory, and empirically, marginal equity fund managers will underperform their benchmarks. Intuitively, since not every manager can be above average, and if the sum of all portfolios equals the index, the average fund will receive the market return, and then trail the index once fees are taken into account.
However, this theory doesn’t apply as easily to the bond market. Active managers, who aim to preserve capital and generate modest income, do not make up the entire market. Larger investors like Central Banks, for example, also trade bonds to stabilize currency flows and control the money supply. Banks and insurance companies, meanwhile, can make decisions in response to regulatory measures. This might explain why there is currently such a great demand for “Giffen-esque” bonds offering negative yields. With larger market participants focused on other means, it is possible that, going forward, even the average active bond manager could outperform net of fees.
Additionally, passive investing results in a situation where the largest debt issuers receive the largest allocations. Because the size of an issuer’s outstanding debt is a poor measure of financial health, we prefer active managers that can conduct independent credit analyses to determine which investments offer the best trade-off between return and risk.
Most importantly, while bonds remain an important part of a diversified portfolio, receiving index returns over the next market cycle could make it much more difficult to achieve long-term financial objectives.
Unlike their equity counterparts, future returns for bonds are somewhat easier to forecast. As highlighted in the graph above, the yield-to-maturity on the day you buy the index (the blue line) does a good job of determining what type of return you will likely achieve over the next decade. However, this doesn’t mean that every year’s return will closely track that yield. For example, as interest rates continued to fall in 2014, passive bond investors achieved an 8.8% gain, even though the yield had been just over 2% for the last several years.
When a passive investor achieves annual returns higher than the starting yield-to-maturity, in essence they are “borrowing” returns from future years. In the graph, the purple columns show the return actually achieved by the index – in every case higher than the return suggested by starting yields. The blue bars show the return likely to be realized once a full decade has passed. Unfortunately, with a current yield of just 1.7%, passively investing in bonds is likely to disappoint.
Vanguard’s low-cost, index-tracking philosophy certainly resonates well with investors. Despite this, we continue to believe that, through active strategies, bond investors can construct portfolios with better diversification and improved long-term performance. Interestingly, Vanguard seems to agree. In light of the current environment, founder John Bogle recently acknowledged that it may be time to rethink the bond index in order to better serve investors.