By Karishma Vanjani
Pity the poor stock manager who can't beat the benchmark -- and spare a thought for the bond managers who outperform but still can't attract the funds passive management does.
At a luncheon hosted in a New York City hotel penthouse on a mildly cold December afternoon, Joe Sullivan, CEO of Allspring Global Investments, called passive investing in bonds "about the dumbest trade that you can make."
Allspring had just launched three actively managed exchange-traded bond funds, but Sullivan wasn't simply talking his book. Most years, a vast majority of active fixed-income fund managers beat the passive indexes. In 2024, 84% of active bond ETFs outperformed the benchmarks listed in their prospectuses, up from a win rate of 73% in 2023, according to data from Morningstar Direct.
On a trailing 10-year basis, which smooths out the performance picture, 55% of active funds outperformed their passive indexes, while 62% outperformed over five years. The degree of outperformance tends to get larger over shorter time frames.
The opposite happens in the equity world, where no matter how long or short the period -- one year or 10 years or something in between -- only between 33% and 37% of active funds manage to top passive benchmarks. It's not just a matter of bad luck. With largely democratic access to information, it's tough for a manager to find inefficiencies to exploit in the market, especially when most of the outperformance is coming from a handful of the market's biggest stocks. Add fees and the tendency of investors to invest based on fear and greed -- getting it wrong most of the time -- and the do-nothing, low-cost, passive equity index usually ends up winning.
The world of bonds is different. An active fixed-income manager has far more inefficiencies to exploit, as the flow of information is limited and the cost of accessing it can be high. Access is also more tightly bound. Many corporate bonds, for instance, get bought and sold "over the counter," where only institutions trade the securities.
Opportunity also comes in the form of idiosyncratic features. Stocks are homogeneous -- every share of Apple is like every other share of Apple -- but each bond that Apple issues will differ from its previous offerings. Different maturities, interest payments, and seniority can set them apart, thus offering a chance for a manager to swoop in and buy a bond when it looks mispriced. Add it all up, and the chances are better that a bond manager will actually provide what investors are paying for, unlike their equity manager brethren.
With stocks, "buy an index, index, index," says Jim Bianco, president of Bianco Research. "But if you want to know what to do in bonds, give it to an active manager."
Bianco got into the game recently, when he launched the Bianco Research Total Return Fixed-Income Index. It serves as the benchmark for the WisdomTree Bianco Total Return ETF (ticker: WTBN), which started trading in December 2023. The fund returned 2.2% in 2024 and beat the widely held Vanguard Total Bond Market ETF's $(BND)$ 1.4% return. Still, it fell short of the average passive and active bond ETF returns last year of 3.2% and 4.8%, respectively, according to Morningstar Direct.
The winning bond fund of 2024 was the actively managed Simplify Interest Rate Hedge ETF (PFIX), with a total return of 36.46%. It made money as rates on long-term bonds went up. Rising rates can cause big losses in bonds, but because this fund is designed to use over-the-counter derivatives that act like insurance against falling bond prices, it profited.
Among all active funds, North Square Preferred and Income Securities (ORDNX) has offered the best bang for the buck over the past 10 years, with an average annualized return of 11%. Its relevant benchmark returned 4.1% over the same period. The fund holds income-producing corporate issues.
Despite stellar returns, U.S. investors didn't rush into actively managed bond funds last year. Active amassed $111 billion in net flows, while passive bond ETFs got $183 billion. In the U.S., active open-end funds, such as mutual funds, saw way more flows than passive, but there are also 25 times more active bond open-end funds than passive. ETFs are closer in number and thus better reflect the demand.
The migration could be because of investors' reluctance to take on more risk, as active managers typically reach into lower-credit-rated bonds for higher returns, or because active funds charge higher fees -- an average 0.45% versus 0.21% for passive funds.
Elisabeth Kashner, director of global fund research and analytics at FactSet, reminds investors that there hasn't been a huge wave of corporate defaults in about 15 years. "So people who took on credit risk, that's largely paid off. [But] under different market conditions, they might not have paid off," she says.
Don Burrows, founder of Burrows Capital Advisors, takes the middle ground in the active/passive debate. His firm uses broad-market passive ETFs for high-net-worth retail clients as a core position, and then "we will go in and we will use active ETFs around that," he says.
The firm recommends active ETFs in more-inefficient markets like high-yield and commercial mortgage-backed securities, where "good bond pickers at actively managed ETFs will be able to go in and pick off those credits from doing very deep due diligence," Burrows says.
This approach allows investors to tailor exposure based on the risk they'd like to take. For example, investors can buy the iShares Core U.S. Aggregate Bond ETF $(AGG.NZ)$, with its 45% weighting in U.S. Treasuries and other conservative investments, and match it with higher-returning active bond ETFs, where security selection is helpful.
The bottom line is to "just stay balanced and give yourself the ability to adjust as the market changes over time," says Jason Bloom, Invesco's fixed-income ETF Strategy head. "Don't feel the need to try to predict the future and make a big bet."
Let the active managers do that instead.
Write to Karishma Vanjani at karishma.vanjani@dowjones.com
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(END) Dow Jones Newswires
January 17, 2025 21:30 ET (02:30 GMT)
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