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The Strange Case of the Active Bond Fund
Bond funds buck the trend towards passive indexing. Here’s what the data shows.
Key Takeaways
Passive is massive: indexing has come to dominate the modern fund-management industry.
However, actively managed bond funds are an important exception.
Morningstar data shows that actively managed bond funds have a much higher long-term success rate than actively managed equity funds.
Passive funds dominate the modern fund-management industry. In the US, net flows into passively managed funds have outpaced net flows into actively managed funds every year since 2013. Last year, US-domiciled passive funds closed with more assets under management than active funds for the first time (see chart). Lower fees and generally superior long-term performance point to a continuation of the trend: fewer than one in four active strategies survived and beat their average passive counterpart over the 10 years through December 2023, according to Morningstar’s US Active/Passive Barometer.
These headlines are compelling. Yet they mask vital details revealed in Morningstar data (see chart). Since 2014, active US equity ETFs, active international equity ETFs, and active taxable bond mutual funds and ETFs have all achieved modest cumulative net inflows. Only active US equity open-ended mutual funds and active international equity open-ended mutual funds have experienced outflows. These equity flows dominate the news because they are so large: over the past ten years, the cumulative net outflow from active US equity open-ended mutual funds alone exceeds $2 trillion.
What’s Driving Inflows to Active ETFs?
The net inflows into active equity ETFs can be explained by the secular shift out of mutual funds and into vehicles that better meet diverse investor needs: outflows from actively managed equity mutual funds far exceed inflows into active managed equity ETFs. But this is not true of bond funds, where cumulative net flows into both mutual funds and ETFs are positive. In other words, the shift from active management to passive indexing is, in fact, more accurately a shift from active to passive equity investing.
Proponents of passive investing tout efficient markets: indexes have become harder to beat because financial markets have become remarkably good at establishing prices that reflect the intrinsic value of the security. Arguably, this is less true of bond markets than of equity markets. One reason: the bond market’s size and complexity. With more than $50 trillion outstanding, the US bond market includes treasuries, mortgage-backed securities, corporate bonds, municipal bonds, agency bonds and asset-backed securities.
The Complexity of Bonds Presents Opportunity
Most companies have a single share class of stock. But a single issuer often creates many different types of bonds, which can differ by credit quality, seniority, collateralization, payment structure, coupon, maturity and optionality. All these differences can affect the price. Morningstar’s US Core Bond Index, which measures the performance of fixed-rate, investment-grade securities with maturities greater than one year, includes 9,446 constituents, capturing about half of outstanding U.S. bond issuance.
The bond market’s structural diversity may present more opportunities for mispricing, which can be exploited by active managers. Its splintered nature even requires passively managed bond funds to exercise discretion. Because the costs associated with trading all the elements of a bond index can be much larger than for an equity index, portfolio managers must constantly weigh the incremental benefit of owning an index constituent against the cost of executing the trade. For this reason, most passive bond fund managers hold only a subset of index constituents and must constantly monitor their tracking error.
The performance data support the flow of funds. According to Morningstar’s US Active/Passive Barometer, actively managed bond funds have a much higher long-term success rate when compared with their passively managed peers than do actively managed equity funds (see table). Like equity funds, however, the lowest-cost bond funds perform much better than the highest-cost funds.
The Nature of Active Management
Should portfolio managers continue to focus product strategy on active bond funds? It is often noted in the equity markets that index funds benefit from the activities of active investors: it is their trading patterns that establish efficient prices. As fund managers and traders bring more focus on pricing discrepancies in the bond markets, opportunities may shrink, and active fund managers could once again become victims of their own success. Alternatively, the growth of index funds in fixed income markets may present them with even more opportunities to take advantage of mispricings.