It’s an often-sung refrain in the investment industry: active managers are unable to outperform passively managed funds, like ETFs. But a new analysis from Pacific Investment Management Company (PIMCO) reveals that, in the fixed-income space, active managers can beat a passive fund.
“We look at performance numbers and find that, unlike their stock counterparts, active bond mutual funds and exchange-traded funds (ETFs) [in the US] have largely outperformed their passive peers after fees,” said PIMCO analysts in a report titled Bonds Are Different: Active Versus Passive Management in 12 Points
In fact, more than half (63%) of the active bond mutual funds and ETFs examined by the firm beat their median passive counterparts in most categories, within historical time frames ranging from 1 year to 10 years. Compare that with active equity mutual funds and ETFs, only 43% of which outdid their passive rivals over the past five years.
Beating a passive fund isn’t necessarily the same as beating a benchmark, however. For instance, only 25% of active funds in the high-yield bond category outdid their benchmarks over the past five years, but 81% did better than their median passive pears over the same period. “This indicates the difficulty of replicating the performance of high yield benchmarks, possibly due to the lower liquidity of the market and the high transaction costs for all but the largest issues,” the authors said.
The analysts also suggested that active managers should be evaluated over a long period; according to them, it takes a hypothetical active manager 7 years to have a 90% chance of beating the index they track.
They also point out that, in the bond space, there should be a minimum of three investor categories: passive investors, who hold a market-based portfolio; economic investors, who pick investments actively to maximize their return; and noneconomic investors, who choose investments for reasons other than return. Noneconomic investors — such as central banks, commercial banks, and insurance companies — have a bigger role in the bond market, and they tend to be outperformed by economic investors.
Information is also more critical in bond trading and rebalancing. Most equity indexes are rebalanced annually or quarterly. In contrast, most bond indexes get rebalanced monthly; bonds mature, new bonds are issued, and index inclusion and exclusion rules cause movement into and out of a given index. Active bond managers who invest in quants, income strategists, credit analysts, and information systems can use their knowledge to find securities they can buy at a lower offer and sell at a higher bid than passive managers.
The authors also discussed two other factors: structural tilts (such as duration, investment grade, and high-yield credit spreads) and the option to go for financial derivatives (such as currency swaps, futures, and credit-default swaps) could help explain how active bond managers do better than their counterparts in the active equity space.
However, they qualified that passive managers have a role to play:
“They do not need to spend resources to beat the benchmarks. As a result, they usually charge much lower fees than active managers. For many investors who … only seek index replication at the asset class level, passive investment provides a cost-effective way to access individual markets.”
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