The trouble with passive fixed-income funds

Benchmark constraints and hidden costs of passive investment could give active strategies an edge

The trouble with passive fixed-income funds
Passive strategies have been hugely successful for equity ETFs over the past few years, but active managers could be set for a comeback as volatility is expected to return. Similarly, certain features of passive strategies may make them ill-suited for changing fixed-income markets.

Rob Glownia and Tim Anderson of RiverFront Investment Group recently commented on the weaknesses of passive strategies in an article on As an example, they noted questionable allocation decisions made by many popular passive indices such as the Bloomberg Barclays US Aggregate Bond Index (AGG).

“First, the AGG index is weighted by debt issuance,” the pair said. “We view this weighting methodology as counterintuitive, since growing debt burdens can also signify escalating risk.”

They also noted that AGG focuses solely on investment-grade bonds with fixed-rate coupons, effectively excluding high-yield bonds, emerging-market debt, and floating-rate notes. “Because of the inherent biases in many of the popular fixed income indices, we believe an active manager has multiple opportunities to add value to a fixed income portfolio,” they said.

Yields from passive strategies can also be constrained if low inflation persists. Going back to AGG, Glownia and Anderson noted that strategies tracking that index will have around two thirds of their assets tied to US Treasury bonds and agency mortgage-backed securities. “With both of these sectors having coupon payments near historic lows, investors should expect returns in-line with yields and since there are few signs of inflation, rates may remain lower for longer,” they said.

Irrational purchasing decisions of large investors can also have a significant bearing on popular passive benchmarks. Many companies and government pensions, for example, will want to buy bonds that mature at the same year as their obligations to investors, “regardless of their view on future interest-rate movements.” Central banks that are carrying out their quantitative easing programs also make buying decisions based on growth and inflation mandates rather than returns.

“Passive products and benchmark sensitive fund managers can be most susceptible to this potentially irrational behaviour given that their investment process is driven by minimizing tracking error with little if any consideration of valuations,” Glownia and Anderson said.

Finally, they noted that passive investors may be unaware of hidden costs from trading and rebalancing within high-turnover products. Citing Bloomberg, they said turnover in the AGG index over the past three years has been around 35%, compared to 5% for the S&P 500 index. “A passive product has to sell bonds before they mature and buy the new issues coming to market, creating trading costs for the end investor,” they said.

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What bond ETF investors need to prepare for