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Market View

In the fixed-income market, when it comes to selecting active versus passive strategies, low cost does not always mean good value.   

There has been no shortage of articles in the financial media covering the debate between the “active versus passive” approaches to investing. In a recent Market View, we highlighted four myths related to this topic when it comes to equity investing. Today, we turn our attention to passive approaches to fixed income.   

Fixed income encompasses a very large universe. For example, within investment-grade fixed income, the Bloomberg Barclays U.S. Aggregate Bond Index includes more than 10,000 issues, with a total market value of more than $19 trillion (with the Bloomberg Barclays Global Aggregate Index representing more than $45 trillion in market value), as of November 30, 2016. The high-yield bond market (as represented by the Bank of America Merrill Lynch Global High Yield Index) includes another 3,000 issues, with a total market value of more than $2 trillion (as of the same date). This provides a wide opportunity set, allowing active managers multiple levers to attempt to enhance returns while managing risk. They can adapt to the market environment by adjusting their portfolios’ maturity and term structure, credit quality, sector, and industry exposure.

Without getting into a philosophical debate about which approach is best, a review of the largest passive funds in the major mutual fund categories suggests the following:

  • The largest passive funds historically have underperformed the “average” active manager.
  • It is important to understand a portfolio’s exposures, whether in active or passive strategies.
  • Low cost does not always translate to a good value.

There are many nuances to consider in such an analysis, since there are a wide range of asset classes within fixed income, and numerous indexes that can be used as benchmarks within each segment of the market. But what follows is a review of the following Morningstar Fixed Income categories: intermediate-term bond, short-term bond, high-yield bond, and bank loans. 

Intermediate-term bond represents the largest fixed-income category in Morningstar, with more than $1.1 trillion in open-end mutual funds, including more than $300 billion in passive index funds, as of November 30, 2016.  Funds in this category often serve as a core bond allocation for an investor’s portfolio, and the Bloomberg Barclays U.S. Aggregate Bond Index is a common benchmark.  As of November 30, this index has a duration of 5.8 years, and is heavily weighted in U.S. government-related securities, so it tends to perform well in stable or declining interest-rate environments, and provides valuable diversification benefits during difficult equity markets.  However, the duration exposure of the index leads to significant interest-rate risk during periods of rising rates. 

The largest passive index mutual fund in the category has a duration of 5.8 years (as of November 30), as compared with five years for the category average. While the index fund provides a very low cost, the fund has trailed the category average by 0.59% per year over the trailing five years, placing it in the bottom quartile of the category. While the longer-duration, government-focused strategy generally performs well during “risk-off” periods, rising rates can provide a headwind.  Over the trailing three months, as U.S. Treasury yields have moved sharply higher, the index fund has trailed 93% of its peers in the category.  The largest passive exchange-traded fund (ETF) has had a similar experience, trailing the category average by 0.47% per year over the trailing five years.

(Those looking to reduce such interest-rate risk may be tempted by certain large “intermediate-bond” index products.  However, these index products track a longer duration benchmark of five- to10-year maturity bonds, and have durations of six and a half years years.  While these index funds have generated strong returns, the duration is 30% higher than the category average, which has led to volatility that is more than 40% higher than the category average.)

 

Chart 1. Category Check: The Biggest Passive ETF and Mutual Fund, Intermediate-Term Bonds
Total return and risk (standard deviation) for the indicated ETFs, funds, and Morningstar category averages (trailing five years as of November 30, 2016)

Source: Morningstar. Volatility as measured by standard deviation. Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.  Largest passive index mutual fund: Vanguard Total Bond Market Index Fund Investor Shares (VBMFX).  Largest passive index ETF: iShares Core U.S. Aggregate Bond ETF (AGG).

 

Short-term bond represents the second largest fixed-income category, with more than $300 billion in assets, and is comprised of funds that invest primarily in investment-grade securities, with a duration in the range of one to three and a half years. The category average duration is just less than two years, with many funds in the category tracking a one- to three-year benchmark. The largest passive index mutual fund and ETF, however, track a one- to five-year index with duration of 2.8 years. If the purpose of a short-term bond fund is to limit interest-rate exposure, is it ideal to have duration exposure that is 40% higher than the category average? This duration risk came to light during the rising rates period of the trailing three months, when the largest index mutual fund and ETF placed in the bottom quartile. Over the trailing five years, these products have lagged the category average, with slightly higher volatility than the average fund in the category.

 

Chart 2. Category Check: The Biggest Passive ETF and Mutual Fund, Short-Term Bonds
Total return and risk (standard deviation) for the indicated ETFs, funds, and Morningstar category averages (trailing five years as of November 30, 2016)

Source: Morningstar. Volatility as measured by standard deviation. Past performance is no guarantee of future results.  For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment. Largest passive index mutual fund: Vanguard Short-Term Bond Index Fund Investor Shares (VBISX).  Largest passive index ETF: Vanguard Short-term Bond ETF (BSV).

 

High-yield bond represents the third largest fixed-income category, with more than $260 billion in assets, and includes funds that invest more than 65% of assets in below-investment-grade securities. Given that credit risk is a major risk to high-yield investing, one would think that an active approach would be most appropriate. Rather than matching the exposure of the largest issuers of high-yield debt, an active manager can undertake rigorous fundamental credit research on individual issuers and chose to over-weight the best opportunities, while avoiding those credits that pose the largest risk of default, or trade at unattractive valuations. In addition, a seasoned investment team’s macro insights lend themselves, in an active portfolio, to favor those industries that are better positioned for the economic environment, while adjusting overall risk exposure across the credit-rating spectrum. This especially came to light during the commodity price collapse of 2014–15, when the energy sector, the largest industry in the major high-yield indexes, suffered sharp price declines. An active approach provides flexibility to take advantage of market opportunity while mitigating risk. A review of the category performance illustrates this point.

Although the category does not include any passive index mutual funds, two index ETFs have gained significant assets. These large ETFs track indexes that are not commonly followed by other funds in the category. As Zane Brown, Lord Abbett Fixed Income Strategist, highlighted in a piece earlier this year, these ETFs do not always track their benchmarks. Once again, their expense ratios are below the mutual fund category average, but they have both lagged the mutual fund category average over the trailing three and five years.  Some investors may be willing to accept lower returns if it comes with lower volatility. But in this case, these ETFs have delivered lower returns with much higher volatility than the category average.

 

Chart 3. Category Check: The Biggest Passive ETFs, High-Yield Bonds
Total return and risk (standard deviation) for the indicated ETFs and Morningstar category averages (trailing five years as of November 30, 2016)

Source: Morningstar. Volatility as measured by standard deviation. Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment. Largest passive index ETF: iShares iBoxx $ High Yield Corporate Bond ETF (HYG).  Second largest Passive Index ETF: SPDR® Bloomberg Barclays High Yield Bond ETF (JNK).

 

The bank loan category is the eighth largest fixed-income category in Morningstar, but has seen strong inflows in recent weeks as investors have been positioning for a rising-rate environment. Similar to high yield, credit risk is the major risk when investing in bank loans, suggesting that in-depth credit research and active portfolio management would be a prudent approach to investing in this space. While there are no index mutual funds in the category, there is a sizeable ETF that tracks an index of the 100 largest loans in the S&P/LSTA Leveraged Loan 100 Index. This passive ETF has trailed the category average over the trailing three and five years, placing in the fourth quartile and the third quartile of the category, respectively, with higher volatility than the category. 

 

Chart 4. Category Check: The Biggest Passive ETF, Bank Loans
Total return and risk (standard deviation) for the indicated ETFs and Morningstar category averages (trailing five years as of November 30, 2016)

Source: Morningstar. Volatility as measured by standard deviation. Past performance is no guarantee of future results. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment. Largest passive index ETF: PowerShares Senior Loan Portfolio (BKLN).

 

A Word about Costs
While ETFs tend to have lower expenses than actively managed mutual funds, not all ETFs are priced like an S&P 500® Index fund or a Bloomberg Barclays Aggregate Index fund, which may have expense ratios of less than 0.10%. The largest high-yield ETF comes with an expense ratio of 0.50%, while the largest bank-loan ETF expense ratio is 0.65%—which is not much less expensive than some low-cost, actively managed portfolios. But despite having lower costs than most active funds, the largest passive funds have trailed the category averages, and have done so with higher volatility, leading to lower absolute returns and lower risk-adjusted returns. 

Keep in mind that these comparisons have been made versus the category average. If you can identify those managers who are consistently above the category average, the opportunity cost of the passive approach becomes even greater.

Summing Up
So, perhaps the question should not be the quandary of “should I be active or passive in fixed income?”  A better question may be, “Which strategy can deliver more attractive risk-adjusted returns (after expenses) to investors.” From the performance comparisons above, it would appear that in many cases an active approach to fixed income historically has delivered more attractive risk-adjusted returns. Rather than defaulting to a passive approach, we suggest that an investor should analyze a side-by-side comparison.  (See how Lord Abbett funds compare to the largest passive funds.)

Recent changes at Morningstar will make this analysis easier for investors. Historically, the fund-rating firm had kept separate categories for open-end mutual funds and ETFs. But as of December 1, 2016, ETFs now are included with open-end mutual funds into a single peer group. For those who may have defaulted to choosing the ETF to get exposure to an asset class, they may have to reevaluate this approach when they see an ETF that has provided lower returns with higher risk than achieved by the average manager of an active portfolio.

 

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