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John Kinsellagh
John Kinsellagh
Articles (155) 

Active Bond Funds Poised to Excel

Changing interest rate environment less favorable for passive funds tied to disproportionately Treasury-weighted indexes

February 08, 2019

Passive stock index funds have enjoyed great popularity during the past decade due to their low costs and stable returns versus their actively managed peers, which have struggled to consistently beat their benchmarks. However, the exact opposite holds for bond funds. Actively managed bond mutual funds and exchange-traded funds have outperformed passive funds that track various indexes.

Data from Morningstar shows that active bond funds produced superior returns compared to index funds during the one, three, five and 10-year performance periods through December 31.

The annualized returns for one year were 1.05% for active bond funds versus -0.17% for index funds; for three years, 2.98% versus 2.82%; for five years, 2.99% versus 2.49%; and for 10 years, 4.64% versus 3.71%. The spread was most pronounced during the past year, as managed funds were able to readjust and capitalize on the changing interest rate environment occasioned by the Federal Reserve’s steady 25-basis point increase each quarter. Active bond funds also reap the benefits of being able to take greater risks in a robust economy as well as favorable market conditions for fixed-income instruments.

Another distinct disadvantage of index funds is that many are disproportionately weighted in Treasuries. Although Treasuries are characterized as “riskless investments,” they pay a lower rate of interest for that minimal risk. Other debt instruments, such as high-grade corporates or real estate investment trusts, offer higher and, in some cases, depending on the risk premiums, substantially higher yields with only a modicum of additional risk.

As the government increases borrowing to fund the tax cuts, passive bond funds become even more weighted with Treasuries, eliminating those fixed-income vehicles that have greater returns. Treasuries now comprise almost 40% of the value in the Bloomberg Barclays U.S. aggregate index, the leading bond market benchmark passive funds use to gauge their returns. That is an increase from the approximate 20% weighting in 2006.

Actively managed bond funds' ability to pare back Treasury holdings in response to increased government borrowing as well as a changing yield curve has contributed to their superior returns.

During the past year, active funds were well poised to adjust to the changing yield curve as well as steady increases in the federal funds rate every quarter — the most consistent and significant rate increases in over a decade. When the federal funds rate rose sharply for the first 10 months of the year, bond market rates followed suit. Active fund managers were nimbler in reacting to these short-term changes in the yield curve as they were able to shift into debt instruments with shorter maturities. Index funds, by their very nature, cannot take advantage of reweighting maturities to maximize investor yields in tandem with unforeseen and sudden rate changes.

The weighting of passive bond funds precludes many from participating in rallies within difference sectors of the corporate bond market, such as investment-grade corporates, high-yield junk bonds and emerging market fixed-income vehicles. For comparison purposes that illustrate the inherent disadvantages and inflexibility of passive funds, only 24.4% of the Bloomberg Barclays Index is comprised of investment-grade corporates; the index contains a mere 1.7% emerging market debt and no junk bonds.

Although the returns of active bond funds have outperformed index funds, most notably during the past year, many investors still remain unmoved. One reason is that the management fees of active bond funds are greater and, in some cases, significantly greater than those charged by passive index funds. According to Morningstar, actively managed bond mutual funds and ETFs carry an annual expense ratio of 0.785%, compared with 0.274% for passive funds.

Another reason for the reluctance to switch is many investors have still not yet acclimated themselves to the changed investment climate that occurred once the Federal Reserve started raising rates at a steady clip beginning in 2017. The era of placid, stable zero-interest rates is over. Many analysts, as well as individual investors, are still disinclined to believe the stable low-rate conditions that have prevailed over the past decade will change anytime soon. Many passive investors mistakenly believe their view was ratified by the Fed recently, with its about-face policy announcement that stated no rate hikes for 2019.

However, for those whose investment window is long term, as every performance measure for one, three, five and 10-year periods indicate, active bond funds outperform their index peers.

Disclosure: I have no position in any of the securities referenced in this article.

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About the author:

John Kinsellagh
John Kinsellagh is a freelance writer, former financial adviser and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts Society course on investment analysis and portfolio management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

He is the author of "The Mainstream Media Democratic Party Complex" and "Election 2016," both available on Amazon. Follow him on Twitter @jkinsellagh.

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