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Other than “gold” and “slop”, there has been another word on investors’ lips in the past year: bubble. For those retail investors keen to protect their portfolios, there is a retro solution: add more bonds to your portfolio.
The simplistic 60/40 equities/bonds strategy may have gone out of fashion since the bond bear market which followed Russia’s full-scale invasion of Ukraine, but the appetite for bonds in an uncertain world is back in a big way.
The question is, how best to gain access to defensive income investments: through active or passive management?
When it comes to stocks, passive inflows now far exceed the amount put into active funds. But a passive approach to bonds does not work the same way.
Over the past decade, cumulative flows into active open-ended and exchange traded bond funds (ETFs) have outpaced those of passive funds by roughly a trillion dollars, according to data from Morningstar.
Why have active funds attracted more attention? There are a number of reasons to prefer active over index-tracking passive, says Johanna Kyrklund, group chief investment officer at Schroders.
First, she says, bond markets have plenty of exploitable inefficiencies for active managers, including potentially profitable mispriced bonds. Also, there may be attractive opportunities, such as new issues, which are not in any index.
And there is a technical reason. Equity benchmark indices usually depend upon market capitalisation, which often reflects a company’s financial prospects. Not so in bond indices. Borrowing more with bonds can increase the weighting of an issuer, even if that boosts leverage to high levels. (Note last year’s massively debt-fuelled US M&A deals, including for Electronic Arts and Warner Bros Discovery.)
“The bond market is a continuum,” says Mara Dobrescu, a director in fixed income strategies at Morningstar. “At one end are very liquid and high- quality government bonds. Here, passive investment can work very well using ETFs. But as you move away from these — for example towards corporate, emerging market and securitised debt — it gets harder to track these passively.”
While active equity portfolio managers have a poor record on average against major indices, they have more luck on bonds. Long-term studies from Morningstar show that only about a fifth of active stock fund managers beat their benchmarks over long periods. But the “success rate” is over 50 per cent for active bond managers.
For investors focused on the highest returns from fixed income, active managers can provide this potential while also avoiding defaults, which could mean losses. “Bonds don’t have the upside of equities, but [theoretically] do have the same downside,” says Bryn Jones, head of fixed income at Rathbones.
“Active managers may be the right choice but [one should] think about fees over the long term,” points out James Norton, who oversees UK and European financial planners at Vanguard. “Fees are important in a [fixed income] asset class that already has lower returns than other classes.” On average, passive bond funds charge around 20 basis points compared with 90 basis points for active funds, says Morningstar.
Those firms that specialise in passive bond management, such as Vanguard and BlackRock’s iShares, now perceive passive as complementary to active funds. “We think that the active versus passive split is outdated,” says Vasiliki Pachatouridi, European head of fixed income product strategy at iShares. “Having a blended approach is the most cost-effective,” she adds, enabling any savings to be directed to those active funds if desired.
Individual investors can learn from the professionals. Becky Qin helps run Fidelity International’s multi-asset portfolios, specialising in fixed income. She has the choice of both Fidelity funds and external offerings. “We only use passive when the fund is very cost conscious,” she says. Her team may use passive funds for high-grade corporate bonds, for example. “We know that in the investment grade space [the market] is liquid enough.”
Other professional investors use passive funds as low-cost defensive ballast. While stocks can offer long-term growth, having a slug of passive bonds can help. “You can get the risk management and save a ton of money on fees,” says Nuwan Goonetilleke, head of capital markets at Phoenix Group, a pension fund specialist.
For others, passive provides the best way to express defensive views. “We do use passives quite a bit on government bonds,” says Jason Da Silva at Arbuthnot Latham, a private bank. “There’s a dearth of active managers in [the government bond segment] who outperform their index.”
As Dobrescu at Morningstar says, bond investors are fully aware that “active management isn’t dead but expensive active managed funds will be under pressure”.