Studies Highlight Value of Active Fixed Income Management

August 7, 2024

Actively managed fixed income funds are having a moment. According to the Financial Times, investors are “shovelling cash” into active bond ETFs at a record-setting pace.

Surging interest in fixed income investing in general is a key factor driving the inflows. Investors are finding bond yields attractive for the first time in many decades. They’re also concerned that those yields won’t be available for much longer if economic growth slows as anticipated.

The strong performance of these funds over the long-term is another factor drawing investors into these funds, as a series of recent studies have highlighted.

A May 2024 study from Morgan Stanley Investment Management found that, over the past three, five, and ten years, actively managed funds in nine fixed income sectors outperformed passive funds. This outperformance was particularly marked during the bond market sell-off of the past few years, demonstrating the value of active management in mitigating downside risk, suggest study authors Christopher Remington, Katie Herr, and Jun Li. They also note that the outperformance has been quite consistent, with active funds providing superior returns in 87% of the rolling three-year periods.

Focusing on just one sector of the fixed income market, an April 2024 study from PineBridge Investments found that actively managed high yield bond funds outperformed over the trailing one-, three-, five-, and ten-year periods. Author Andrew Karlsberg points out active management outperformed on a risk-adjusted basis, with active funds producing higher Sharpe ratios than passive ETF alternatives, as well as on a total return basis.

The conclusions of these studies from asset managers are supported by the work of academic authors Jaewon Choi, K. J. Martijn Cremers, and Timothy B. Riley. In a working paper titled “Passive bond fund management is an oxymoron (or the case for the active management of bond funds)”, they find that, from 2011 through 2021, the average active bond fund outperformed its passive counterpart.

In fact, they note, “the most active bond funds – those with high active share in particular – substantially outperform.” These highly active funds also tend to experience less downside in market sell-offs.

Of course, past performance is no guarantee of future investment success, but Choi, Cremers, and Riley suggest that active fixed income’s outperformance is likely to be sustained. They explain that tracking a fixed income benchmark is complicated, given that the average bond index includes over 7,000 securities and updates its holdings frequently. As a result, most bond index funds don’t hold all the securities in the index, which introduces greater tracking error risk. At the same time, bond index funds must trade often – in issues that can be illiquid – reducing their cost advantage over active funds. Interestingly, the study finds that passive bond funds are most likely to emphasize liquidity in determining portfolio weightings.

On the other hand, bond returns are much less skewed than stock returns, meaning that “star” bond performers are infrequent. In a stock fund, it’s easy for an active manager to not own a stock with exceptional returns and to find themselves in a performance hole as a result. That’s much harder to do in active fixed income investing, where upside potential tends to be less issue-specific.

All in all, Choi, Cremers, and Riley conclude that, “along multiple dimensions, there are strong, rational reasons for investors to consider active bond funds.”