The wave of money flowing out of active funds and into passive investments causing plenty of headaches for the world’s equity fund managers, is affecting fixed income investors too. PIMCO, the world’s largest actively managed bond fund manager, is preparing its defence.
In a paper titled “Bonds are different”, a team of researchers headed by Jamil Baz, PIMCO’s global head of client analytics, argues a number of reasons why passive investing doesn’t work as well in bonds, giving active bond investors plenty of room to beat the market.
“We’re talking about different animals here,” Mr Baz told The Australian Financial Review, referring to the differences between passive investment in equities and bonds. The paper’s argument is made most forcefully with figures that show actively managed funds more often than not outperformed their passive competitors across a range of time frames and bond fund types.
These calculations are debated. Others who’ve looked at this question, such as S&P Dow Jones Indices, conclude that bond funds frequently under-perform benchmark indices, particularly over long time periods after fees are taken into account.
However, in bonds, the benchmark and the returns offered by passive funds after fees are not necessarily the same thing.
Passive funds offer cheap exposure to assets by replicating a broad index, far more cheaply than managed funds do. But bond indexes are notoriously tricky to replicate, as bond markets have far lower liquidity than equities and the constituent parts of bond indices change far more quickly (generally every month) than they do in most equities indices.
And bonds, which are sold-on corporate or government debt, can go funny in times of crisis, leading to the curious situation of many active funds having under-performed the index in 2008-09 but having outperformed passive bond funds over the same period.
Comparing the performance of active bond funds to the index in shorter durations that exclude the financial crisis yields better results, according to PIMCO. And in all the categories and time frames examined, with the exception of one-year high-yield bond funds, more than 50 per cent of active bond funds beat passive funds after fees.
There are a number of technical reasons why active management gives greater returns in bonds than equities, Mr Baz argued.
Around half of the $102 trillion global bond market isn’t held by investors seeking a return at all, but by “uneconomic” investors. Central banks, for example, use bond buying and selling to control their currencies and inflation. Commercial banks and insurance companies use bonds for their regular yields rather than their alpha. These “non-economic, constrained investors” are not able to act with the freedom of those investing for profit – so their alpha is there for the taking by “economic” investors.
“Economic investors tend to outperform non-economic investors, as the former buy cheap fallen angels from the latter and sell them expensive high-coupon bonds. Active managers potentially may also be compensated by passive managers for providing the liquidity around changes in index construction,” the paper states.
“We absolutely concede that there is a place for passive management,” Mr Baz said. “Some take advantage of the lower fees, and passive funds put active managers on their toes and incentives them to do better.” But, he added, active bond managers are able to take advantage of opportunities passive managers cannot.
And there are more such opportunities in the bond market. Companies, for example, usually issue only one form of stock. But they can and do issue multiple types of bonds – only the largest of which will make bond indexes even though the others can be, in effect, the same. Active bond managers can do the research needed to discover and buy such bonds when they are cheaply offered.
In this sense, bond managers are somewhat like small caps managers, said BetaShares chief economist David Bassanese, who also tend to perform better against passive funds compared to other equities categories.
For most investors, passive bond investing is the only way to access the fixed income space at all.
“Before the advent of exchange traded funds, the only way retail investors could access fixed income was through unlisted, typically actively managed funds which charged a high fee for their efforts. ETFs, irrespective of debate of active versus passive, give retail investors access to fixed income products.”
Vanguard manages the world’s largest bond fund, which is passive. The issue of fees was also raised by its head of investments for Asia-Pacific, Rodney Comegys.
“Cost matters a tonne, and even more in fixed income than it does in equities,” he told the Financial Review. “There’s lower expected returns in fixed interest, so what you pay really takes away from your return. In a low-yield environment, that matters.”
“In aggregate – whether across equities or fixed income – passive investing keeps costs as low as possible. You don’t spend much on research. And for all the advantages of active … you also have the opportunity to underperform.”
Fees can vary widely across different fixed income active fund managers, and investors have to trade off the performance of an active fund with how much of that performance is eaten up by fees.
“Active is hard,” Mr Comegys said. “Hard for the investment manager and hard for the investor.”
But someone’s got to take the risk, Mr Baz argued. A market fully comprised of passive investors would encourage “free-riding, adverse selection and moral hazard”.
“You could have a situation where companies offer lower-quality paper, knowing it’ll be absorbed by the market because it’s passive and less research-intensive,” he said.
“The more passive fund buying there is, the more uncritical buying there’s going to be.”