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The Case for Actively Managed Bond Funds

When you’re looking to invest in a bond fund, cost is probably top of mind. Indeed, that’s often what attracts fixed income investors to bond index funds, which tend to be much less expensive than actively managed funds.

However, when it comes to the mainstream U.S. bond market—to say nothing of riskier emerging-market and high-yield issues—having a manager handpick a fund’s portfolio can make sense.

Here are three reasons why actively managed bond funds may be worth the extra fees.

 

1. Flexibility

Many of the biggest and most popular U.S. bond funds track the performance of the Bloomberg Barclays U.S. Aggregate Bond Index. But recent market changes have eroded some of the benefits of this broad benchmark, including:

  • Treasury overload: Due largely to the flood of federal bonds issued in the wake of the 2008–2009 financial crisis, the index has a significantly higher allocation to Treasuries than it did a decade ago. In 2007, U.S. Treasuries represented just 22% of the Bloomberg Barclays U.S. Aggregate Bond Index; at the end of 2018, their share had jumped to 39%. Given today’s anemic Treasury yields, such overexposure can come at a cost to investors in such funds.
  • Changing credit risk: Over the past decade, the credit quality of the corporate bonds in the Bloomberg Barclays U.S. Aggregate Bond Index has deteriorated. At the end of 2007, 65% were rated A or higher; in 2018, less than half were rated that high. This may not be of immediate concern given the index’s 39% allocation to Treasuries but could become an issue should that allocation shrink.
  • Interest rate risk: A combination of historically low interest rates and demand from the market prompted both companies and governments to issue an abundance of longer-maturity bonds over the past decade, pushing the index’s average duration to 6 years at the end of 2018 versus 4.7 during the preceding two decades. Why is that significant? Because higher durations generally mean higher volatility when interest rates change. For example, a bond fund with a 6-year duration will generally decrease in value by 6% for every 1% increase in rates.

 

With an actively managed bond fund, by comparison, the fund manager has the flexibility to buy and sell bonds as needed to account for changing market forces, including credit quality and interest rates (see “Know your fund,” below).

2. Expertise

When you invest in a bond index fund, the rules of the index dictate which bonds are included. An active fund manager, on the other hand, can use her or his expertise to select the bond that best fits the fund’s stated goals or offers the most attractive yields at a given moment.

This matters because a single issuer could have dozens—if not hundreds—of different bonds available in the market. Consider General Electric Company (GE). While there are only a handful of GE equities available to trade, there are more than 200 varieties of GE bonds, with coupons ranging from as little as 2% to more than 7% and maturities ranging from a few months to more than a decade. What’s more, some are highly liquid, while others rarely trade. An active manager can sift through all available options to find the ideal holding.

Such expertise is even more critical when investing in emerging-market and high-yield bonds, which tend to be both less transparent than mainstream bonds and more prone to special risks, such as fluctuating exchange rates. That said, such expertise is not a guarantee that a fund will outperform the market or generate positive returns.

 

3. Returns

Although actively managed bond funds typically command higher fees than passively managed bond index funds, three categories of bond funds tracked by Morningstar—intermediate-term, corporate and high-yield—have generally delivered higher returns in recent years. For example, intermediate-term actively managed bond mutual funds and exchange-traded funds outperformed their passively managed counterparts over the past three, five and 10 years—even after accounting for the difference in fees, according to Morningstar (see “Active beats passive,” below).
 

Active beats passive

Actively managed intermediate-term bond mutual funds and exchange-traded funds outperformed their passive counterparts during the three, five and 10 years ending 12/31/2018.

Source: Morningstar. Returns are net of fees. Past performance is no guarantee of future results.
 

In other words, sometimes you really do get what you pay for.

What You Can Do Next

  • Read more bond insights from Collin Martin and other Schwab experts.

  • Schwab clients can log in to search for and compare bond funds across a variety of criteria.

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Important Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. None of the information constitutes a recommendation by Schwab or a solicitation of an offer to buy or sell any securities. Supporting documentation for any claims or statistical information is available upon request.

All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Indexes are unmanaged, do not incur management fees, cost or expenses, and cannot be invested in directly.

Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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