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.
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).
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.
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.