Money is flowing into passively managed bond funds

Key Points
  • The migration to passive management is happening in the fixed-income markets, but at a slower rate than in stocks. Over the past five years, $629 billion in assets have flowed into passively managed bond funds.
  • In smaller, less liquid segments of the bond markets, active management is perceived as adding greater value than in the Treasury and investment-grade bond markets.

Conventional wisdom has it that active equity fund managers have a better chance of beating their benchmarks when things get volatile.

That's probably not the case, however, for active managers in fixed-income markets.

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"Active bond fund managers have been able to increase their returns [over indexes], by adding credit risk to their portfolios, especially over the last five years," said Alex Bryan, director of passive strategies research at research firm Morningstar. "Anytime volatility picks up, you'll see more flows into Treasurys, and active managers taking on more risk will look worse than their index peers."

Since the financial crisis, assets have been migrating en masse from higher-cost actively managed funds to lower-cost passive funds that track an index. In the stock market, the numbers are staggering. If the trend continues, passively managed equity fund assets could top active within a couple of years.

It's happening in the fixed-income markets, too, but at a slower rate. Over the past five years, $629 billion in assets have flowed into passively managed bond funds and $206 billion has flowed into active funds. Yes, that's slower than the trend in stocks.

"We like the lower cost of Vanguard bond funds," said Barry Glassman, a certified financial planner and president of Glassman Wealth Services. "It's hard to justify paying higher fees when yields are so low."

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The Vanguard Total Bond Market Index fund, which tracks the performance of the broad market weighted Bloomberg Barclays US Aggregate Bond Index, has an expense ratio of just 0.15 percent.

While low-cost bond funds that track an index have become more popular, actively managed funds are still attracting plenty of cash from investors. Last year, the taxable bond category experienced the biggest inflows of any category tracked by Morningstar. Indexed mutual funds and ETFs attracted $210 billion and actively managed funds pulled in $179 billion.

In smaller, less liquid segments of the bond markets, however, there is a wider dispersion of returns on individual securities and active management is perceived as adding greater value than in the Treasury and investment grade bond markets.

"There's a perception that there is a higher return to fundamental research in the high yield market," said Bryan. "Active management is much bigger in high yield." At the end of April, actively managed junk bond funds held $247.5 billion in assets versus $41.6 billion in index funds.

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Active management is also more popular in emerging markets and municipal bonds, where credit risk is also a bigger concern for investors.

"The bond universe is so diverse," said Glassman. "Outside of traditional bonds, active managers have more opportunities to add value." Glassman, who prefers active management in market segments outside his clients' core holdings of Treasurys and investment grade bonds, added that "giving managers flexibility to invest where they see those opportunities is a positive."

Many investors also have issues with market cap weighted indexing in the bond markets. In the stock market, traditional market cap weighting can lead to heavy concentrations in the most popular stocks — the weighting of the FAANG stocks in the over the past several years being a good example.

In fixed income, market cap weighting means index funds are skewed towards the companies — or countries — with the greatest amount of outstanding debt.

"It's counterintuitive; with market cap indexing, you end up with the most exposure to the largest debtors," said Rick Harper, head of fixed income at Wisdom Tree Asset Management, one of the trailblazers in "smart beta" funds.

"We believe there is a better approach," he said.

Wisdom Tree starts with bond indexes and screens its components for desirable characteristics such as credit quality, yield or low volatility. It applies rules to the process — systematically doing what active fund managers do.

Active bond fund managers have had higher success rates beating their benchmarks than equity managers. But there is risk.
Alex Bryan
director of passive strategies research at Morningstar

Market cap weighting in the bond markets doesn't typically mean greater risk, but rather greater concentration in the biggest and often highest quality issuers. For example, the Bloomberg Barclays US Aggregate Bond Index — the broadest, most commonly followed benchmark in the bond market — currently has about a 40 percent weight in Treasury bonds and a 70 weight in AAA rated bonds overall. That's a recipe for low returns and provides an opportunity for active fund managers in the intermediate bond space to outperform by adding in credit risk on the margins.

"Active bond fund managers have had higher success rates beating their benchmarks than equity managers," said Morningstar's Bryan. "But there is risk."

With interest rates rising and credit spreads potentially widening further, the risk is growing. The simple strategy of adding in higher-yielding credit risk versus the more conservative indexes may not work going forward. In fact, it may work against them.

Investors follow performance, and if active managers start underperforming their index benchmarks, the migration to lower-cost passively managed funds will likely pick up pace.

"A lot of active managers are closet indexers," said Harper at Wisdom Tree. "They may soon find it hard to justify their higher fees."