Many investors regard passively managed index mutual funds or ETFs as favorable options for stock investing. However, they may also find that actively managed funds offer substantial advantages for bond investing. While passive strategies often outperform in equities, the same cannot be said for fixed income.
In stock markets, investors can buy or sell shares of a relatively limited number of companies, and the valuation, purchasing, and selling processes are efficient. In contrast, bond markets are significantly larger, more complex, and less efficient.
Even experienced equity investment managers frequently find it challenging to outperform established market indices such as the S&P 500 consistently. However, the bond market's size, complexity, and inefficiencies have historically allowed skilled active managers to outperform those of well-followed ‘benchmark’ indices.
To appreciate the significance of active management, it’s essential to realize the bond market's size. The investable bond universe is so extensive and varied that even a broad index like the Bloomberg US Aggregate Bond Index (Agg) reflects less than half of the overall market. Therefore, selecting an index fund that exclusively tracks the Agg excludes most potential bond market opportunities.
Compared to equities, fixed-income securities have significantly less information about them, reduced liquidity and price discovery, a larger market size ($55 trillion versus $44 trillion), and a greater number of securities, particularly when considering various durations and credit ratings. These factors increase opportunities for savvy, active managers to generate alpha.
Every security is chosen in an actively managed bond portfolio because it offers potential opportunities. Active managers have the flexibility to modify the portfolio based on market dynamics, which can help mitigate risks and improve returns. In contrast, a passive index-tracking bond strategy comprises a portion of the market that might not always meet investor preferences.
Unlike a stock index that mimics a selection of specific companies, the constituents of an index like the Agg—which encompasses a broader range of assets—can vary considerably over time. These changes can significantly influence the index's performance and characteristics. For instance, US Treasury bonds constituted 35% of the Agg in 2014, but this share surged to 44% by 2024. This rise was not the result of a manager focusing on opportunities in Treasurys; instead, it came from the government increasing its bond issuance to meet escalating deficit spending. Therefore, during this period, a passive index-tracking fund would have been required to raise its Treasury holdings to keep pace with the Agg's evolving composition, potentially negatively impacting the portfolio's returns and risk profile.
The bond market's extensive size, intricacies, and inefficiencies often lead to differing opinions on bond valuations. Active managers can generate value for their clients by pinpointing mispriced bonds, purchasing undervalued ones, and selling those deemed overvalued. Active managers can analyze various factors and decide which bonds to purchase or sell to attempt to outperform the index. They can also adjust credit and interest-rate risk levels based on changing market conditions, allowing them to identify lucrative investment opportunities that passive strategies might overlook. On the other hand, passive funds focus on mirroring index structures without considering valuations or fundamental aspects.
In addition to being able to research and trade a broader selection of bonds than a passive strategy, active bond fund managers possess the flexibility to modify key portfolio attributes to potentially enhance total return (the yield produced from both interest income and capital appreciation from rising bond prices).
For example, fluctuations in bond prices due to changing interest rates can significantly impact a fund’s total return. While a passive fund must adhere to its benchmark's composition regardless of rate movements, an active manager can strategically modify a portfolio to capitalize on shifting rates and address the resulting volatility. For instance, if the Federal Reserve's interest rate hike were to depress bond prices—and subsequently, the Agg—a passive fund would follow the index downward, detrimentally affecting an investor's portfolio value. In contrast, an active manager could mitigate the effects of the rate hike by acquiring shorter-maturity bonds that tend to be less responsive to rate changes while avoiding those likely to decline in value as rates rise.
David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning (https://whartonwealthplanning.com/). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.