Active bond managers are having to work hard to convince investors that they can provide better value for money than passive strategies, finds Paul Amery
In equities, passive, index-tracking funds have witnessed a remarkable surge in assets since the turn of the millennium. According to Morningstar, over 40% of overall US equity fund assets were invested in index-tracking mutual funds and exchange-traded funds (ETFs) by 2016. Equity passive funds’ market penetration is sharply on the rise in Europe and Asia too.
But in fixed income, active managers have long claimed that things are different. The active approach, say its supporters, is better equipped than a naive index-following mandate to deal with the opaque pricing and illiquidity that is characteristic of the bond markets. Further, investing in a bond index that weights its constituents by their market value means, by definition, allocating more portfolio assets to the most indebted issuers, an approach that seems sub-optimal. “Index-tracking funds are the dictionary definition of ‘dumb money’,” wrote Kevin Murphy of active fund manager Schroders last June.
But despite these well-worn arguments, active bond fund managers are seeing their assets leak away to passive competitors, albeit at a slower pace than in equities. Passive funds’ market share in the US fixed-income market rose to 27% in 2016, compared with 20% at the end of 2013, according to Morningstar.
And index-tracking fixed-income ETFs staged a record year for asset gathering in 2016, despite signs that the multi-year bull market in bonds has passed its peak. Assets in ETFs tracking bond indices reached $594bn (€565bn) worldwide by November, a 10-fold increase since 2007, according to BlackRock.
Jim Moore, global head of investment solutions at PIMCO, is keen to stress that the arguments for indexing in equities cannot automatically be applied to the fixed-income markets. “Fixed income still differs from equities in important ways,” he says. “Bonds are still largely traded away from a central exchange and there’s an important human element involved when transactions are struck.”
“And bonds are idiosyncratic,” he adds. “As an example, Bloomberg shows that one issuer, JP Morgan, has 462 outstanding bonds, with different maturity dates, covenants, optionality and liquidity.”
Active fixed-income managers are keen to emphasise the illogicality of standard fixed-income index construction. “If you go passive you follow the behaviour of the index,” says Lionel Pernias, head of fixed income buy and maintain at AXA Investment Management in London. “There’s no way of distinguishing a good company from a bad company. In fixed income you can add value by doing your credit research.”
However, Pernias concedes that a low-turnover approach in fixed income, a key selling point of passive managers, is increasingly attractive. “Liquidity in investment-grade bonds has gone down since the financial crisis and we don’t expect it to improve any time soon,” he says. “Asset managers face higher trading costs, causing a performance drag. A decade ago the average bid-offer spread on an investment-grade sterling bond represented less than 10% of the annual yield. Now it’s over 25%.”
Unsurprisingly, given the potential drawbacks of weighting bond indices by constituents’ market value, interest in so-called smart-beta approaches is on the rise. Smart-beta indices use alternative weighting methodologies to avoid the concentration risks of standard indices.
Deutsche Asset Management, for example, offers indices which apportion weights to countries based on their fundamental economic strength, rather than the volume of debt they have issued. Similarly, PIMCO’s GLADI indices use GDP, rather than the amount of outstanding debt, as the basis for weighting sovereign bonds.
However, there are vocal opponents of smart beta approaches in fixed income. “It’s difficult to optimise an index if you have to examine the covenants, callable features and optionality in every corporate bond issue. You need to do your own homework to understand the risks you are taking,” says Pernias. “Factor investing in fixed income is also a big challenge,” he adds.
“Just crunching numbers is insufficient to assess the market’s liquidity. And you can’t necessarily compare accounting measures for companies operating in different countries on a like-for-like basis.”
“The genesis of a lot of smart-beta solutions in fixed income was the global financial crisis,” says David Lloyd, head of institutional public debt portfolio management at M&G. “But rather than examining where their own processes went wrong and why they priced risks incorrectly, some fund managers decided to blame the benchmark. That’s ducking the issue, in my opinion, as well as relying on hindsight.”
“The important thing is not to overpay for the services you receive. Costs matter”
“New issuance is much more important in fixed income than in equities. New equity issuance represents around 1% each year of the market’s overall capitalisation, whereas in US investment-grade credit it’s 19-20% a year,” says Moore. “A passive fund is tied to an index, which typically rebalances at the end of each month,” he adds.
“If a new issue comes to market mid-month with a price concession, the index fund could help its performance by buying it, but the fund risks tracking error by dealing away from the index rebalancing date. And there’s no guarantee that the index fund will receive a full allocation – a fund manager’s overall relationship with the underwriter is important.”
The removal of bonds from indices for other reasons, such as credit-rating downgrades, also puts passive funds at a disadvantage, argues Lloyd. “Every time a bond gets downgraded to below the investment grade threshold some passive funds become forced sellers,” he says. “In our experience, downgrade announcements are nearly always the worst time to sell.”
However, Julien Bouillat, head of ETF portfolio management at Deutsche Asset Management, disputes the assertion that passive fund managers’ hands are unnecessarily tied by index rules. “We can buy a new issue during the month, knowing that it is likely to enter the index at month-end, as an alternative to buying it on the rebalancing date in the secondary market. We’re always looking to place trades with minimum market impact and we can add a lot of value for clients by getting that decision right,” says Bouillat.
“We have leeway to manage our portfolios when aiming to match index returns,” says Paul Malloy, European head of fixed income at indexing giant Vanguard. “We focus on replicating broad risk factors, rather than holding every bond in the index.”
Ultimately, the battle between active and passive in fixed-income fund management may come down to an intensifying argument over the costs of intermediaries’ services. Costs have been at the forefront of recent regulatory reviews of the asset management sector, both in the US and the UK.
“There may be some index-related inefficiencies that active fixed-income managers could exploit,” concedes Malloy. “But they are likely to be worth basis points a year in performance, not percentage points. The important thing is not to overpay for the services you receive. Costs matter.”
Malloy’s assertions are supported by data from fund research service Morningstar. In its June 2016 Active/Passive Barometer, Morningstar showed that 39% of actively managed US intermediate-term bond funds survived and outpaced their passive counterparts over 10 years. Active managers did better in bonds than in equities, where only 15-30% beat index funds, but still fewer than half of the sample produced the 10-year performance to justify their higher fees.
While active funds may advertise their greater competitive edge in fixed income, it seems they will need to back their assertions with performance, or cut costs, to avoid losing even more market share to index trackers.