Ask an investor if most active bond funds outperform their passive counterparts and the response is likely to be "no."
After all, if one investor beats the market, another must lag it. Active strategies incur higher fees, so the majority should underperform their lower-fee passive counterparts. Recent media coverage on the rotation from active to passive funds – although focused chiefly on the equity market – may only reinforce this perception.
Our research suggests otherwise – at least for bonds, if not for stocks.
As the chart below shows, the majority of active bond funds and ETFs beat their median passive peers after fees over the past 1, 3, 5, 7 and 10 years, with 63% outperforming over the past 5 years. In contrast, the majority of active equity strategies failed to beat their median passive counterparts during the period. Only 43% outperformed over the past 5 years; in every other period, the percentage is lower still.
Bonds are different
We believe the reason why active bond strategies have been more successful than active equity approaches for this period lies in the bond market's unique structure. Consider:
- Noneconomic investors make up roughly 47% of the $102 trillion global bond market.Central banks, insurance companies and other noneconomic investors typically have objectives other than generating alpha. Central banks, for instance, may buy bonds to weaken their currency or boost inflation and asset prices. Commercial banks and insurance companies may care more about book yield or credit ratings than total return. The result: noneconomic investors leave alpha potential on the table for active bond managers.
- The composition of bond indexes changes frequently. When fixed income securities join or leave an index, their prices tend to rise or fall as passive investors rush to buy or sell. Active investors seek to anticipate and profit from these changes.
- Bonds, unlike stocks, mature after a number of years, leading to more turnover in the bond market. New securities make up about 20% of bond market capitalization annually, compared with about 1% in equity markets. Importantly, they typically are offered at concessional pricing to drive demand. Yet these discounts are generally not available to passive managers, who tend to buy new securities when they join an index, often a couple of weeks after they've been issued.
- Structural tilts can be an important source of durable added value. Active managers, for instance, can target factors such as duration and exposures to high yield credit, mortgages, high yielding currencies and other sources of potential alpha.
In short, informational efficiencies make beating equity markets difficult. But we believe that's not the case with fixed income, where noneconomic and passive investors pursue agendas that are not exclusively about total return.
Put simply, bonds are different.
Jamil Baz is a managing director and PIMCO’s global head of client analytics
Management risk is the risk that the investment techniques and risk analyses applied by an active manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to an active manager in connection with managing the strategy.
Performance results for certain charts and graphs may be limited by date ranges specified on those charts and graphs; different time periods may produce different results. Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investors should consult their investment professional prior to making an investment decision.