Active management has a proven edge in the bond market, according to a new study by global fixed income giant PIMCO, where almost two-thirds of index-ignorers have outperformed passive peers in the US.
The PIMCO analysis found more than half of US active fixed income mutual and exchange-traded funds (ETF) beat the average passive counterpart manager after fees across all time periods it measured (from one to 10 years) “with 63 per cent of them outperforming over the past five years”.
“In contrast, only 43 per cent of active equity mutual funds and ETFs outperformed their median passive peers over the past five years,” the PIMCO report says.
Likewise, the study found over half of all US active bond funds outperformed their respective pure benchmarks after fees and across all time periods bar the 10-year stretch (which included the possibly distorting effects of the GFC where spreads and illiquidity bumped up fixed income trading costs that were not reflected in the index).
Broken down by category, PIMCO found only high-yield active bond managers underperformed the benchmark – a result consistent in all time periods covered in the study. Only 35 per cent of active high-yield fixed income funds returned above-benchmark after five years, representing the best result in the time series under scrutiny.
“Although the percentage of active funds and ETFs outperforming their benchmarks for [the high-yield] category appears low, 81 per cent outperformed their median passive peers over the same five-year period,” the report says. PIMCO says the apparent contradiction reflects the fact that lower liquidity and relatively high transaction costs in the high-yield market make it difficult for passive managers to closely track index returns.
Well under half of US active equity managers, meanwhile, failed to return above their respective indices across all time periods and sub-categories included in the study.
In the ‘Bonds are different: active versus passive management in 12 points’ report, PIMCO says the fixed income market has a few index-repellent features compared to equities that may explain the divergent results between the two asset classes, including:
- the large proportion of noneconomic bond investors;
- benchmark rebalancing frequency and turnover;
- structural tilts in the fixed income space;
- the wide range of financial derivatives available to active bond managers; and,
- security-level research and new issue concessions.
For example, the PIMCO report says almost half of the US$102 trillion global bond market is owned by ‘noneconomic’ investors such as central banks and insurance companies that typically buy fixed income instruments for reasons other than maximising returns.
“To the extent [noneconomic bond-buyers] constraints are binding (most of them are), by construction, economic investors tend to outperform noneconomic investors, as the former buy cheap fallen angels from the latter and sell them expensive high-coupon bonds,” the study says. “Active managers potentially may also be compensated by passive managers for providing them with liquidity around changes in index construction.”
Compared to equities, the bond market also has a much higher turnover rate – where about 40 per cent of the latter index changes hand in an average year compared to 4 per cent of the former – and higher concentration of new issues (20 per cent per annum compared to less than 1 per cent for the share market).
Despite the downside of index-hugging in the fixed income space, the PIMCO report says passive investing has its place, particularly in keeping active managers honest in “highly efficient and liquid” marketplaces.
While market dynamics will ensure active investment strategies continues to have value, if the balance tips too far towards passive investing there was a strong potential for “free riding, adverse selection and moral hazard”, the study says.
Furthermore, the report – authored by PIMCO executives Jamil Baz, Ravi Mattu, James Moore and Helen Guo – says the passive management ideal as simply holding the entire market will always remain a fantasy.
“The market is an ever-evolving set of assets that need to be traded actively for replication purposes. This is more acute with securities that have finite lives and regularly return capital,” the study says. “… after all, there is no such thing as passive, just different shades of active management.”