With seemingly perpetual low interest rates—and even the threat of negative interest rates, as seen in parts of Europe and elsewhere—does it make sense to pay for active management in fixed-income mutual funds? One view is that it makes more sense to go the passive route with low-cost bond ETFs when rates are this low, since it sidesteps the high fees that active managers must overcome before they can even start to add value.
But another view is that in the search for higher yields, active bond managers may have an advantage, especially if they are able to use “go anywhere funds” that allow more flexibility to choose the best investments. For instance, they could extend bond duration, take on more credit risk, move to higher-yield or “junk” bonds, emerging-markets debt or other special situations.
So, what’s the best approach for fixed-income investments: passive or active? We’ll look at the arguments for and against both strategies below.
The pro-passive camp
The lower cost of passive investing provides a big advantage both in stocks and particularly in fixed income, says investor advocate Ken Kivenko of Toronto-based Kenmar Associates. Former Tangerine advisor Dale Roberts, who blogs at Cut the Crap Investing, agrees that although investors might be inclined to think active management can add some value in the fixed-income arena, SPIVA studies show bond fund managers underperform the passive benchmarks—especially after you add in an advisor’s fee.
Indeed, with fixed-income yields so low, fees consume a disproportionate portion of those yields, and thus any available returns. Besides, Roberts adds, investors have the required passive bond ETFs in their portfolio toolkit. “We can shape the portfolio with core bond funds, higher yield, more tax-efficient bond funds, and classic treasuries that are known as the greater risk managers.”
As for the argument that active bond managers may be able to get higher yields using junk bonds, Michael Wiener, the blogger behind Michael James on Money, believes the premium that investors get for lower-quality bonds is almost always too small. “Bond Rating Agencies can’t be trusted to get their ratings right,” he says. “I’d rather seek higher returns by buying more stocks or tolerate low returns in short-term Canadian or U.S. government bonds.”
While one fee-for-service financial planner, who asked for anonymity, suggests a nearly 40-year bull market has lulled investors into thinking passive is automatically best—which may not hold true into the future—he concedes funds need to cut their MERs to be competitive. “When this megacycle turns, active management may be the winner,” he says. “But the investor won’t see the results if outperformance is eaten up in management expenses.”
GICs and high-interest savings accounts for short-term needs
Costs are so important when it comes to most bond funds that investors are better off with very low-fee products, says value stock picker Norman Rothery of the Stingy Investor blog. A simple Guaranteed Investment Certificate (GIC) ladder, for example, is competitive with many bond ETFs these days, while good high-interest savings accounts can replace short-term bond ETFs. “The only area that might be an exception is high-yield bond funds, which should really be viewed more like equity funds,” he says.
Retired advisor Warren Baldwin agrees costs are particularly critical in this low-rate environment. “If you’re paying 1% plus to own the [bond] fund, where is the value add?” he says. While it might be achieved by tilting more to corporate bonds, he’s not opposed to a strategy of going 50/50 with GIC ladders and bond fund ETFs. This combination works well because GICs* tend to be less liquid, but you can always get cash instantly with bond funds, he says.
One popular shop for fee-based advisors like John De Goey, of Toronto-based Wellington-Altus Private Wealth Inc., is index mutual fund provider Dimensional Fund Advisors (DFA). “As with stock products, I would agree it is likely hard to justify if the choice is between passively and actively-managed. The real factor, however, is cost, not structure.” De Goey says anyone licensed to sell securities and/or ETFs who recommends traditional bond mutual funds is “doing their clients a disservice.”
If you compare MERs of the F-class versions of fixed income mutual funds provided by the big embedded compensation firms through both a Deferred Sales Charge (DSC) and front-end load with the low- or no-commission camp (profiled in “The best mutual funds you probably never heard of”) it appears the fee differential is marginally more pronounced with fixed income than it is for the equity fund comparison.
For his part, Mark Seed, who runs the My Own Advisor blog, believes GICs are currently a better bet than bond funds. However, bond mutual funds and bond ETFs provide more liquidity for rebalancing fixed-income exposure beyond Canadian borders, while GICs seldom do.
The case for actively managed longer-term fixed-income funds
If you want to make the fixed-income portion of your portfolio work harder, can active management generate higher net returns? Here, expert opinion is mixed. Whether or not you believe active stock management can pay off, a surprising amount of evidence indicates active can indeed work in the fixed-income space.
A recent article in MarketWatch (Dec. 16, 2019), for example, cites research by Guggenheim Investments showing that bond funds perform better under active managers. The global asset management and investment advisory firm found that, over five years, active intermediate-term bond fund managers outperformed their benchmark 57% of the time, even as the average active large-cap stock fund manager underperformed the S&P500 100% of the time over the same period.
Why this discrepancy between actively managed equity and bond funds? With 3,600 publicly traded U.S. stocks, the equity market is hugely efficient, the Guggenheim report suggests. But the fixed-income universe is “sprawling, diverse and huge,” and has less transparent pricing than equity markets.
An August 2019 paper by Aegon Asset Management, High Yield: The Drawbacks of a Passive Approach, underlines the point: “Investors may choose a passive strategy as a relatively inexpensive way to gain broad market exposure and generate index-like returns. While this may hold true for equities, we believe this expectation is flawed when it comes to fixed income, particularly lower-quality or less liquid credit.”
Some of the lesser-known active managers do seem to add value when departing from the broad bond indexes. Over the 10 years ended Sept. 30, 2019, Leith Wheeler Core Bond Fund returned 4.1%, versus 3.2% for the median bond fund. In late 2019, performance was aided by an overweighting in short-dated corporate bonds as well as more complex interest rate curve strategies that outperformed the benchmark.
Active management of bond funds also lowers volatility, says Leith Wheeler fixed income high yield manager Dhruv Mallick. “Most people think of bond ETFs as generally tracking the index, but ETFs can actually deliver significantly higher volatility than the indices they’re trying to replicate,” he says. Over the last four years, the iShares U.S. High Yield Bond Index ETF not only lagged the broad High Yield Index by nearly 1% per year (5.98% vs. 6.94%) but did so with a standard deviation (volatility) of 6.87%, versus the index’s 3.84%. “Passive high-yield investors in this fund got a really raw deal,” he notes.
While the Leith Wheeler High Yield Bond Fund was slightly behind the index over the last four years (but ahead since inception), Mallick says the process is much closer to managing a stock portfolio. “We keep it fairly concentrated (40 to 45 names), but our credit-analysis and portfolio-risk controls contributed to the modest risk profile—exhibiting even lower volatility than both of the reference indices, at 3.16%,” he says.
Over at Beutel Goodman, senior vice president of fixed income Derek Brown says most bond managers add value beyond the benchmarks over time on a gross basis, although many do not on a net-of-fee basis. So, if all you want are income-producing vehicles, then GICs* or high-interest savings accounts may suffice, he says. But if you want fixed income as a more strategic risk-mitigation tool to offset equity risk, then active management may add some value. Here, fixed-income active management should be viewed as a form of insurance. “When the economic environment deteriorates, active managers have historically tended to outperform [as in 2008-2009 and 2015-2016],” he says.
Brown adds that we have been in a bond bull market since the early 1980s, as interest rates plummeted from 15% to 1%, providing strong returns to bond investors. He doubts interest rates will go negative in North America, which means they “will likely rise over time,” increasing the need for active management. Retail investors may not realize the passive Canada Universe benchmark is more suitable for institutional than retail investors, he says: interest-rate risk of the index has risen, with two-thirds of the risk coming from 10- to 30-year bonds. It can be dangerous to buy a passive bond ETF when you get into the lower-credit-quality products, such as emerging-market bond ETFs or high-yield bond ETFs, says Brown.
Problems with indexing fixed income
An article by Canso Funds entitled “The Problem with Fixed Income Indexation” touches on both sides of the active/passive issue. “Bond managers make important choices on term, yield-curve positioning, sector, and issuers on a continuous basis. A manager can make a fabulous call, only to be wrong a few months later,” it states. “This makes bond indexing a very attractive option.”
On the other hand, a major weakness of bond indexation is issuer choice, the article says: “Unlike equity indexation, bond indexation is inherently slanted towards making wrong issuer choices.” Indexers tend to reward government deficits, (“Witness Japan,” the piece points out), but governments that are heavily increasing their debt issuance are not usually the best investments.
Furthermore, passive fixed-income products expose investors to outsized risk late in the credit cycle, says Mallick. “If you have not, for example, high-graded the quality of your holdings before defaults rise (or, more accurately, before the market starts discounting the risk of higher defaults), you’re accepting that you’ll incur losses when that eventuality occurs. Active management, therefore, becomes that much more important.”
A balanced approach is key
With the emergence of go-anywhere bond strategies, private market investments, income-paying equities and the like, there is a lot of yield chasing going on—which adds to portfolio risk, says Highview Financial Group vice-president and principal Dan Hallett. But, as he cautions here, investors would be wise to think twice before replacing supposedly risky bonds with “safe” stocks like high dividend payers, utility stocks and real estate investment trusts (REITs). In short, he still believes in balanced portfolios that include both stocks and bonds, whether held in bond mutual funds, bond ETFs, or both.
For Adrian Mastracci, senior portfolio manager with Vancouver-based Lycos Asset Management Inc. the active vs. passive debate is beside the point. “Investing is not [just] about getting the highest returns,” he says. If it were, there would be no need for bonds, GICs*, T-bills, etc., because a “100% equity portfolio would be just the ticket.” For his money, “A well-diversified portfolio that follows a prudent asset mix is the best medicine.”
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