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Bonds Are Different: The Active Advantage

Most active bond funds and ETFs beat their median passive peers over the past 1,3,5, 7 and 10 years.

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.

The figure shows two bar charts showing the percentage of active mutual funds and ETFs that outperformed their median passive peers, according to Morningstar data. One chart shows bonds, the other, equities. Bonds show much higher percentages of active funds that outperformed passive peers compared with those of equities over all time horizons. The charts show percentages for one year, three years, five years, seven years and 10 years. For bonds, the percentage of active mutual funds outperforming ranges between 50% and 70% for all categories, and are higher than the average of all bond categories over the long-term for intermediate, high-yield and short-term funds. By contrast, among all equity categories, the percentage of outperformers ranges between 30% and above 40%, depending on the time horizon. The ranges were generally lower than average for large growth, large blend, and large value.

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.

The Author

Jamil Baz

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Tokyo
PIMCO Japan Ltd
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Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized.

Past performance is not a guarantee or a reliable indicator of future results. PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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.