The advantages of index funds over their actively managed counterparts are well-known: Their fees are lower, they provide extensive diversification, and the risk of severe underperformance by an individual manager is taken out of the equation.
In the bond world, however, there are times when indexing has pronounced disadvantages, and when an actively managed approach makes more sense.
Now might be one of those times.
The Limitations of Bond Index Funds
Whether in mutual fund or ETF form, the typical bond index fund that tracks the Barclays U.S. Aggregate Index offers low fees and decent — if unspectacular — past performance.
Two prime examples are the Vanguard Total Bond Market ETF (NYSE:BND) and its mutual-fund counterpart Vanguard Total Bond Market Index Fund (MUTF:VBTLX). The funds have rock-bottom expense ratios of 0.1% and 0.11%, respectively, 30-day yields of 1.66% and three-year average annual returns of about 5.3%.
That’s not a bad profile, but it’s also important to consider that funds benchmarked to the Barclays Aggregate have weightings of about 37% in U.S. Treasuries, 31% in mortgage-backed securities and 21% in corporate bonds. That means the funds are both highly rate-sensitive and heavily tilted to the segments of the market that offer the least favorable profile of return potential and downside risk.
This shows in recent returns: Since Nov. 30 — a time in which the yield on the 10-year Treasury note has moved from 1.61% to 2.01% — BND has shed 1.6%, erasing nearly a year’s worth of income. If rates continue to rise in the months and years ahead, index funds are in jeopardy of losing more in principal than they pay out in income … maybe much more.
This underscores a second problem with index funds: Since they are constrained by the holdings of the underlying index, they lack the ability to invest in high-yield or emerging-market bonds. While both of these asset classes also are extended at this point, they also offer less rate sensitivity than the investment-grade portions of the market. Further, index funds’ inability to move into these areas takes away a source of potential yield — one reason they currently offer yields that are only in mid-1% range.
Global or international index funds have a separate problem, but one that’s no less troublesome: They hold their heaviest weightings in countries that have the most debt. And higher debt, of course, is a sign of poor issuer health and a problem that can lead to weaker returns over time. For example, SPDR Barclays International Treasury Bond ETF (NYSE:BWX) holds 22.8% of its assets in Japan — the country with the worst debt-to-GDP ratio in the world. As a result, investors in passive international bond index funds might be taking on more risk than they realize.
The Case for Active Management
Given the limitations of index funds — and taking into account that the bond market as a whole offers an asymmetric risk/reward profile — bond investors might want to take a closer look at actively managed funds whose managers have strong track records. At this stage, having a skilled manager who can actively seek opportunity, avoid risk or raise cash could be a major plus.
Certain funds already are benefiting from their active style. The highest-profile example is Bill Gross’ PIMCO Total Return ETF (NYSE:BOND). Since the fund’s inception on Feb. 29, 2012, BOND has racked up a total return north of 12% — a time in which the Barclays Aggregate has only gained about 2.4%. In that same period, Jeffrey Gundlach’s DoubleLine Total Return Fund (MUTF:DBLTX) has registered a gain of 7%, while the Loomis Sayles Bond Fund (MUTF:LSBRX), managed by Dan Fuss, is up 9.3%.
For the time being, investors who want to look further into actively managed funds will largely be confined to the world of mutual funds rather than ETFs. According to XTF.com, only 20 of the 222 bond ETFs are actively managed, with the bulk of the assets invested in the PIMCO Total Return ETF ($4.1 billion) and PIMCO Enhanced Short Maturity Strategy Fund (NYSE:MINT, $2.2 billion). Still, this is an area that appears likely to grow in the years ahead following the success of BOND and the recent introduction of WisdomTree Global Corporate Bond Fund (NASDAQ:GLCB).
The Bottom Line
The potential for weaker bond market returns in the coming years makes a strong case for actively managed strategies rather than passive approaches that expose investors to the potential impact of rising rates. The expense ratios of actively managed funds might be higher, but investors might find that they get what they pay for.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.