Many investors underestimate the size of the fixed income market. Globally, bonds account for nearly…
Within the fund management sector, funds are generally categorised as active or passive depending on how actively the fund is being managed and whether it is aiming to outperform the market or more simply to closely mimic market performance.
For example, the Vanguard Australian Shares Index Fund (VAS) is designed to track the ASX 300 benchmark performance over the long-term (figure 1). This necessarily means that there is a consistency in the portfolio’s construction and that it should rebalance to maintain similarity with the benchmark index. In contrast, active funds aim to outperform a reference benchmark essentially through detailed individual stock research, macro-positioning, opportunistic trading or short-term arbitrages generated by market mispricing or information asymmetry.
Figure 1. Performance Comparison (Vanguard Australian Shares Index Fund ETF vs ASX 300)
Source: Bloomberg, BondAdviser
Compared to passive funds, active funds usually require high levels of manager expertise and knowledge about underlying assets and they charge a substantial fee for the additional expenses incurred for these services as well as to recoup higher costs from more frequent trading. In theory, the flexibility and opportunism afforded from active fund management offers investors a higher chance of capturing upside gains but may also increase downside exposures during times of economic downturns or poor investment selections by the manager.
Figure 2. Active and Passive management – Key Differences
However, the return/risk profile in actively managed funds (equity funds) does not appear very symmetric on a backward-looking basis. Despite many funds under active management exceeding market performance temporarily (especially during peaks of economic cycles), they have broadly failed to generate a justifiable excess return over a long timeframe. This is largely due to the more expensive fee structure and a higher risk-concentration (figure 2) from holding a smaller universe than passive approaches.
This is not to say that passive strategies are more rewarding than active strategies all of the time since there are a number of occasions where hedge funds have demonstrated a robust record of bettering market performance in the short run.
In contrast to equity trading, active fixed-income funds have maintained a good track of record of outperforming the market for quite some long time. One (deliberately not a Bond Adviser managed portfolio) recent example would be the Smarter Money Higher Income fund where total net returns consistently beat benchmarks.
There are however some structural advantages in fixed income markets which give active managers a performance edge. More specifically, fixed-income benchmarks are usually ‘poorly’ constructed, and include a large proportion of low-yielding government bonds and higher-grade corporate bonds (to reflect the market composition) but minimal or no high yield holdings. Active managers, with a larger investable universe are able to selectively position their portfolios and can achieve good diversity whilst posting reasonable gains which consistently beat ‘low’ benchmarks. Also, passive funds might lose opportunities as they are usually rebalanced at the end of a period (generally monthly) whereas active managers can trade more frequently as value is found. Actively managed fixed income funds can also offer other advantages which includes flexibility as well as lower trading costs from a lower overall turnover since they are not subject to rebalancing.
Given that we are in a rising interest-rate environment driven by a strengthening economy, we believe that improving fundamentals can continue to support the broad market performance, indicating that more stable gains can be captured from passively traded equity funds, although noting that valuations are very high. Fixed income investors, who have to navigate this environment as well as probably deal with unknown and as yet unexpected effects from the unwind of quantitative easing are probably better served through active management.