Bonds are very different from stocks, particularly when it comes to active management and it does not only have to do with odd personalities…. Active bond managers outperform their passive peers, a PIMCO Quantitative Research report noted. There are reasons for the divergence, the report noted, as well as reasons for concern regarding the passive takeover of investment markets.
Active bond managers outperform their passive alternatives
On a ten-year basis, actively managed bond funds outperformed their passive investment ETF peers, the PIMCO study shows.
It was short and intermediate bond funds that outperformed their passive ETF investment competition most consistently. Short term bond funds outperformed their passive alternatives 80% of the time on a 1-, 5- and 7-year basis. Intermediate bond funds beat 70% of similar passive ETFs on a 1-, 5- and 7-year basis.
Contrast this with active equity managers and their passive counterparts. Active equity funds, by contrast, only outperformed their passive ETF counterparts less than 40% of the time across most time horizons.
There are numerous reasons for the differential, PIMCO observes in its April 2017 report titled “Bonds Are Different: Active Versus Passive Management in 12 Points.”
Report authors Jamil Baz, Ravi Mattu, James Moore and Helen Guo point to seven primary points of difference that allow active bond managers to outperform their equity counterparts by such a notable margin and on a consistent basis.
Active bond fund managers outperform for specific reasons
There are a wide range of financial derivatives available to active bond managers that are not available to stock pickers, the report noted. With a host of low cost derivatives offering cheaper holding costs than the physical product, active bond managers can use currency SWAPs, listed futures and credit default SWAPs to engage in what PIMCO categorized as “smart” strategies such as carry, value and momentum, each of which “have historically displayed substantially positive Sharpe ratios.” PIMCO founder Bill Gross was known to be an early advocate for derivatives-based strategies.
The bond market is filled with noneconomic investors which make active investing more profitable, the report noted. Central banks buy bonds to depreciate their currency exposure, for instance, while banks and insurance companies hedge yield exposure. In fact, by PIMCO’s accounting such noneconomic buyers make up nearly 47% of the $102 trillion global bond market.
Another factor influencing the outperformance of active bond managers is the rebalancing, which can cost more in bond funds. Further, new issuance can influence the differential. “The contribution of a strong presence in the new issuance market to performance for equity would be much less significant compared with that for bonds,” the report observed. In stocks “listed companies today are bigger, older and better established than they were two decades ago,” as “greater informational efficiency” has led to “fewer material mispricing in the U.S. stock market.” In bonds, where research is not as prevalent, the opportunity for an active bond manager to find opportunity is greater.
Other factors in active bond funds outperforming their passive counterparts include new issue concessions and structural tilts in fixed income that favor active managers.
In the active versus passive debate, there has always been the issue beyond returns. What happens if the entire stock market becomes passive? Will the market’s role in price discovery be compromised?
Here PIMCO weighs in on the affirmative.
“At a macro level, we believe that a purely passive market would cause severe market risk and resource misallocations,” they concluded, pointing out that the best markets are those with a balance of passive and active funds. “There is reason to believe that, unchecked, passive management may encourage free riding, adverse selection, and moral hazard.”