A few weeks ago a headline grabbed our attention: active bonds funds are better because passive funds buy “more of the worst”. The argument is that the most indebted companies have the biggest index weights, leading to poor performance. However, the data does not support this thesis: most active bond funds underperform just like their equity peers.
According to S&P Dow Jones’s SPIVA database, 41% (credit funds) to 99% (core plus funds) of active bond funds underperform over 5 years. No category has most managers outperforming over 10 years as even credit rises to 64% underperformers. Unsurprisingly, picking managers also doesn’t work as less than 15% of 1st quartile funds remain 1st quartile 2 years later. After 3, most end up in the bottom half or change strategies outright.
There are a few reasons for this. Paying 0.75% in fees for a 5%-yielding fund has a material impact on returns. But trading costs are also key – in the U.S. there are more than 20,000 bonds, many of which cost a lot to trade. Active funds often seek out smaller and less liquid bonds to outperform, incurring higher trading costs along the way. In addition, for U.S. taxpayers, all that trading leads to higher year-end taxes as funds distribute gains.
Lastly, the “more of the worst” argument was debunked ages ago. In stocks, a high market cap must be paired with earnings and growth to determine value. Similarly, a high amount of outstanding bonds can’t be viewed in isolation. Companies with high cash balances overseas, hard assets, steady earnings and high free cash flow can easily handle more debt. Context matters.
To be sure, picking bonds can matter for long-term buy-and-hold strategies. But for total return, bond ETFs solve most of the above issues. We can target our desired duration, credit, currency and geographical exposure profile. We can tilt to up-in-quality bias within high yield, between local and hard currency EM, etc. All the while we pay lower management fees, transact at lower bid offer spreads, have lower turnover and can change portfolios quickly if needed. The proof is in the data – we’ve outperformed in global bonds for 9 of the last 10 years, entirely via ETFs.
DISCLOSURES
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Active portfolio management, including market timing, can subject longer term investors to potentially higher fees and can have a negative effect on the long-term performance due to the transaction costs of the short-term trading. In addition, there may be potential tax consequences from these strategies. Active portfolio management and market timing may be unsuitable for some investors depending on their specific investment objectives and financial position. Active portfolio management does not guarantee a profit or protect against a loss in a declining market.
Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.
