In the second part of my series on bond fund management, I’m going to offer two more reasons to consider active management. Last time I discussed three important reasons to consider an active manager. This time, you’ll find two more reasons why holding on to passively-managed indices isn’t a great idea.
Index Constructions Isn’t That Great
I’ve mentioned that the most famous bond index is the Barclays Capital U.S. Aggregate Bond Index. So let’s compare this oh-so-important index to another of its creed: the S&P 500.
The S&P 500 Index is cap-weighted, so it invests more in large, even legendary, financially robust companies. This approach allows investors to own a larger share of mature companies with both growth and value opportunities.
However, allocations within fixed-income indexes are determined based on issuance. There is no cap-weighting. Instead, the index is weighted by how much debt an entity issues — the more debt issued, the larger the allocation within the index.
The largest issuers in the country are the U.S. Treasury and other government-sponsored entities, so its no surprise that they are the largest positions.
Therefore, if you invest in Barclays Capital U.S. Aggregate Bond Index, you are getting only those entities that issue a lot of debt. That’s about an un-diversified as you can get.
The contrast is that active managers have no such restrictions. Why increase a position in a bond if the issuance increases as well? Why overexpose yourself to one group of entities? Active managers can pick and choose to find a properly balanced portfolio.
What About Benchmarks?
Typically, bond indexes are created with the objective of earning total return. Index investors earn index returns, and that is the best they can expect to do. So no matter how great your fund may be, it will never beat the benchmark if it is passively managed.
Active managers seek to outperform the index, to beat that benchmark. That’s why you’re paying them. You want them to aim higher and to do so in a thoughtful manner without taking on undue risk.
A recent Morningstar report suggested that investors are willing to pay for active management. And why wouldn’t they? Given the comparatively low cost, and the chance to beat the index, it’s a good buy.
In the last five-year period ending in July 2014, passive index taxable bond funds raked in about $315 billion, while actively managed taxable bond funds took in $743 billion.
The risk you take with active management is if the manager doesn’t beat the index. Yet again, the cost is so low that vetting a manager should yield people who have a track record that makes spending your money worthwhile.
Active management remains a prudent strategy for fixed income investors, especially in the current environment. Active management has the potential to achieve higher returns and greater diversification while providing the desired level of liquidity.
About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]