After a dismal 2022, it's true that bond valuations are now lower while yields and long-term expected returns are both up. But central banks aren't necessarily finished hiking interest rates and a recession is still likely. Both mean that we're probably not done with volatility over the short term.
Greater volatility can mean greater opportunity for active management. But greater opportunity does not necessarily guarantee greater outcomes. Before we explore this, let's look first at what puts the odds in favour of active managers.
Setting the odds in favour of winning active fixed income managers
Vanguard believes that both active and index investing can help investors achieve investment success. But our faith in the former is contingent on active managers meeting a number of criteria. These include:
- A deep and experienced team, with expertise across sectors and global regions.
- A clear investment philosophy and robust investment process. If a manager cannot explain their approach, stay away.
- A true-to-label approach with transparency. Bonds are meant to be a defensive asset class, so they should behave that way - with no surprises.
- Stringent and systematic risk controls, preferably with independent risk teams that can provide objective opinions and risk assessments.
- Relative consistency in performance and in the portfolio, not causing a whiplash experience for investors.
All these criteria should be packaged with low costs, as even the most talented managers cannot consistently overcome the hurdle of high operating and transaction costs. According to Lipper data for US-domiciled funds as at year-end 2022, the average five-year annualised return for the investment-grade intermediate fund category (which includes funds that we consider to be core bond holdings) lagged the return of the benchmark (the Bloomberg U.S. Aggregate Bond Index) by a mere 8 basis points, or 0.08 percentage points. According to the Investment Company Institute, the average expense ratio for bond funds in 2022 was 0.37%. Choosing funds with lower expense ratios alone stacks the odds more in favour of active managers.
The challenges facing active management
If it were easy for active managers to outperform their benchmarks in volatile times, then a larger share of managers would have outperformed their indices not just in 2022, but also over longer periods that capture varying environments for interest rates and inflation.
Instead, at best, the record was mixed. The chart shows the percentages of funds in select categories that underperformed their benchmark indices over various periods as at year-end 2022. The longer periods include a number of volatile years in bond markets - among them 2008, 2013, 2015, 2020 and 2022. The results demonstrate that active managers who can add alpha are a shrinking minority over longer periods, even when opportunities abound in the form of market disruption and wider dispersion of returns.
Fewer US active bond managers outpaced benchmarks over time
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: This chart illustrates the data for five representative categories from the last semiannual SPIVA U.S. Scorecard. The full scorecard had data for 17 fixed income fund categories and compared their performance against the relevant Bloomberg, Standard & Poor's or iBoxx indices as benchmarks. Over one year, 11 out of 17 categories had a majority (more than 50%) underperform; over three years, 12 of 17 categories had the majority underperform; over five years, 16 of 17 categories had the majority underperform; and over 10 and 15 years, 16 of 16 fund categories had the majority underperform (one fund category did not have a full track record over 10 and 15 years).
Sources: Vanguard, using data from the SPIVA U.S. Scorecard as at 31 December 2022.
The bottom line for investors
Identifying that shrinking minority in advance—the future elite among active managers who beat their benchmarks over the long run—is the real challenge for investors who choose to go down the active route.
But it doesn't have to be an "either/or" decision. There's room for both active and index investments in a portfolio. Ultimately, for investors, it's a matter of preference. Some might prefer the predictability (relative to market benchmarks) of index funds. Others have the appetite for potential outperformance and the risk tolerance to accept potential underperformance. Still others might combine both approaches.
For those who want active management, whether wholeheartedly or partially, the outlook for active fixed income is supported by where we are in the economic cycle. As the economy slows and different sectors and issuers diverge in navigating the contraction, some disciplined active managers will successfully separate the winners from the losers and dynamically adapt to new information and new conditions.
Although outperformance is never guaranteed, investors who use a disciplined manager selection process, coupled with low costs, increase the potential for positive and consistent alpha over the long term. Investors should have the patience to let these factors play out, not just in 2023, but over the next decade.
This post is funded by Vanguard
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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