Mark Mitchell – FS Advice
Given the recent passing of Jack Bogle, who is largely considered to be the father of passive investing, we felt it might be a reasonable time to look at passive versus active investing in fixed income purely on its merits from an investor’s perspective.
There has been significant growth in demand for passive fixed income strategies. We see four likely drivers of this trend, the first and most obvious one being lower fees. On average passive strategies do tend to have lower fees than active ones, and who wouldn’t want to get something at a cheaper price? But of course, you have to make the distinction between price and value.
A second feature of passive strategies that appeals is their ease of use. These types of funds allow individual investors to get easy access to a much more diversified portfolio than would otherwise be practically possible. Unless you have a relatively large pool of capital, it could be challenging to construct your own appropriately diversified fixed income portfolio.
Another idea that seems to appeal to passive fixed income investors is the perception of liquidity, especially for exchange traded funds (ETFs) and exchange traded managed funds (ETMFs). We largely agree with this idea, but investors do have to understand that market makers could step away in an extreme scenario and the liquidity of the ETF will be impacted by the liquidity of the underlying assets. You have to be mindful of the underlying risks. In other words, not all liquidity is the same across ETFs and ETMFs.
One last point on the likely drivers of passive demand – it is our perception that part of the reason for the growth in passive fixed income investment is the assumption that what holds true for equities probably holds true for bonds. Unfortunately, the data does not support this idea (as we’ll discuss shortly). Anyone who invests a bit of time looking at the research would find it hard to draw the conclusion that economically they would be better off in a passive strategy, so the conclusions are either 1) they haven’t looked at the data or 2) they are less interested in economic outcomes and more focused on the other perceived benefits.
Looking at active management, let’s start with the most important idea: the data shows that active fixed income managers tend have a good track record of outperforming passive fixed income managers. According to Morningstar’s Active/Passive Barometer February 2019, the majority of Intermediate Term Bond and Corporate Bond funds outperformed their relevant passive peers over the last 10 years. Looking at low cost fixed income funds, 70-80% outperformed over same period. Contrast this with funds in the US large capitalisation sector equities where only about 10-15% outperformed over the same period.
In Australia we’ve seen the launch of a number of passive fixed income strategies. While they do meet the criteria of being low cost and easy to use, our concern is that many of them are arbitrarily constructed and poorly diversified. They appear to have a heavy exposure to Australian financial institutions and not much else. While we have a favourable view of this sector, we believe a more diversified portfolio approach will lead to better investment outcomes over time.
The rise of passive (or non-economic) strategies creates opportunities for active equity and fixed income managers. As an active fixed income manager, we welcome the dislocations and opportunities created by the growth of these strategies. However, we are loath to see uninformed investors pile in too aggressively as we don’t believe it will serve them well in the long run.
For investors looking for a simple low-cost exposure to fixed income, these passive strategies might make some sense. However, if your priority is better investment outcomes with lower risk it might make less sense. We believe in the old saying that “you get what you pay for”, and that most certainly rings true when considering the question of active and passive management in fixed income.