Picking Through the ‘Dystopian Hellscape’ of Active versus Passive Bond Performance

When “the last humans are roaming the earth, picking through dystopian urban hellscapes in search of food, they will still manage to argue about the relative merits and demerits of passive investing,” mooted FT journalist Katie Martin, in the paper’s Unhedged blog.

It is indeed a perennial favourite bunfight of the fund world. I’ve stumbled across two irate iterations on LinkedIn this morning, and I wasn’t even looking. The argument has generally been fought on the terrain of equities. And, indeed, the shift from active to passive—particularly in the US—has been huge. But there is also a significant and seemingly accelerating shift happening in fixed income. For example, last year active bond funds suffered redemptions of £7.61bn, while passive funds took £18.17bn. For the first half of 2024, those figures are -£12.87bn and £22.01bn, respectively.

Earlier this year, we looked at whether investors had made the right decision in migrating from active to passive equity funds, focusing on Equity UK funds. Comparing the performance relative to benchmark of active versus passive funds, we found that, on average, investors had been rewarded for this trade.

Does the same logic hold for fixed income?

Recently, I heard it argued (unsurprisingly by an active bond fund manager) that the dynamics of active versus passive for bond funds were different than for equity funds. This is because bond indices are weighted relative to the amount of outstanding debt, so in the corporate bond market, indexed investments are ploughing ever more into the most debt-bloated companies. Active managers have the capacity to depart from this, overweighting less indebted, and therefore potentially healthier companies, while avoiding those sluggish debt-gorged beasts.

Sifting through the numbers

It seemed a plausible thesis, so I thought I’d see if the numbers back it up. The following analysis looks at the performance of active and passive bond funds relative to benchmark, rather than in absolute terms, to determine whether active managers have been able to deliver value to their investors on this basis.

The sample is comprised of funds from the Bond EUR Corporates, Bond EUR High Yield, Bond GBP Corporates, Bond USD Corporates, and Bond USD High Yield Lipper Global Classifications, as these had enough primary share classes registered for sale in the UK to make meaningful comparisons between active and passive performance.

As in the equity analysis, I’ve taken a 10-year period from 2014 to 2013 and looked at average performance after charges on an annualised, three-year rolling, and five-year rolling basis (charts 1, 2, and 3, respectively—see below).

On an annual basis, active managers outperform passives on three out of 10 years, most significantly in 2020, by 43 basis points (bps). However, passives outperformed active by the largest margin in 2022, by 120 bps. The average annual outperformance of passive over active was 37 bps. In each of the five Lipper Global Classifications, active managers underperform passive on an annualised 10-year figure relative to benchmark.

As can be seen from charts 2 and 3, passive beats active on each of the rolling three- and five-year periods.

Attentive readers will notice that there are a few periods where passive funds outperform their benchmarks—something that, after costs, would seem unlikely. However, there are a number of reasons why passive portfolio returns can diverge from the indices they track, such as the method of replication, where use of swaps or sampling can lead to divergences.

Of course, the top active performers will always leave the trackers way behind. Of those active funds with a full 10-year track record, the top one by relative return beats its benchmark by a cumulative 71.84 percentage points. But the inverse is also true, as the bottom active fund underperformed its benchmark by 57.79 percentage points. Given the relative volatility of the asset class, it’s perhaps no surprise that both funds are Bond USD High Yield.

Ms Martin, however, is correct: this research is far from any final word. While the fund universe is more than 700, and the metrics and data used both robust and standard, different methodologies and samples will yield different results. Our descendants will doubtlessly continue to hurl abuse and desiccated rat fragments at one another in the ongoing active/passive feud.

Chart 1: Bond fund returns relative to benchmark, 12-month discreet periods

Source: LSEG Lipper

Chart 2: Bond fund returns relative to benchmark, three-year rolling periods

Source: LSEG Lipper

Chart 3: Bond fund returns relative to benchmark, five-year rolling periods

Source: LSEG Lipper