Active Management vs. Passive Management in Bond Funds

Negatively Managed Bond Funds

Negatively managed bond funds – also known as index funds – invest in a portfolio of bonds designed to match the performance of a specific index, such as the Barclays U.S. Aggregate Bond Index. Index funds hold the securities that comprise the index, or in many cases, a representative sample of the index’s portfolio. When the composition of the index changes, the portfolios of the funds also change. In this case, fund managers do not seek to achieve returns greater than the index – the goal is simply to match its performance.

Actively Managed Bond Funds

Actively managed bond funds are those where portfolio managers seek to select bonds that will outperform the index over time and avoid those they see as likely to decline. In general, they aim to find bonds whose values are mispriced or position the portfolio to benefit from expected interest rate changes. Active managers can adjust the average maturity and duration as well as the average credit quality of their funds, or position themselves across different sectors in the market. While actively managed index funds are less common, they do exist.

Key Differences

The key differences between active and passive funds are as follows:

• Fund Manager: Active funds involve a fund manager who makes decisions about the portfolio, while passive funds typically track an index.
• Fees: Active funds incur higher fees due to the trading, research, and management costs they require compared to passive funds. Sometimes, this is justified, but very few active funds can maintain their outperformance compared to indices over a long period.
• Trading and Taxes: Because actively managed funds continuously adjust their portfolios in response to market conditions, they have a much higher turnover rate than index funds, which change only when the underlying index changes. This can result in a larger tax bill at the end of the year, reducing after-tax returns for investors.
• Performance Variance: One of the main reasons investors may choose to invest in an actively managed fund is the assumption that the fund will be able to outperform the market over the long term. This may happen in reality, but along the way, even the best funds can experience years of weakness. In contrast, passive funds aim to achieve returns in line with the market, while actively managed bond funds can diverge, either up or down, from the return of the underlying index.

Which Strategy is Right for Me?

There are many factors that determine the success of your bond fund investment. Passive bond funds have lower fees and less turnover compared to active bond funds, meaning they do not negatively impact your returns. On the other hand, active bond managers tend to deviate from a passive index-based fund portfolio, meaning taking risks that can lead to huge gains. However, the performance of the fund is contingent on economic conditions and the efficiency of the fund manager. Nonetheless, selecting a manager who will outperform in the next five to ten years is much more challenging. Keep this in mind when selecting funds for your portfolio.

Frequently Asked Questions (FAQs)

What is a bond index fund?

A bond index fund is an investment fund that matches its portfolio to a bond index to simulate the index’s performance. Index funds are also referred to as passive funds because their portfolio only changes when the underlying index changes. This stands in stark contrast to actively managed funds where the fund manager makes adjustments to the fund’s portfolio. Bond index funds typically have lower fees and lower turnover compared to actively managed bond funds.

What

What is a high-yield bond fund?

A high-yield bond fund is a fund that invests in junk bonds. Bonds are loans made by investors to borrowers in exchange for interest. Bonds receive a credit rating based on the creditworthiness of the borrower (similar to consumer credit scores). The lower the rating, the higher the chance that the borrower will default. Bonds with low ratings and thus high risk are referred to as “junk bonds.” To compensate for the risk, these bonds offer the highest interest rates or high yields.

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Sources:

The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.

Morningstar. “Market Volatility Hasn’t Helped Active Funds Beat Their Passive Peers.”

Fidelity Investments. “Why Bond Investors May Benefit from Actively Managed Mutual Funds and ETFs,” Page 2.

Board of Governors of the Federal Reserve System. “Policy Tools.”

Investor.Gov U.S. Securities and Exchange Commission. “What Are High-yield Corporate Bonds?”

Source: https://www.thebalancemoney.com/active-vs-passive-management-in-bond-funds-416943