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Nimble fund managers are going to need to be essential.

The Case For Fixed Income Active Management

If your clients have passively managed fixed income funds, it may be time to get out.

With the current angst over interest rates, and last year’s tumult over the exit of Bill Gross from PIMCO following a few years of underperformance in his Total Return Fund, does it still make sense to have a high-profile, actively managed bond fund in your clients’ portfolios?

Champions of active management say that nimble bond fund managers are going to be essential as the market navigates higher rates, which may be coming later this year. Those in the passive camp say the benefits of that agility are oversold and the funds aren’t worth the extra management expense.

But rate hikes are coming, maybe as early as late spring or early summer. Federal Reserve Chair Janet Yellen told the Senate Banking Committee on Feb. 24 that the Fed is considering the move “on a meeting-by-meeting basis,” although many pundits believe that improving job growth (the jobless rate is now at 5.5 percent) puts the Fed in its comfort zone to raise the rate.

The uncertainty over the Fed’s ultimate decision puts many investors in a quandary: Do you stick to fixed allocations with total market bond funds that index the market? That strategy has worked longer than many might have expected, and may continue to do so. Or do you go with an active manager to hopefully avoid some of the hurt that will likely come when bond prices fall?

“There are benefits to having actively managed bond funds,” notes Sumit Desai, an analyst at Morningstar. “Sometimes passive funds find it difficult to navigate through illiquid bond markets during times of heavy redemptions.”

To date, despite the outflow of money after Gross left PIMCO last year for Janus, the bulk of investors seem to favor actively managed intermediate-bond mutual funds.

Of the more than $1 trillion invested in this category, more than $750 billion is actively managed, with $262 billion in the passive camp as of January, according to Morningstar. In exchange traded funds the roles are reversed, with $68 billion in passive funds and only $2.5 billion in the relatively new actively managed ETFs.

Proponents of passive management point to the low costs of holding nearly the entire U.S. bond market in one portfolio. You can hold the Schwab Aggregate Bond ETF (SCHZ) for as little as 0.06 percent annually in management expenses, for example. That expense ratio is appealing when considering how low bond fund yields are in the post-2008 era. Every basis point saved on management costs adds to total return.

With most bond funds, hewing to passive management and a benchmark is probably the best idea. According to the most recent Standard & Poor’s Index Versus Active (SPIVA) U.S. Scorecard, index funds hold the upper hand in most fixed income categories. In other words, the majority of actively managed bond funds fail to beat their index.

But for some reason, this passive advantage melts away when you look at the performance of investment-grade short- and intermediate-bond funds and global income funds. Only half of intermediate funds were outperformed by benchmarks, for example, compared to 95 percent of long-maturity government funds, S&P reported.

In this popular middle ground in the bond fund world, managers appear to be adding value. They are more expensive, but their managers should be nimble enough to navigate the rise in rates, where passive management won’t.

If History Is Any Indicator ...

John Zhong, an analyst with MyPlanIQ.com, has identified a group of active funds that have good historical records where active managers are earning their keep.

“Active total return bond mutual funds can outperform a total bond market index consistently, more so than stock funds,” he says. Zhong identified six funds that have beaten the passive Vanguard Total Bond Market Index Fund (VBMFX) over the past five years in annualized returns through March 5. They include:

  • TCW Total Return Bond N (TGMNX) at 6.2 percent;
  • Metropolitan West Total Return Bond M (MWTRX) at 5.9 percent;
  • PIMCO Income D (PONDX) at 11 percent;
  • Loomis Sayles Bond Retail (LSBRX) at 7.4 percent;
  • PIMCO Investment Grade Corp Bond D (PBDDX) at 7.3 percent;
  • PIMCO Total Return D (PTTDX) at 4.6 percent.

The common denominator for these funds—other than beating the Vanguard index fund by up to 7 percentage points—is a positive alpha measure, demonstrating a manager has added value beyond a risk-free rate of return.

What can active managers bring to the table if rates rise? Simply shelter. They could find pockets of the bond market that won’t be bruised as badly when the Fed hikes rates.

Of course, the conventional wisdom is that buying the broad-market fixed income index and holding through thick and thin is the right choice for most investors.

The strategy of simply holding the popular Barclays Aggregate bond benchmark “could be flawed,” according to Tom Lydon, a money manager and publisher of ETFtrends.com.

“It’s fine if you hold issues to maturity. But active managers may be able to bring alpha with less risk” by moving into less-impacted emerging markets, mortgage-backed securities, and sovereign debt, among other things, Lydon notes.

“Active management may help you avoid landmines,” Lydon adds. “There’s no systematic approach to tackle risks in a rising-rate environment.”

If clients want a more cautious approach, Lydon suggests finding managers who shorten bond maturities and avoid long-term U.S. Treasurys, which are the most volatile on the downside when rates climb.

Keep in mind that no one quite knows what’s going to happen with rates—or how the bond market will react. Will it overreact as it did with the “taper tantrum” of 2013? Or will it be a nonevent because the Fed has been telegraphing possible rate increases for years?

There are few, if any, bond managers who have any experience with or memory of what happens when rates rise significantly, so Lydon advises that it’s important to have a game plan for your clients’ portfolios.

“If you don’t have a strategy,” Lydon adds, “you’ll be caught flat-footed.”

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