Passively Managed Funds
Passively managed funds – also called index funds – invest in a portfolio of bonds designed to match the performance of a particular index, such as the Barclays U.S. Aggregate Bond Index. Index funds simply hold the securities that are in the index, or, in many cases, a representative sample of the index holdings. When the composition of the index changes, so do the fund’s holdings. In this case, the managers of the funds aren’t seeking to produce returns greater than the benchmark – the goal is simply matching its performance. Most ETFs are passive funds that mimic an index as well.
Actively Managed Funds
Actively managed funds are those with portfolio managers who try to choose bonds that will outperform the index over time and avoid those they see as likely to underperform. In general, their goal is to find bonds that are undervalued or to position the portfolio for anticipated changes in interest rates. Active managers can adjust their funds’ average maturity, duration, average credit quality, or positioning among the various segments of the market. Though actively manage ETFs are less common, but they do exist.
Active Funds Vs. Passive Funds: Key Differences
Turnover and Taxes
Since actively-managed funds are steadily shifting their portfolios in response to market conditions, they have a much higher turnover than index funds, which only change when the underlying index changes. This can result in a higher tax bill at year-end, which reduces investors’ after-tax returns.
Performance Variability
One of the most important reasons investors would choose an actively managed fund is the notion that the fund will be able to beat the market over time. That may, in fact, occur, but along the way, even the best funds can have off years. And when a fund underperforms, investors run the risk that they will be correct in their initial choice (for instance, to invest in high yield bonds), but they won’t receive the full benefit of their decision.
Performance Results
This is the most important difference between active and passive management. One reason for this is the fees – the gap between the two types of funds is large enough that the difference compounds over time. Also, the market is so efficient – i.e., analyzed by such a large number of investors – that it’s extremely difficult for a manager to deliver consistent outperformance over the long term. Another aspect to consider is that active bond fund managers are likely to take on more credit risk compared to passive bond funds. This strategy can lead to substantial gains if it pays off, or in a challenging economic environment, can drag down the fund’s performance if it doesn’t work. For example, in 2022, the Federal Reserve began raising rates to combat high inflation. When interest rates rise, bond prices fall which in turn impacts bond fund negatively. According to Morningstar data, over a one year period ending June 2022, less than a third (29%) of actively managed bond funds fared better than even the most average bond index funds. Active fund managers focusing on high-yield bonds and corporate bonds saw some of the lowest success rates.But those figures represent a very short time frame in a year that has been especially challenging for bonds. For a 10-year period ending Dec. 31, 2021, Morningstar data analyzed by Fidelity suggests that most active bond funds have outperformed their benchmark index in several short and long-term bond funds categories. It is important to understand the context behind these numbers. The ten years represented by this data were years where interest rates were relatively low. Also remember, since long-term bonds are more sensitive to changes in interest rates, bond funds that have long-term bonds in their portfolio hurt more if interest rates rise. The biggest takeaway from these numbers is that in theory, active management should enable the managers to add value through security selection, avoidance of losses, or the anticipation of rating changes to the bonds they hold in their portfolios. In reality, however, the numbers don’t show this to be true in all scenarios.
Active Funds Vs. Passive Funds: Which Strategy Is Right For Me?
There are a lot of factors that determine the success of your bond fund investment. Passive bond funds have lower fees and lower turnover compared to active bond funds, that’s two things that won’t eat into your returns. On the flip side, active bond managers tend to veer away from the index-based portfolio of passive funds, taking risks that could deliver huge rewards. But economic conditions and the fund manager’s competence determines the fund’s performance. However, picking which manager will outperform in the next five to ten years is much more challenging. Keep this in mind as you’re selecting funds for your portfolio.
