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Active vs. Passive Bond Investment

An actively managed portfolio is meant to generate alpha and therefore to outperform its assigned benchmark/index over time. The active fund's performance greatly depends on the investment manager's skill level and security selection process. Rather than being actively managed the index fund simply holds the securities that are in the index, or, in many cases, representative sample of the index holdings. This means, the underlying structure of the index fund will change according to changes in the composition of the assigned benchmark.

Why to invest passively

In today' volatile market environment there are primarily two motives why an index fund may be desirable. First, the average domestic bond fund has an expense ratio of little over 1.0%, while the average international and high-yield bond fund each checks in with an expense of about 1.35%.[2] The expense ratio of a mutual fund is the percentage of assets that the fund company takes off the top each year to pay its expenses and earn a profit.

 Active fundPassive fund
Ticker SymbolXYZXYZ
Investment Amount$10,000$10,000
Annual Rate of Return5.00%5.00%
Holding Period20 years20 Years
Fund Value after 20 Years$21,203.46$26,268.99
Profit/Loss$11,293.46$16,268.99
Total Fees$3,287.31$168.45

Table 1: Cost comparison active vs. passive bond investment

Table 1: effectively illustrates the impact of an investors profit over a 20 year investing period in a sample actively managed bond fund and a bond market index fund with a starting capital of $10,000.00. Based on the assumption that both investments will experience the exact same rate of return the index investment will significantly outperform the actively managed investment due to the lower expense ratio of 0.05% compared to 1.1%. These fees take a large chunk of investors cash over time, especially in light of the fact that companies charge the fees regardless of how their funds perform. Index funds help minimize the impact of fees. Since index funds require fewer resources to manage, they can pass the savings along to investors. Furthermore most index investors can expect a more consistent performance and a rate of return that represents the broader bond market.

Why not to invest passively

As tempting as the above illustrated scenario might be, passive bond investment unbolts significant hidden risks. While in many asset classes index funds in general have a lot going on for them the case is not entirely iron-clad for the bond market. Funds that are supposed to mirror the broad bond market based benchmarks such as the most widely known Barclays U.S. Aggregate Index (formally Lehman Brothers) typically have a substantial amount of their composite invested in government or government-related securities. One might ask why this is the case, and to understand this I would like to introduce you to the kids in my Geology class in 1996.

What does my Geology class has to do with passive index investment?

Well, every now and then one of the other 29 kids in my class forgot their lunch. Since I was the youngest of four children, mornings were pretty hectic and my mother usually just gave me a few dollars to take care of myself and one day a great idea popped into my mind.

"When lending some of my lunch money to my classmates to buy lunch for a certain interest rate, I can significantly increase my pocket money."

Knowing that most of the kids in my class came from wealthy families attending private school I did not see much risk of not getting my money back and immediately started my lending business.

But then there was Joe!

Joe was one of 30 kids in my Geology class back in school, who pretty much forgot his lunch any day. Over the next few weeks while most of the kids infrequently borrowed my lunch money and paid me back in time, Joe had a lot more need of my kindness. After the first 30 days most of my money was lend to Joe and of cause when I stopped lending my money to Joe he started to ask other kids he was friends with. Slowly I had to realize that my whole investment idea was becoming more and more dependent on Joe's ability to pay back the other kids and me. I actually had to realize that I lend my money to the one person who owed the most. However I still was not too concerned about my money, since I only chose the wealthiest of all the kids in my class and Joe not only promised to pay me back if I waited he actually guaranteed me to do so. Well he did not and slowly but steadily I kept losing money and finally went bankrupt.

All the kids in my school represent different companies and different sectors while Joe represents the U.S Government and all together the U.S Aggregate Bond Index. If you had seen me during the first few you weeks and would wanted to participate it probably would not have cost you much. All I had to do was lending my money to whoever needed to borrow and slowly you invested in a passive index fund composed of Joe. Today the U.S. Agg. Bond Index is composed of up to 73% government issues (37% treasuries, agency debentures 5% and agency mortgages 31%).

Outlook

I believe that government securities and US treasuries are overvalued and investors buying bond index funds have significant exposure to overvalued US government securities. Better value can be found in other non-government sectors and active management can add significant value to fixed income investing. Central banks around the world have implemented massive and widely untested stimulus programs. In an effort to push yields on US treasury and government agency debt to historic lows, the FED has implemented a massive purchase program in the government debt market. These market interventions by the Federal Reserve has likely helped the economic recovery, but has also driven government bond prices higher to levels, most people believe to be overvalued. By investing in index funds, investors are investing a majority of their assets in US treasuries and government agencies which are among the most expensive of all fixed income investments in the market.

Recommendation

· Underweight US government securities

· Seek mutual funds that are invested in corporate investment grade debt issues

· Seek mutual funds that are invested in high quality mortgage and asset backed securities

· Avoid bond index funds


[2] Morningstar Direct as of 06/30/2013.

Source: The Risk Of Passive Bond Investing