Passive investing for stocks, but how about bonds?

Warren Buffett thinks that the smartest thing your money can do is climb into a hammock and take a nap (of course, he's smarter than we are, so he doesn't do this personally). While research has shown that passive investing makes sense for stock investing, research shows that it's a different story for bonds.

Let's look at the numbers: based on analysis by Morningstar (as of June 2023) over the past 15 years, 54% of active US corporate bond funds managed to beat its passive peers. This is compared to only 9% of active US large blend equity funds managing to beat its passive peers in the same period and on average underperforming by 1.5%.

How active bond managers outperform passive managers

We would love to embrace Warren Buffett's romantic laissez-faire view on investing in its entirety, but as evidence-based investors, we think a little more work is required before shutting both eyes and dozing off.

Not all asset classes and markets are created equally. In the case of the bond market, it is possible to get higher returns with the same risk through active investments. 

Here are some reasons why it might be the case:

1. Bond markets are made up of irrational players

There are 'noneconomic' players moving huge amounts of money that do not always act rationally in the economic sense. Central banks prioritise their country's growth and inflation mandates over portfolio returns.

For example, when central banks implement quantitative easing policies, they would buy their own government bonds to boost spending in order to reach inflation targets and stimulate economic growth. This 'irrationality' affects the market.

2. Bond ratings and bond indices allow for mis-pricing opportunities

In the stock market, the price of a stock reflects all known information on the company. For some reason, we humans decided not to place our trust in the power of markets when it comes to bonds — we allow ratings issued by organisations to help the world decide the 'quality' of a company's bond.

Funnily enough, these ratings almost always lag changes in a company's bond price, which means that the market participants see the changes in a company's fundamentals before the rating agencies can get around to changing their laggard ratings.

As investors, we would very much prefer to leverage on the collective wisdom of the market and use the information in prices, as we do for stocks. This means having someone in the driver seat of our bond portfolio, so we are not stuck behind an old smoke-spewing truck when the light turns green. But unfortunately, benchmark indices have to track these laggard ratings religiously, which is inefficient for fixed income index investors.

3. Active bond managers charge a much lower management fee

The general rule is that if fund managers can get away with high fees, they will. Luckily for us, over the years they have lost the ability to justify their high fees due to a lack of outperformance, which has put downward pressure on their share of the pie. The fee dispersion between active and passive managers in bonds is much smaller than in equities, and at a level where active bond fund managers are taking home less (in their fees) than their median outperformance over their benchmarks.

Don't blindly turn away from active bond fund management. The passive strategy in bond investing unfortunately does not work as well as it does in stock investing. 

Accessing Best-In-Class fixed income funds through Endowus

Endowus Hong Kong offers a diverse range of Best-In-Class fixed income active funds managed by world-class bond managers such as AllianceBernstein, JP Morgan Asset Management, and PIMCO.  

Here are some selected fixed income funds on the Endowus Fund Smart platform, you can also access the full list here.

Spotlight on fixed income funds

Read more:

• A focus on fixed income — curated bond funds
• Prime Time for Bonds
• Fixed income investing amid uncertainty — Q&A with J.P. Morgan

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