Investors are warming to passive fixed-income products, but that may be a mistake, according to one of the world’s largest asset managers.
According to “Active Advantage,” a report from Newark, N.J.-based PGIM Investments, the retail manufacturer and distribution arm of PGIM, which is the global investment management business of Prudential, there are now more than $3.8 trillion in fixed-income mutual funds and ETFs, with actively managed assets making up the majority. Yet PGIM also notes that most assets are flowing into passively managed strategies, even within fixed income. In 2016, 64 percent of fixed-income net flows were allocated to passive products, according to PGIM Investments.
Despite a bevvy of research suggesting that active management inevitably underperforms, PGIM Investment’s report suggests that the opposite may be true, says Rich Woodworth, PGIM Investments vice president of product management and investment analytics.
“What we found is an overall migration towards lower-cost investments, not just passive, but also towards institutional share classes and lower-fee accounts,” says Woodworth. “If we’re going to compare active and passive, then we should be comparing passive to where most of the money is moving in active. We should compare everything net of fees. When we do, we’re finding that active managers have generally outperformed their passive counterparts in fixed income over time.”
Rather than compare funds to their benchmarks, PGIM Investments compares active products to passive counterparts which track the same benchmark. In doing so, the authors produce evidence that most active managers may reliably create alpha in fixed-income mutual funds.
According to PGIM Investments, actively managed funds ranked in the first and second quartiles of performance tend to beat passive managers over a 10-year period ending Dec. 31, 2016. For example, in intermediate-term bond funds the average passive manager reported 10-year annualized returns of 4.43 percent, while a first-quartile active manager reported returns of 5.01 percent, and a second-quartile active manager reported returns of 4.67 percent.
Passive approaches may not be best for most investors, according to the PGM Investments report, because passive funds inevitably lag their indexes, have difficulty tracking their indexes, often weight the most indebted companies or governments, and buy and sell indiscriminately—often at inopportune times.
The authors argue that active management is the only route to alpha for fixed -ncome investors. Even the best-managed passive index funds are sandbagged by their expense ratios. As returns become muted across all asset classes, more investors will rely on their fixed-income allocation as a source of alpha generation.
“There are fewer opportunities to generate returns solely relying on market beta,” says Woodworth. “We’re going to be in a lower for longer interest rate environment, so any basis point of return over a benchmark becomes more significant for investors, especially those coming from a lower opportunity set.”
While fund expenses are important, many passive investment opportunities in fixed income carry substantially larger expense ratios than passive equity funds. Thus, the gap between average active and passive expense ratios is only 31 basis points, according to PGIM.