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.

Passive managers may not be able to account for rising interest rate risk, says Woodworth, and passive products don’t always provide the most robust diversification benefits. For example, many aggregate bond indexes are highly concentrated in low-yielding government debt, notes Woodworth.

“The lower the potential risk, the less opportunity there is for yields or returns,” says Woodworth. “Our belief is that active can add value anywhere in fixed income, but as you go further into risky areas of fixed income the more opportunity there is for active managers to provide extra returns.”

Yet a volume of data disputes PGIM Investments' assertions.

According to the recently released 2017 Mutual Fund Landscape report from Dimensional Fund Advisors, half of all actively managed fixed-income mutual funds outperformed their benchmarks over a 5-year period, 26 percent outperformed over a 10-year period, and 18 percent out performed over a 15-year period. All of these are based on returns before taxes, but with an asset-weighted average expense ratio applied.

S&P Dow Jones Indices confirms DFA’s findings in its most recent SPIVA U.S. Scorecard by noting that, on average, active managers underperform both equal- and market-weighted benchmarks across all sectors of fixed income.

“While it's true that many active managers haven't outperformed their benchmarks, keep in mind that you can’t buy a benchmark in fixed income,” says Woodworth. “The devil’s really in the details here. Since passive management must by definition underperform its benchmark, an average of passive products creates a better basis for comparison

But when past returns show that active fixed-income managers may be producing some alpha, investors still face challenges in selecting which funds will outperform in the future. For fixed-income mutual funds, a 5-year track record of outperformance was a poor predictor of returns, according to the DFA research; just 27 percent of funds that posting a 5-year record of outperformance at any given time were able outperform over the next year.

Survivorship is also an issue. DFA found that 85 percent of fixed-income mutual funds survived over a 5-year period ending December 2016. When a 10-year time horizon was used, 66 percent of fixed income mutual funds survived. Over a 15-year time horizon, 57 percent of fixed income funds survived.

“In fixed income, it pays to screen for stronger asset managers because that helps to mitigate the survivorship issue,” says Woodworth. “Buy into managers with long track records, strong capabilities and a deep infrastructure. For example, PGIM Fixed Income has been managing assets for 100 years. It’s not impossible or unheard of for our products to close up, but closures are few and far between.”

S&P Dow Jones Indices reports even lower 10- and 15-year survival rates for mutual funds across most fixed-income sectors. For example, investment-grade corporate bond mutual funds posted a 61 percent 10-year survival rate and a 43 percent 15-year survival rate in the most recent SPIVA U.S. Year End Scorecard.

Actively managed bond funds also suffer from high levels of style drift, according to S&P Dow Jones Indices. Average style consistency, the percentage of funds retaining the same style classification at both the beginning and end of a given time period, drops below 50 percent for mutual funds in most fixed income sectors over a 15-year time period.

“Investors need to look at historical allocations and return streams to make sure they’re getting something that will maintain its risk-reward profile,” says Woodworth.

Yet in many areas of fixed income, such as global bonds, high-yield, and short- and intermediate-term bonds, active managers can add diversification, risk management and selectivity to an investor’s allocation.

There may be some areas of the fixed-income market efficient enough to make passive investing worth it, Woodworth admits, and as a new generation of smart beta products proliferate into fixed income, new passive investing options may be attractive to investors.

“Smart beta is an area where you really want to make sure you know what you’re getting,” says Woodworth. “Smart beta products often require you to allocate around them, and they’re stuck tracking their index. Active managers have the ability to move away from making investments that might not be advantageous and weigh factors appropriately given the market environment. That’s not to say that factor investing isn’t good in the long term, but not all factors work all of the time.”