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.