In the long-running active versus passive debate, the conversation tends to be centred on stocks. The concentration of global equity indices and how hard it has been for active managers to outperform over the past few years remains a live discussion.
Passive bond funds have not held the spotlight to the same extent, even though there are plenty of options for investors. They can be useful in a portfolio, but some say they have more drawbacks than their equity counterparts.
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Costs
As with stocks, a key advantage is low fees. But experts don’t quite agree on how big the gap between active and passive costs is within fixed income.
“On average, active bond funds underperform the index, and this is mostly due to the higher fees they’re charging,” argues Matthew Bird, chartered financial planner at Falco Financial Planning. “As fees for bond funds can be similar to those for equity funds yet their expected returns are lower, one could conclude that the argument for passives is even stronger when it comes to bonds.”
Laith Khalaf, head of investment analysis at AJ Bell, agrees that passive funds have a cost advantage. But he adds: “This is less pronounced in the fixed income space, where active fund charges tend to be lower.”
In short, it very much depends on which funds you are looking at. For example, the four bond funds included in the IC’s Top 50 Funds list – TwentyFour Dynamic Bond (GB00B57TXN82), Royal London Sterling Extra Yield (IE00BD0NCB41), Rathbone Ethical Bond (GB00B77DQT14) and Premier Miton Corporate Bond Monthly Income (GB0003895496) – have ongoing charges of 0.79 per cent, 0.84 per cent, 0.65 per cent and 0.35 per cent, respectively. That means they range from the decidedly cheap to roughly in line with the costs of a global stocks fund.
So if you do decide on an active strategy, keep an eye on costs; what would be a reasonable fee for an equity fund might arguably count as more expensive for a bond fund.
On the other hand, if you choose a passive option, you should be aware that bond indices are not necessarily as conventional as, say, the MSCI World. “Whereas plain vanilla equity trackers are simple and straightforward, buying a bond tracker probably requires a bit more knowledge and experience to understand the characteristics of the index being followed, in particular its duration and credit risk,” says Khalaf.
So, regardless of whether you opt for a passive or active approach, you should check the factsheet and understand the kind of debt the fund is buying. There are all kinds of bond indices, from the very broad to the very specific, which allow you to target specific types of debt, currencies and duration.
One-stop shops
The Bloomberg Global Aggregate Bond index is a broad index that is often used as a proxy for the whole market, just as the MSCI All Country World is for stocks. It is tracked, for example, by the iShares Core Global Aggregate Bond ETF GBP Hedged (AGBP), which is included in our Top 50 ETFs list.
Bloomberg states that the index is a “measure of global investment-grade debt from 27 local currency markets” and comprises “treasury, government-related, corporate and securitised fixed-rate bonds from both developed and emerging markets issuers”.
As of the first week of January, the iShares ETF had just shy of 20,000 holdings and yielded 3 per cent. It invested just over 50 per cent in government bonds, including 19 per cent in US Treasuries, 8 per cent in Japanese government bonds and nearly 3 per cent in UK gilts. It was well spread across maturities, with a quarter in the zero-three years range, just over half in the three-10 years range, and a fifth in longer durations.
With a fee of just 0.1 per cent, it is certainly a quick, cheap and diversified way to achieve broad exposure. But there are a few things the ETF does not offer: exposure to high-yield bonds, for those seeking riskier assets; a significant allocation to UK gilts, which for UK-based investors often makes a lot of sense; and, of course, an expert manager making calls on how to navigate a complex market.
The index is also a useful comparator for strategic bond funds such as TwentyFour Dynamic Bond, Schroder Strategic Bond (GB00B7FPS593) and M&G Optimal Income (GB00B1H05718). Strategic bond funds invest freely across the fixed income space, making calls on bond types, duration, sectors and credit risk. Comparing their positioning to that of the Bloomberg Global Aggregate Bond index gives you a good sense of the characteristics of a fund. However, there can be big differences, and strategic bond funds are often riskier.
“There is a propensity for managers to take on credit or duration risk to juice short-term returns,” Bird says. “Many such managers were found out in 2022 in a rising rate environment.” Allocations depend on the fund in question, and you may well want some exposure to high-yield bonds in your portfolio, but again a good look at the factsheet is in order.
For example, as at the end of November, TwentyFour Dynamic Bond held only 2.6 per cent in bonds with a maturity of more than 10 years, meaning it had less exposure to longer duration bonds than the Bloomberg Global Aggregate Bond index. However, it had 11.5 per cent in high-yield bonds and an average rating of BBB+, implying more credit risk than the index.
Higher risk does tend to bring higher returns, and as the chart below shows, strategic bond managers have significantly outperformed the iShares Core Global Aggregate Bond ETF over the past five years, on average. But given that, for many investors, bonds are intended to reduce risk and volatility in their portfolio, some caution is warranted.
Mixed approach
The alternative to owning one broad bond fund is using a mix of active and passive funds, targeting different areas of the market. But there are certainly areas where you don’t need anything more complicated than a tracker.
“There is arguably little value to be had from active management in the UK gilt fund market,” says Khalaf. “But once you start mixing and matching government and corporate bonds, in different currencies, then an active approach starts to become more attractive.”
Remember that you can also buy UK gilts directly. The capital gains element of the return is tax-free, so if you have assets outside a tax wrapper, buying low-coupon gilts is certainly a tax-efficient option. Funds do not enjoy the same treatment.
One reason that a mixed approach makes sense is that when you are looking at corporate bonds, opting for passive products means owning more bonds issued by companies with the most debt. Ben Yearsley, director at Fairview Investing, says he doesn’t like passive bond funds for this reason. “Bonds are all about avoiding the losers, not necessarily picking the winners. Passive just buys everything,” he says.
Passive bond funds that Bird likes include the Vanguard Global Bond Index (IE00B50W2R13), for broad exposure to global bonds; the iShares UK Gilts All Stocks Index (GB00B83HGR24), for UK government bonds; and the Vanguard UK Investment Grade Bond Index (IE00B1S74Q32), for sterling-denominated corporate bonds.