Active management has enjoyed an advantage in fixed income with remarkable consistency
Last week, we discussed active vs passive management and reviewed the performance of both management styles across various asset classes over both the short- and long-term. Which management style (active or passive) is superior in any given asset class can change over time, however, active has enjoyed an advantage in fixed income with remarkable consistency. In addition to its tendency to underperform active strategies, there are multiple other issues with passive fixed income.
Performance
Perhaps most important to most investors is the issue of performance. As we have reviewed passive vs active management over the years, we have found a few consistent themes. One is that the S&P 500 (SPX) has been a very difficult benchmark for active managers to beat over the last 10 – 15 years. Another is that, out of all the markets we’ve examined, US fixed income has been the most favorable to active management as the US Aggregate Bond Index (LBUSTRUU) consistently ranks near the bottom of the US core fixed income universe, meaning that investors who have chosen an AGG-tracking fund over an actively managed strategy have almost certainly sacrificed performance.
Your Exposure Can Materially Change Without You Doing Anything.
Unlike the major equity indices, which usually have stable constituencies from year to year, the composition of bond indices changes much more frequently. Whereas the S&P 500 and the Russell 1000 (RUI) are updated quarterly and annually, respectively, the composition of the Bloomberg Barclays US Aggregate Index changes monthly. The iShares Core U.S. Aggregate Bond ETF (AGG), for instance, had a turnover of 81% for the 12-month period ending February 28, 2025; meanwhile, the SPDR S&P 500 ETF (SPY) had a turnover of just 3% over the same period.
Why should the average investor care about the more frequent rebalances and higher turnover of fixed income indices? With roughly 7% of the holdings in the Aggregate Bond ETF changing every month on average, the exposure in the fixed income portion of a portfolio can change quickly and it can happen under the surface, i.e., without an advisor or client seeing any trades in the portfolio. While this is often viewed as a primary benefit of the ETF product structure, it may not be as advantageous if you don’t understand what the impact of those changes is. Unless they are looking at the exposure breakdown of the index every month, an investor could find that the exposure in the indexed bond ETF they bought six months ago looks very different than the exposure it brings to the portfolio today.
The “Bums” Problem
The changing nature of fixed income indices we discussed above also contributes to the “bums” problem. As with equity indices, many fixed income indices are essentially market cap weighted. In equity indices, market cap weighting means that the most historically successful companies (at least in terms of increasing their market value) become the most heavily weighted. In a fixed income index, however, the most heavily weighted entities are those that have issued the most debt. This presents a problem for the buyer of a cap-weighted fixed income index, as they will be most heavily exposed to the most debt-laden and not necessarily the most creditworthy of issuers. Apple (AAPL) maintained an enviable credit rating for many years but only had its first bond issuance in 2013. As such, AAPL couldn’t have been included within investment grade or AGG-tracking bond funds before that time.
Furthermore, unlike equity indices which typically include only corporations, issuers within fixed income indices can include corporations, states and municipalities, and sovereign governments. Heavily indebted sovereign governments present a unique challenge as they can (and at various points have) simply decide to cease payments on their notes, leaving debtholders with limited recourse.
The “bums” problem can be mitigated by utilizing another weighting schema, e.g., equal weighting, but this can introduce new problems, such as a heavier weighting toward thinly traded, illiquid issues. And so, many bond funds employ some form of market cap weighting, and the impacts of this are quite different than we find within the US equity category.
Passive Bond Indexes Can Become Riskier at the Worst Time.
You’re undoubtedly aware that prior to 2022 we had been in an ultra-low interest rate environment for many years and a declining rate environment for far longer still. That trend has shifted, but among the effects of the years of low-interest rates is that the bond market itself became riskier. Since 2009, the duration of the US AGG Index has increased from around 3.5 years to around six years. For the bond aficionados out there, this suggests that a 1% rise in yields today would cause a corresponding decline in bond valuations of about 2.5% more than a similar rate move back in 2009. This is caused, again, by passive bond portfolios investing in a market that hasn’t itself remained “passive”. As the chart below shows, the duration (or rate sensitivity) of the Agg peaked in 2021, when interest rates were near multi-year lows. So, while investors were taking on more risk, they were also receiving lower yields.
Although the duration risk of the AGG has improved moderately in the last couple of years as higher interest rates have pushed coupons higher and made long-term debt less attractive, the core market remains significantly more sensitive to rate movements than it was prior to the financial crisis and this shift in risk happened under the surface of AGG-tracking funds. While there are additions and deletions to equity indexes, if you own SPY you probably have a pretty good idea of what your exposure is, even if you haven’t recently reviewed a holdings list. However, in the case of a passive fixed income fund, the exposure could have materially shifted since you added it to client's portfolio.
Developing a Plan
In our estimation, a market like fixed income - where active management has a record of outperformance and the exposure of passive funds can change under the surface – is an ideal environment for a tactical approach. Currently the fixed income rankings in the Asset Class Group Scores favor exposure to non-core areas of the fixed income market like convertibles, high yield, and international bonds. But this is not a static situation. As we discussed in yesterday’s report, the market is now pricing in a strong probability that the Fed will resume cutting interest rates next month, which could be beneficial for the rate-sensitive core market. Tactical strategies will attempt to navigate these potential shifts by allocating toward strength in the market.
Tactical fixed income strategies are available both as separately managed accounts and guided models. If you would like to discuss tactical managed account solutions please contact Andy Hyer at AndyH@dorseymm.com or (626)535-0630.
If you are interested in implementing a guided model we have several options available on the platform including:
The First Trust Fixed Income Model (FTFIXINC.TR)
The iShares Fixed Income Model (ISHRFIXED.TR)
The NDW Tactical + Ladders Fixed Income Model (LADDERS.TR)
Each of these models are rules-based, relative strength methodologies capable of providing rotation within the fixed income asset class. Each model employs a unique investment inventory that dictates both the boundaries by which it may concentrate exposure and the markets it may utilize. Collectively, they offer solutions for fixed income sleeves within a larger portfolio or can be part of a core-satellite strategy that uses low-cost indexing as well.
