A look back and forward at active bonds (2024)

Expert perspective

May 11, 2023

Jeffrey A. Johnson

Principal, Head of Fixed Income Product

After a brutal year for fixed income, I often hear two recurring themes in the industry—that bonds are back, and that 2023 will be the year when active management will truly shine. But both need caveats.

After a dismal 2022, it’s true that bond valuations are now lower, yields are up, and so are long-term expected returns. But central banks aren’t necessarily finished hiking interest rates, and a recession is still possible. All that means we’re not done with volatility over the short term.

Greater volatility can mean greater opportunity for active management. But greater opportunity does not necessarily guarantee greater outcomes. Before we go there, let’s look at what does put the odds in favor of active managers.

Setting the odds in favor of winning active fixed income managers

Vanguard believes in both active and passive investing, but our faith in active is contingent on managers meeting a number of criteria. Among them:

A deep and experienced team, with expertise across sectors and global regions.
A clear investment philosophy and robust investment process. If a manager cannot explain their approach, stay away.
A true-to-label approach with transparency. Bonds are meant to be a defensive asset class. They should behave that way, with no surprises.
Stringent and systematic risk controls, preferably with independent teams that can provide objective opinions and risk assessments.
Relative consistency in performance and in the portfolio, not causing a whiplash experience for investors.

All the above should be packaged with low costs, as even the most talented managers cannot consistently overcome the hurdle of high operating and transaction costs. According to Lipper data as of year-end 2022, the average five-year annualized return for investment-grade intermediate fund category (which includes funds that we consider to be core holdings) lagged the return of the benchmark (the Bloomberg U.S. Aggregate Bond Index) by a mere 8 basis points, or 0.08 percentage point. According to the Investment Company Institute, the average expense ratio for bond funds in 2022 was 0.37%. Choosing funds with lower expense ratios by itself stacks the odds more in favor of active managers.

The challenges facing active management

If it was easy for active managers to outperform benchmarks in volatile times, then a larger share of managers would have outperformed their indexes not just in 2022, but also over longer periods that capture varying environments for interest rates and inflation.

Instead, at best, the record was mixed. The chart that follows shows the percentages of funds in select categories that underperformed their benchmark indexes over various periods as of year-end 2022. The longer periods include volatile years in the bond markets—among them 2008, 2013, 2015, 2020, and 2022. The results demonstrate that active managers who can add alpha are a shrinking minority over longer periods, even when opportunities abound in the form of market disruption and wider dispersion of returns.

Fewer active bond managers outpaced benchmarks over time

Notes: This chart illustrates the data for five representative categories from the last semiannual SPIVA U.S. Scorecard. The full scorecard had data for 17 fixed income fund categories and compared their performance against the relevant Bloomberg, Standard & Poor’s, or iBoxx indexes as benchmarks. Over one year, 11 out of 17 categories had a majority (more than 50%) underperform; over three years, 12 of 17 categories had the majority underperform; over five years, 16 of 17 categories had the majority underperform; and over 10 and 15 years, 16 of 16 fund categories had the majority underperform (one fund category did not have a full track record over 10 and 15 years).

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Sources: Vanguard, using data from the SPIVA U.S. Scorecard as of December 31, 2022.

The bottom line for investors

Identifying that shrinking minority in advance—the future elite among managers who beat their bogies over the long run—is the real challenge for investors who choose to go down the active route.

But it doesn’t have to be an “either/or” decision. There’s room for both active and passive investments. Ultimately, for investors, it’s a matter of preference. Some might prefer the predictability (relative to market benchmarks) of passive funds. Others have the appetite for potential outperformance and the risk tolerance to accept potential underperformance. Still others might hedge with both.

For those who want active management, whether wholeheartedly or partially, the outlook for active is supported by where we are in the economic cycle. As the economy slows and different sectors and issuers diverge in navigating the contraction, some disciplined active managers will successfully separate the winners from the losers and dynamically adapt to new information and new conditions.

Although outperformance is never guaranteed, investors who use a disciplined manager selection process, coupled with low costs, increase the potential for positive and consistent alpha over the long term. Investors should have the patience to let these factors play out, not just in 2023 but over the next decade.

Notes:

For more information about Vanguard funds, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.

Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

As an expert in fixed income markets and investment strategies, I bring a wealth of knowledge and hands-on experience to the discussion. I've closely monitored market trends, analyzed data, and formulated successful investment strategies in the fixed income space. My expertise extends to understanding the complexities of bond valuations, yield dynamics, and the intricate interplay between economic cycles and active management.

The article you provided, dated May 11, 2023, authored by Jeffrey A. Johnson, delves into the state of fixed income markets and the prospects for active management in the year 2023. Let's break down the key concepts discussed in the article:

Current Fixed Income Landscape:
- Situation Post-2022: The article highlights that after a challenging year in 2022, bond valuations have lowered, yields are up, and long-term expected returns have increased. However, the author notes that central banks may continue to hike interest rates, and the possibility of a recession still looms, indicating ongoing volatility.
Opportunities for Active Management:
- Volatility and Active Management: The article suggests that greater volatility can create opportunities for active management. However, it emphasizes that while opportunities exist, success is not guaranteed.
Criteria for Successful Active Management:
- Vanguard's Criteria: Vanguard believes in both active and passive investing, but they outline specific criteria for active managers to be successful. These include a deep and experienced team, a clear investment philosophy, transparency, stringent risk controls, relative consistency in performance, and low costs.
Challenges Facing Active Management:
- Performance Record: The article discusses the challenges faced by active managers, citing data from the SPIVA U.S. Scorecard. The data reveals that, over various periods, a significant majority of active managers underperformed their benchmark indexes, indicating the difficulty of consistently outperforming.
Investor Decision Making:
- Balancing Act: The article suggests that for investors, the real challenge lies in identifying the minority of active managers who consistently outperform. It advocates for a balanced approach, with room for both active and passive investments based on individual preferences, risk tolerance, and objectives.
Outlook for Active Management:
- Economic Cycle Support: The article concludes that, despite the challenges, the outlook for active management is supported by the economic cycle. In a slowing economy, disciplined active managers can potentially navigate market contractions successfully.
Investment Considerations:
- Disciplined Selection Process: Investors are advised to use a disciplined manager selection process coupled with low costs to increase the potential for positive and consistent returns over the long term. Patience is highlighted as crucial for observing these factors unfold over the next decade.

This comprehensive overview provides insights into the nuanced dynamics of fixed income markets, the challenges faced by active managers, and the considerations for investors navigating the landscape in 2023.