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By Ben Johnson, CFA and Jeremy Glaser | 11-12-2015 03:00 PM

Bond Funds: The Pros and Cons of Going Passive

Index funds' low fees are a big advantage, but investors shouldn't look at expenses in isolation when picking a bond fund, says Morningstar's Ben Johnson.

Note: This video is part of Morningstar's November 2015 Income Investing Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Ben Johnson--he's the director of global ETF research here at Morningstar. We'll look at the pros and cons of taking a passive approach to fixed-income investing.

Ben, thanks for joining me.

Ben Johnson: Jeremy, I'm glad to be here.

Glaser: Let's start by looking at where the investor fund flows are going. Has there been a strong preference amongst investors for passive fixed-income investments?

Johnson: So, if you zoom out and you look very broadly at where flows have been going across the landscape--inclusive of actively managed mutual funds, index mutual funds, and ETFs--what you've seen is that for the year to date through the end of October, there's been $67.5 billion in net new inflows into taxable-bond funds. So, that category across mutual funds and ETFs, active and passive, has been the second-highest asset-gathering category for the year to date thus far.

Now, if you go one level deeper and you divide that space between active and passive--so actively managed mutual funds, actively managed ETFs and then passively managed mutual funds and ETFs--what you see is a stark dichotomy. We've seen $108 billion in investors' assets flee from actively managed taxable-bond funds, and we've seen $40.5 billion of net new inflows into passively managed bond funds and ETFs.

Now, going another layer deeper still, what you see is that amongst the actively managed bond funds, nearly half of those outflows can be attributed to one fund--that's PIMCO Total Return (PTTRX). And there is another $7.7 billion that has flowed out of the Templeton Global Bond Fund (TPINX). If you look at the passive side of the ledger, the top three asset gatherers amongst index mutual funds and ETFs have been Vanguard Total International Bond Index Fund (VTIBX), their Total Bond Index Fund (VBMFX)--which just houses U.S. securities--and then the iShares Corporate ETF (LQD). So, these are fairly vanilla, fairly core, not very exotic fare gathering a lot of investors' assets on the passive side of the ledger.

Glaser: Let's looks at some of the factors of why investors might be going for passive now. Cost has to be a big one. Is that a major factor in trying to decide if you want to go active or passive when it comes to bonds?

Johnson: Well, cost clearly matters. Regardless of whether it's a fixed-income fund, an equity fund--you name it--cost matters. We know that with certainty. Now theoretically, it might matter incrementally somewhat more in the bond-fund space; if you think about the distribution of returns in bond funds, it's inherently narrower than it might be in equity funds--and certainly more-volatile asset classes, more generally speaking. So, fees clearly matter. And I think part and parcel of what you're seeing in flows is that investors are increasingly aware of just how much they matter. And again, theoretically, fees matter somewhat more, all else equal, in the realm of bond funds.

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