Where Active Investing Has an Edge

Passive stock investing is popular for good reason. It’s maddeningly difficult for most active equity managers to consistently beat their index fund competitors. 

The bond market, however, is different. Its makeup and indexing challenges give skilled active managers a chance to distinguish themselves. And unlike their passive counterparts, active managers have access to tools, asset classes, and flexibility around interest rate and credit risk exposures, giving them an advantage over passive funds and their indexes. 

These elements make the bond market fertile ground for active managers to outperform. The chart below shows that active bond managers beat their benchmarks more often than active stock managers.

Source: Morningstar Direct. Data as of July 31, 2025.

For investors, a fairly priced, proven active bond fund makes sense for fundamental reasons rooted in the nature of bond markets and the inherent structural advantage active bond managers have over their benchmarks.

This article first appeared in the Q1 2026 issue of Morningstar magazine.

The bond market isn’t as inefficient as it used to be. Innovations such as credit default swap baskets, index-tracking exchange-traded funds, and block-style trading have improved efficiency in some bond market segments. But inefficiency still lingers, and this creates opportunity for active managers to add value.

The added efficiency credit default swaps and ETFs bring to the bond market is fairly narrow; investors often view the landscape as bifurcated between the largest, most liquid bonds that respond quickly to market events and those outside that arena that trade much less often.

Wide swaths of the bond market also haven’t come close to the near-frictionless activity of stock trading. Market fragmentation and infrequent, decentralized trading are the most significant factors that stand in the way of efficiency.

Morningstar’s database includes at least 100,000 developed-markets stock listings, including roughly 20,000 from the US. It’s more difficult to estimate the number of US bonds, only a relative handful of which trade on exchanges. Morningstar’s database contains at least 5.8 million bonds if we count them by the number outstanding in an issuer’s home country and currency. If we account for bonds issued across multiple currencies globally, estimates are often 3 times that number.

When there are so many bonds, and they are not registered with a centralized platform for access and information, just understanding where to find them and whether there’s someone else willing to buy or sell them are factors in and of themselves.

Most bonds are owned by a relatively small number of large investors, which can limit the number of buyers and sellers willing to transact. Although there are trillions of US dollars managed outside of mutual funds and ETFs, Morningstar’s data for those vehicles represents money managed by nearly every global asset manager, and most of those firms’ investment selections have significant overlap between their mutual fund and ETF complexes and their collection of non-mutual fund accounts.

In a 2021 study, we looked at approximately 350,000 bonds in fund and ETF portfolios in Morningstar’s database, representing the debt of more than 32,000 issuers. The small number of asset managers that own the same bonds is jarring. Of that 350,000-bond cohort, close to 200,000 (57%) were each owned in the funds of only one firm, as shown in the chart below.

The number of bonds with ownership across two firms was 50,000 (14%) and across three firms was 23,000 (6%). Thus, only around 23% of all the bonds in Morningstar’s database were held in portfolios managed by more than three asset managers.

Source: Morningstar. Data as of June 30, 2022.

Diffuse bond ownership correlates with little trading outside of the largest, most liquid bonds. 

One way to gauge the frequency of trading is to measure the average time between trades for the same corporate bond. We took a sample of 35,000 bonds and found that fewer than half traded at least once in three days. The drop-off thereafter was swift, and more than half of them traded at most once in 19 days. Active managers can take advantage of this inefficiency.

Where trades take place is also relevant. Most bonds still trade over the counter, away from exchanges, sometimes facilitated by situations as simple as trading desks sending bond lists to their clients. One reason is the heterogeneity of terms, conditions, and features, including embedded options, covenants, capital structure placement, and redemption terms. 

Aside from being widely held, however, securities need to be fungible to trade frequently on a central exchange. 

Outside of US Treasuries and very large corporate deals, there’s often too much variation in trading. The industry has been looking for ways to standardize and streamline trading, and there has been incremental improvement over the years, but the differences among most bonds make them difficult to trade on exchanges.

The complexity of the bond market is another feature that active managers can exploit. Indeed, the range of bonds and combinations of features are endless. Even bonds from the same issuers may have distinguishing features, including differences in maturity, coupon, seniority, optionality, and covenants. This complexity is a theme across bond sectors.

Regular Treasury bonds are among the simplest of all. They have fixed coupons, fixed maturities, no calls or puts, and no odd structural elements. 

Things can get messier, though, even among government bond markets. For example, the US issues Treasury Inflation-Protected Securities, whose face values adjust semiannually in line with changes to the Consumer Price Index. TIPS investors receive no less than par, which means TIPS held to maturity guard against inflation and have backstop protection against disinflation.

Beyond Treasuries, the corporate bond universe is arguably less complicated than others. Yet, a dizzying array of features can still distinguish one corporate bond from another.

One example is the differences between bonds issued by subsidiaries and parent companies. It’s common for corporations to shuffle assets into or out of related companies with legally distinct identities. The bond’s structure and terms matter. If the parent company defaults, parent company bondholders may not have a legal claim to valuable assets held by a subsidiary. Investors holding bonds issued by a subsidiary, meanwhile, may find that a company isn’t willing to back those bonds if things go sour.

The same company will often issue an array of bonds that might include one that’s senior to all its others, giving it first claim on being paid back in the event of bankruptcy, as well as a subordinated bond that will only get paid if there’s enough money left over. The bonds would carry different credit ratings and a smorgasbord of caveats and conditions under which the priority of their claims could change, what events could trigger an early repayment, and so on.

Securitized debt is a financial instrument created by pooling various types of debt into one package and selling them as bonds. The process has exploded in recent decades. In most cases, securitized debt is carved up into tranches with different features that can be sold to investors with different appetites for their risks. 

The vast market for securitized debt includes a broad variety of types and styles. The more differentiated they are, the more likely it is that inefficiencies will exist. They can range from asset-backed securities supported by credit card receivables to collateralized loan obligations backed by loans to companies with lower credit ratings, and much more.

It isn’t just that lingering inefficiencies and the complexities of the bond market provide opportunities for skilled active managers. It is also the case that attempting to passively replicate the bond market isn’t always advisable.

In fact, in the real world of bond investing, meaningful market distortions occur across all its major sectors, including government, corporate, and securitized debt. Indexing during times of stress means moving in the opposite direction of the overall market. Some examples include the Greek eurozone crisis of 2011, the proliferation of automobile debt in the early 2000s, and fundamental changes to the mortgage market.

We tend to think about government debt differently from private sector borrowing, but the world is replete with cautionary tales of fiscal and monetary mismanagement that spilled into debt crises, which can filter through to market-weighted benchmarks. Greece had the hardest time of the countries that faced trouble after the 2008 financial crisis. It had already built up debt before the crisis and ramped it up even more as things got worse.

By 2010 and 2011, investors began to worry about scenarios that could lead to default. Either Europe might equivocate on supporting the country, or Greece might leave the monetary union and reissue its own currency at a drastically lower value. So, even though much of Greece’s debt was denominated in euros, investors began demanding higher yields, and the spread of Greek bonds over the EU’s stalwart countries’ bonds shot up dramatically as their prices plummeted.

Even investors with broad index-level exposures to the eurozone would have found themselves on that roller-coaster ride, and not just in terms of performance. The mix of weightings in the EU shifted a great deal even independently of Greece’s debt levels. Even as Greece was adding on more debt, so were some of its neighbors. So, while it had hit roughly 12% of the market in late 2005, its weighting as of August 2008—right before its credit spreads blew out—was still relatively large at 7%, leaving investors roundly exposed to the carnage that followed.

Just as things looked to be their most dire, Mario Draghi, the head of the European Central Bank, said that he would do whatever it took to save Greece and keep the euro together. The country’s debt costs improved nearly overnight, but they remained higher than those of the continent’s strongest economies in 2025.

Company indebtedness can also become a big problem. In the early 2000s, automobile sector debt ballooned and began taking up more of the investment-grade corporate bond market. Only 15 of the 650 issuers in the ICE BofA US Corporate Bond Index were auto sector companies in late 2000, yet their debt comprised nearly 10% of the index. The debt of Ford F and General Motors GM (and their financing subsidiaries) held the top spots, with yield spreads over comparable Treasuries running between 200 to 300 basis points, depending on the nature and terms of each bond. (Lower spreads signify less risk, and vice versa.) Those figures spiked above 500 more than once during turmoil in 2002 before settling back down in 2003 and 2004.

Things soured badly thereafter, though. Before ratings agencies downgraded both companies’ debt to junk status, their bond prices had fallen such that their yield spreads in April 2005 again increased to between 400 and 600 basis points.

After the downgrades, their bonds shifted into high-yield indexes from the industry’s investment-grade corporate benchmarks. That made them the two biggest fish in a much smaller pond, driving up their weightings to 5.5% for General Motors and 5.6% for Ford within ICE BofA US High Yield benchmark, more than twice what their weights had been in the investment-grade corporate universe.

This automobile debt saga had such a dramatic effect that asset managers implored providers to quickly create high-yield market index variants with issuer caps, so the auto companies’ large footprints didn’t woefully distort benchmarks active managers were using to approximate their investable universe.

Caps on the weights of borrowers in high-yield bond indexes have been helpful for strategies relying on them as benchmarks, but the fundamental difference between equityholders and bondholders still leads to all manner of mischief. In the end, equityholders are incentivized to enrich themselves at the expense of bondholders. Just because caps have helped in the past does not mean problems won’t crop up in the future.

Even mortgage-backed securities with government agency guarantees are subject to investor-unfriendly forces.

Although mortgage market growth may sometimes correlate to economic expansions that validate buying a rising stock market index, mortgage originations are extremely sensitive to low homeowner borrowing costs. 

In other words, a new supply of mortgage loans tends to surge as mortgage yields fall. This can have a dramatic effect on the footprint of mortgage-backed securities in indexes. In this case, government agencies don’t necessarily have any incentive to hurt those buying mortgage bonds, but those buyers are still affected by the interests of another party—homeowners. Their activity and incentives will drive the mix of mortgage debt making up the market, and by extension, index exposures.

As we’ve shown, the bond market’s complexity creates inefficiencies so fundamental and inherent that eliminating them anytime soon would be a mammoth and improbable task. These inefficiencies provide fertile ground for skilled active bond managers to exploit. But the challenges of bond indexers don’t end here. Active managers also have structural advantages over their passive peers.

Active bond fund managers use tools, asset classes, and flexibility around interest rate and credit risk exposures that give them even more advantages over passive funds and their indexes. 

We know this because newly required portfolio disclosures have shed light on how active bond managers position their strategies versus standard benchmarks like the Bloomberg US Aggregate Bond Index. 

The N-PORT filing mandated by the Securities and Exchange Commission since April 2019 requires asset managers to provide comprehensive details about all portfolio investments, including derivatives, pricing levels, securities-lending transactions, leverage, and many other portfolio aspects. That level of disclosure had not previously been publicly available, even though those details matter a lot for bond managers and should matter for fund investors, too.

The N-PORT filings alongside Morningstar portfolio data show that active bond managers have tools and levers unavailable to the index or index-tracking vehicles. Herein lies one of the biggest differences between fixed-income indexing and equity indexing. It isn’t necessarily that active bond managers are more skilled as much as their opportunity set is dramatically wider compared with their bellwether indexes.

N-PORT data shows that a significant number of actively managed bond funds have more market exposure than the benchmark, index-tracking funds like Vanguard Total Bond Market VBMFX, and more-staid active strategies. This is clear from the standpoint of gross exposure, financial leverage, or derivatives positioning.

To be sure, gross exposure, defined as total assets divided by net assets, is an accounting measure but it is important in its own right. 

Even if a fund’s to-be-announced positions are fully collateralized with cash, those cash holdings are earning a rate of return that gives the fund an incremental edge over the benchmark and funds that are not taking advantage of the same ability. Indeed, managers enter into these agreements because they think it is beneficial for their portfolios.

The chart below presents the distribution of the gross exposure for the 158 intermediate core bond portfolios submitted to N-PORT. The Vanguard index proxy has 100% gross exposure—or total assets equal to net assets. All told, 98 funds have gross exposures between 100% and 105%, but that leaves 60 exceeding 105%, including six whose gross exposure is above 150%.

Source: US Securities and Exchange Commission. Data as of March 31, 2025. Portfolio dates range from Nov. 30, 2024, to March 31, 2025, because funds have 60 days to file N-PORT data with the SEC.

Funds that use financial leverage borrow money to increase market exposure. Whether a portfolio shows evidence of such borrowing can be seen from summing up all the weights in the holding-by-holding portion of the N-PORT filing and observing whether and by how much that sum exceeds 100%.

The chart below shows that while most intermediate core bond portfolios have little to no leverage, a sizable number have more aggressive profiles. More than one-fourth of the portfolios (43 out of 158) use financial leverage exceeding 105%.

Source: US Securities and Exchange Commission. Data as of March 31, 2025. Portfolio dates range from Nov. 30, 2024, to March 31, 2025, because funds have 60 days to file N-PORT data with the SEC.

Gross exposures include the accounting value of derivatives marked to market, but that says little about the economic exposure such contracts create. For that, one needs to look at the notional value of funds’ derivatives positioning through futures, forwards, and swaps (both interest rate and credit-default contracts). They provide a clearer picture of the market exposure that derivatives can generate.

To illustrate the difference between marked-to-market and notional value, consider a centrally cleared interest rate swap disclosed in American Funds Bond Fund of America’s BFAFX Dec. 31, 2024, annual report. The fund will receive, until April 18, 2026, a fixed annual interest rate payment of 4.8755% while paying the floating Secured Overnight Financing Rate, which is based on the cost of borrowing cash overnight collateralized by Treasuries in the repurchase market. 

At year-end 2024, this swap agreement had a marked-to-market value of nearly $3.9 million based on a notional value of $430 million (a stand-in for the face value of a bond). It was one of more than 80 noncurrency derivatives contracts with a combined notional value of $71.57 billion against net assets of $90.75 billion.

For American Funds Bond Fund of America and all other intermediate core bond offerings that submitted N-PORT filings in 2025’s first quarter, the chart below sums the notional values for all the noncurrency derivatives contracts for each fund, adds it to the fund’s net assets, and then divides the total by the fund’s net assets. The result is a sizable cohort of funds whose noncurrency derivatives exposure based on notional value is significant. Nearly one-fourth of the portfolios (39 out of 158) exceed 110%, including nine above 150%.

Source: US Securities and Exchange Commission. Data as of March 31, 2025. Portfolio dates range from Nov. 30, 2024, to March 31, 2025, because funds have 60 days to file N-PORT data with the SEC.

Funds with higher noncurrency derivatives exposure based on notional value aren’t necessarily riskier than those with lower totals. It is possible, and even common, for the economic exposure of one derivative contract to offset that of another in the same portfolio. A fixed-for-floating interest rate swap, for example, might be subsequently reversed by a floating-for-fixed interest rate swap.

Still, it is useful to consider all such contracts together. Active managers can reposition portfolios repeatedly using derivative instruments whose marked-to-market values may be modest but whose market exposures are large. Adding up the notional values of all noncurrency derivatives contracts and comparing that figure with a fund’s asset base shows the degree to which a manager or investment team is utilizing levers unavailable to the index or index-tracking funds.

Morningstar portfolio data further shows the extent to which actively managed intermediate core bond funds differ from the benchmark and index-tracking funds in terms of holding types, credit risk, and interest rate risk as measured by effective duration.

The chart below presents a box plot of holdings-type data relative to the Vanguard Total Bond Market Index. The vertical blue line signifies the Vanguard fund’s weighting for each holding type. The dark red portion of the box represents the category’s interquartile range (25th to 75th percentiles), with the median (50th percentile) marked by a red line; the light red portion of the box starts at the minimum and extends to the maximum.

Source: US Securities and Exchange commission. Data as of March 31, 2025. Portfolio dates range from Nov. 30, 2024, to March 31, 2025, because funds have 60 days to file N-PORT data with the SEC.

Differences between the Vanguard index fund as a proxy for the benchmark and the category constituents are readily apparent. 

Three holding types, Treasuries, corporate bonds, and agency mortgage-backed securities, combine for more than 90% of the Vanguard fund’s assets, whereas actively managed fund weightings are generally more varied. A lot of that variation dovetails with underweighting Treasuries. The Vanguard portfolio’s 47.7% Treasury stake is nearly 2 times the category median of 25%. Many active managers gravitate toward overweighting asset-backed securities. The 5.9% ABS category median is more than 10 times the Vanguard fund’s 0.55% allocation.

Even when active managers share an exposure type with the benchmark, credit quality can differ. The Vanguard fund’s 24.65% corporate bond weighting was close to the 23.74% peer median, but many active managers overweight bonds with lower credit ratings of BBB and/or own below-investment-grade-rated corporate bonds that the benchmark doesn’t include. Active managers have an incentive to take more corporate credit risk because those bonds’ higher income helps cover their fees and beat their benchmarks if credit doesn’t sell off.

Even if a credit selloff hurts in the short term, our holdings-type research provides a basic recipe for active managers to increase their chances of outperforming in most market environments. 

Starting in 2002, the earliest common date for the index data, a portfolio weighted 85% in the Bloomberg US Aggregate Bond Index, 10% in the Bloomberg Asset-Backed Securities Index, 4% in the Bloomberg US High Yield 2% Issuer Capped Index, and 1% in the Morningstar LSTA US Leveraged Loan 100 Index that was rebalanced annually through mid-2025 would have beaten the Bloomberg US Aggregate Bond benchmark in 78% of five-year rolling periods. 

Moreover, the success rate of its volatility-adjusted returns as measured by the Sharpe ratio was 92.83%, with the only stretch of underperformance occurring from mid-2008 to late 2009, that is, during a severe credit selloff (as shown on the chart below).

Source: Morningstar Direct. Data as of May 31, 2025. The blend of 85% Bloomberg US Aggregate Bond, 10% Bloomberg Asset-Backed Securities, 4% Bloomberg US High Yield 2% Issuer Capped, and 1% Morningstar LSTA US Leveraged Loan 100 indexes is rebalanced annually.

This success is not surprising. 

As we’ve shown, active fixed-income managers have a built-in advantage versus the index and index-tracking vehicles. In that light, comparing the performance of active and passive strategies, even in the tame intermediate core bond category, requires at best some caveats to be meaningful. 

Given that a simple recipe of holding types, to say nothing of the ability to increase gross exposure beyond 100%, goes a long way toward bettering a manager’s chances of beating the benchmark, one can debate whether a manager able to achieve such reflects skill, better tools, or some combination of the two. But that would be a topic for another study. 

For now, in view of the considerations presented above, most fund investors would do well to consider fairly priced, proven active managers as an option for bond market exposure.