A version of this article previously appeared in the July 2022 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.
The most recent edition of the Morningstar U.S. Active/ Passive Barometer reaffirmed that active funds on average failed to outperform their average passive peers. But this generalization doesn't apply to all markets. For instance, active managers stand a better chance at beating their indexed counterparts in fixed income than equity markets.
The advantage of passive investing relies on efficient pricing, ample liquidity, and portfolios that are representative of their opportunity set. These characteristics aren’t present in every corner of the fixed-income market. Here, I will dissect two areas of the fixed-income market where choosing a good active manager may make more sense than using an index fund.
The Price Isn’t Right for High-Yield Bonds
High-yield bonds carry ample credit risk. Their higher yields reflect an increased chance of default. If investors aren’t careful, holding these bonds could be like picking up nickels in front of a steam roller.
The potential for mispricing in this market poses a particular challenge for passive investing. A broad, market-cap-weighted portfolio could work here if known risks were accurately reflected in the bonds’ prices. High-yield bonds don’t trade on exchanges. Trades are conducted “over-the-counter” between two parties. Decentralized trading limits the information available to investors and may diminish the informational content embedded in bond prices. High-yield bonds also trade less frequently than other bonds. Fewer trades mean the information reflected in prices is likely to be stale and lower in quality.
Pricing of high-yield bonds may also be skewed by investor behavior. Recent years saw record-low interest rates, causing investors to take on higher risk in their quest for higher yield. This drove bond prices higher and credit spreads lower, potentially inaccurately reflecting the risks of the high-yield market.
High-yield bond performance over the 15 years through June 2022 shows that investors were punished for getting too greedy as they reached down the credit-rating ladder for yield. BB rated bonds, the top credit rating for high-yield bonds, returned 6.4% annualized, followed by B bonds at 4.8%, CCC bonds at 4.6%, and C to D rated bonds at negative 2.3%. This is at odds with the usual investing wisdom of “higher risk, higher reward,” as investors were overpaying for lower-rated bonds when they chased higher yields.
Active managers can benefit by conducting fundamental research to evaluate a company’s default risk rather than blindly reaching for yield, while an index portfolio is stuck paying the market price. A good active manager can also identify pockets of potential among the lowest rungs of the credit-rating ladder, where the dispersion of returns is wider.
Many passive funds in the high-yield market also track indexes that exclude smaller and less-liquid issues to ease trading costs. However, this sacrifices full market representation and leaves room for active managers to add value.
It takes skill to end up on the right side of mispricing, but a fair number of active managers have successfully carved out an advantage. The odds of outperforming the market are significantly higher for active funds in the high-yield market than other markets. Exhibit 1 plots the distribution of excess returns for surviving active high-yield funds against the equal-weighted average return of surviving passive funds in the high-yield Morningstar Category. Around half of active funds outperformed their average passive peer over the trailing 10 years. While the success rate is about even, successful funds outperform more than unsuccessful funds underperform. Notably, more than one sixth of them earned more than 1 percentage point in annual excess return, while unsuccessful funds trailed passive peers by less than 50 basis points.
Bank Loans—A Quirky Market
Bank loans are another corner of the market where active management looks compelling. Like high-yield bonds, these securities carry a healthy dose of credit risk, as most issuers are rated below-investment-grade.
Bank loans also possess more quirks that render them ill-suited for indexing. Bank loans are often considered safer than high-yield bonds because of their seniority in the capital structure. In event of a default, bank-loan investors are made whole before those holding other forms of debt. But seniority is only one risk consideration. The recovery rates on senior loans tend to be higher when there is ample subordinated debt on the issuer’s balance sheet to absorb the loss.
Alternatively, recovery rates tend to be lower for loan-only borrowers than those holding a combination of outstanding loans and bonds. It follows logic that seniority doesn’t matter when there are no lower levels of debt. In addition, new issuances are shifting toward less-restrictive covenants than traditional loans, making them more akin to bonds instead. That complicates the risk assessment and requires managers to conduct more-thorough research to parse out the nuances.
Bank loans are a niche market and don’t trade often, making liquidity a primary concern. They amount to only one fifth of the corporate bond market and less than 5% of the broader fixed-income market.
Bank-loan trades also take longer to settle, which complicates the daily liquidity needs of mutual funds and exchange-traded funds and can lead to high tracking error. Trades in this market can take more than 20 days to settle during volatile periods or for the most thinly traded loans. This forces managers to get creative in managing fund cash flows, often requiring they hold a sleeve of cash or other liquid securities to meet cash flow demands.
Index providers recognize the challenges of systematically trading in an illiquid market. As a result, indexes often apply a liquidity screen (such as minimum outstanding loan amount) to improve the tradability of the index. This leaves passive funds with only the most-liquid portion of this already-small market. While this alleviates some of the tracking and transaction-cost-related issues, it also leaves out a significant portion of the market.
Active funds benefit from having discretion to consider investments on their merits and to act opportunistically. Exhibit 2 plots the distribution of excess returns for surviving active bank-loan funds against the equal-weighted average return of surviving passive funds in the category. It’s worth noting that there were only two passive offerings in this category of 60-plus funds, which itself is a testament to the difficulty of indexing this market. These results should be taken with a grain of salt, but it’s still a clear victory for active funds. All but three outperformed their average passive counterparts over the trailing 10 years ending June 2022. Similar to high-yield funds, around one fifth of the active bank-loan funds earned more than 1 percentage point in annual excess returns during this period.
Getting the Most From Active Funds
Passive strategies do best in liquid, efficiently priced markets and when their portfolio is representative of the opportunity set. These conditions are not met in all markets. I’ve demonstrated that active managers have a leg up on passive funds in the high-yield bond and bank-loan markets, but this logic extends to any category where liquidity may be lacking and mispricing abundant. Investors need to perform extensive due diligence to pick the right active managers, but the probability of success against the average passive fund is higher in these markets.
Stock- or bond-picking is a skill, and so is manager-picking. Investors can consider some of our active fund Morningstar Medalists in the high-yield and bank-loan categories that Morningstar analysts have thoroughly investigated and written about.
Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Morningstar, Inc. does not market, sell, or make any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.