Fixed income investors have been placing their faith in passive funds for some time, with tracker funds pulling in significant money while their active equivalents are in the red.

Chart 1: UK Asset Class Flows, Passive and Active Mutual Funds and ETFs, 2022 (£bn)

Source: Refinitiv Lipper

This is well illustrated by UK net fund flows over 2022. The most obvious thing from even a cursory glance at Chart 1 is that, while it was a bad year for risk assets, passive bond funds have fared rather better. While their active equivalents suffered redemptions of more than £20bn, passive mutual bond funds took £11.6bn, while bond ETFs netted £6.2bn.
 

Cheap and Liquid

There are a few likely reasons for this. One, of course, is cost: passives are much cheaper. Within the Lipper Fund Classifications on table 1 (of which more later), passive funds are on average between 19% and 30% cheaper than active ones, depending on the sector.

Another is liquidity, especially with regard to ETFs: in an uncertain market, you can get in and out easier. While there were concerns of a mismatch between the liquidity of ETFs as a vehicle and the illiquidity of some of the bonds within them, this seems to have been allayed by their performance in the COVID market meltdown of spring 2020. Plus, what have been selling are mainly passive bond funds tracking very liquid indices of blue chips and developed market sovereign debt.

Lastly, passive bond funds are transparent: it’s easier to model how, say, an investment grade indexed fund will behave, than an actively managed IG fund. In this febrile market, no one is looking for surprises.
 

Dear Prudence

Has this been a prudent move? After all, the active defence is that passive fixed income investing is a mugs’ game: you are, by definition, lending to the most debt-laden entities, whereas the active manager can select issuers with the most attractive fundamentals, giving the bloated leviathans a wide berth.

Which makes intuitive sense. So we thought we’d take a look at who is right: fixed income investors or active managers.

Table 1: Bond Classification Returns, Duration and Cost

Source: Refinitiv Lipper

We analysed five Lipper Global Classifications in the fixed income space, selecting ones that had a significant number of passive and active funds for meaningful comparison (see Table 1). We compared average returns over one, three and five years to the end of 2022, and for January to February of this year.

We also checked whether there was a systematic difference between passive and active products in this regard that was driving performance. One bond characteristic to impact on returns—particularly over the past year—is duration, a bond’s sensitivity to interest rate changes. High-duration vehicles had a wrecking ball go through their returns last year—surprisingly, inflation-linked gilt funds in particular did anything but protect their investors from rising inflation.

Active managers can change the duration of their funds, and many did over the course of the year, with averages decreasing. But what’s interesting is that their passive peers did as well: indeed, the largest decrease in duration to February 2023 is for Bond GBP Government passive funds, which went from 12.5 to 9.21, while its active equivalent went from 11.21 to 9.62. While active managers have been bringing their duration down, the same thing, by a process of rotation within indices, has been happening with tracker funds.

From our sample, it appears that the investors may be on to something. On table 1, periods over which passive beats active are indicated in red. Nine out of 20 are in red. When a performance difference is more than one percentage point in either direction, it is indicated by bold. There is not much bold on the table. In other words, on average, passive investors are getting broadly similar results to active.
 

Benchmark Comparison

One perhaps surprising thing is that returns are more tightly bunched with active funds as opposed to passive within two classifications. For example, 2022 actively managed fund returns run from 0.88% to -7.57%, while their passive peers go from 13.96% to -16.45%. In Bond USD Government, those figures are 1.24% to -9.47% and 14.8% to -27.61% respectively.

That’s not the general rule, however, and there is a wide dispersal of returns in most classifications, whether active or passive. In the latter case, this is due to the plethora of fixed income indices the funds are tethered to, even within the same classification.

Table 2: Single Benchmark Comparison, Percentage Growth to Year End 2022 and YTD

Source: Refinitiv Lipper

So, to ensure we were comparing apples with apples, we also ran a comparison by benchmark, selecting one that had a decent number of both active and passive funds: in this instance, the FTSE Actuaries UK Conventional Gilts All Stocks GBP index, used by many funds in the Bond GBP Government classification. Passive beats active in all but year to date—albeit by a smidgin (table 2). And it does so at 30% of the cost.

None of this means that these performance patterns will continue: the dire warnings of active managers may come to pass, and they will get to utter the four most beautiful words in the English language. But, based on Lipper’s analysis, investors are behaving rationally.

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