Artemis: Why passive bond funds don't work

Passive fixed income funds took in $303bn of new money last year, compared with $237bn for active strategies¹. The passive share of international fixed income markets is now 39% – up from 27% a decade ago². You can see the direction of travel, and I should be cross. 

But the more money that’s sunk into passive strategies, the greater the opportunity for active managers to outperform – because bond markets aren’t like equity ones. 

Bond markets are far more inefficient. At any one time, a single company may have dozens of different bonds on the market – of differing durations and in differing currencies. They’re all guaranteed by the parent company, so the underlying risk is usually the same, and essentially they should be priced the same.

They’re often not. In the short term we see lots of mispricing we can take advantage of if we’re quick and alert. And much of that mispricing is caused by dumb passive funds doing what dumb passive funds do. 

Passive funds become forced sellers in a downturn 

There are a couple of key issues. First, it’s incredibly hard to replicate an index that may hold tens of thousands of bonds in differing sizes. So passive funds are often forced into some form of sampling, where they replicate the duration, sectors, risk and country weights of the index by using the larger liquid bond issuances. 

Whenever you get a bit of panic and everyone is trying to jump ship at the same time, passive funds try to sell the same bond.

The Covid crisis perhaps offered the best illustration of that. We went into the pandemic with more risk than was ideal but still managed to outperform. At times like that you would expect sectors like telecoms or utilities to perform well – we all needed our phones, gas and electricity. But some of these bonds did badly. 

That enabled us to sell out of some of our higher-risk holdings, such as subordinated financials, and jump into lower-risk ones without surrendering much in yield. 

Nonsensical bond pricing 

At the time we thought it was completely crazy and had no idea what was going on. We knew it didn’t make sense. It was only later that we realised these bonds got hammered so badly because passive funds were forced sellers. 

Whenever passive funds have outflows they just have to sell a bit of everything, regardless of the risk event. And that means those lower-risk bonds. We weren’t complaining. 

Similarly, at the start of the pandemic we were holding a Tier 2 Barclays bond – less secure than a senior one. Its price materially outperformed the less risky one for a while. We swapped and were rewarded with a higher yield for the privilege. Again, this was the result of passive bonds jettisoning larger assets indiscriminately, sending their prices down and yields up. 

Passive funds hold the most indebted companies 

The second feature of passive funds which gives me comfort is weightings. Whether they’re investment-grade or high-yield funds, passive vehicles weight their holdings in proportion to the amount of debt a company has in issuance. A thoughtful investor might decide that having most exposure to the company with the biggest debt isn’t necessarily smart. 

Take Virgin Media O2. Broadband is so good these days that Virgin’s service no longer commands much of a premium – who wants the fastest broadband if a slightly slower, much cheaper one does the job for no noticeable difference? 

Virgin is having to cut prices to keep customers, yet it’s still losing many. Meanwhile, its debt costs have risen substantially along with interest rates. Its debt repayments are heading towards £1bn a year, but it has old (lower-cost) debt to refinance (at a higher cost). That’s a risk we’ll avoid, thank you. Not passives, though – a company with £1bn annual debt bill will be a big part of their portfolios, because of that scale. 

Small active funds have an advantage over larger ones

In short, then, a good active manager has many opportunities to outperform passive bond funds. And in markets where there’s a large dispersion of returns, that becomes more apparent. We don’t know what lies ahead, but we do know there will be surprises. Looking back on the past six or seven years, it often seems like the only thing we’ve yet to witness is an alien invasion. I’d like to see how passive bond funds handle that. 

The only other point I would make is that if you’re going to be invested in an active fund, make sure to be invested in one nimble enough to be able to trade these opportunities and not so diversified that they don’t make any difference. 

Looking back on the past six or seven years, it often seems like the only thing we’ve yet to witness is an alien invasion. I’d like to see how passive bond funds handle that.

Many peers have a flagship retail fund with an iceberg of institutional segregated mandates sitting beneath. In an era of ‘treating customers fairly’, it would be difficult for a manager to say: “I’ve got this great trade – I’m just going to put it on for me.” 

Offering the opportunity to the teams managing the segregated mandates may take time, which means you lose the opportunity. Or by the time they’ve all piled on board, your £10m trade has become a £100m trade, and that’s too much – the liquidity isn’t there. 

I’m not saying we can’t manage a lot more money than we do, but there comes a point where you’re too big to take advantage of those dumb passive funds. Thankfully, we’re some distance away from that.