Active vs. Passive Management in Bond Funds

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Investors in bond mutual funds and exchange-traded funds (ETFs) have the choice between two types of portfolios: actively managed funds and passively managed funds.

Key Takeaway

  • Actively managed bond funds have a fund manager deciding on a portfolio while the portfolio of passive funds typically mimics an index
  • Actively managed funds have more fees because they have more turnover which means more maintenance.
  • Passively managed funds have lower fees because they have less turnover which means less maintenance.
  • Performance of passively managed bond funds mirror the underlying index while returns for actively managed bond funds can deviate from the index significantly.

Passively Managed Funds

Passively managed funds – also called index funds – invest in a portfolio of bonds designed to match the performance of a particular index, such as the Barclays U.S. Aggregate Bond Index. Index funds simply hold the securities that are in the index, or, in many cases, a representative sample of the index holdings. When the composition of the index changes, so do the fund’s holdings. In this case, the managers of the funds aren’t seeking to produce returns greater than the benchmark – the goal is simply matching its performance. Most ETFs are passive funds that mimic an index as well.

Actively Managed Funds

Actively managed funds are those with portfolio managers who try to choose bonds that will outperform the index over time and avoid those they see as likely to underperform. In general, their goal is to find bonds that are undervalued or to position the portfolio for anticipated changes in interest rates. Active managers can adjust their funds’ average maturity, duration, average credit quality, or positioning among the various segments of the market. Though actively manage ETFs are less common, but they do exist.

Active Funds Vs. Passive Funds: Key Differences

  Active Funds  Passive Funds
Fund Manager Yes No
Fees Higher fees Lower fees
Turnover and Taxes Higher turnover can create tax liability Lower turnover
Performance Theoretically can provide better returns than passive funds but doesn't always happen Returns mimic the returns of the benchmark index

Fees

Since actively managed funds incur more trading costs and need to devote greater resources to research and portfolio management than passively managed funds, they tend to charge higher expense ratios. Sometimes, this is worth it, but very few actively managed funds can sustain outperformance relative to indices over an extended period of time.

Note

Over time, the higher fees of active bond managers tend to eat into returns – particularly in an environment of ultra-low interest rates.

Turnover and Taxes

Since actively-managed funds are steadily shifting their portfolios in response to market conditions, they have a much higher turnover than index funds, which only change when the underlying index changes. This can result in a higher tax bill at year-end, which reduces investors’ after-tax returns.

Performance Variability

One of the most important reasons investors would choose an actively managed fund is the notion that the fund will be able to beat the market over time. That may, in fact, occur, but along the way, even the best funds can have off years.

Note

Passively managed funds produce returns that are in line with the market, actively managed bond funds can deviate, up or down, from the benchmark index return.

And when a fund underperforms, investors run the risk that they will be correct in their initial choice (for instance, to invest in high yield bonds), but they won’t receive the full benefit of their decision.

Performance Results

This is the most important difference between active and passive management. One reason for this is the fees – the gap between the two types of funds is large enough that the difference compounds over time. Also, the market is so efficient – i.e., analyzed by such a large number of investors – that it’s extremely difficult for a manager to deliver consistent outperformance over the long term.

Another aspect to consider is that active bond fund managers are likely to take on more credit risk compared to passive bond funds. This strategy can lead to substantial gains if it pays off, or in a challenging economic environment, can drag down the fund's performance if it doesn't work.

For example, in 2022, the Federal Reserve began raising rates to combat high inflation. When interest rates rise, bond prices fall which in turn impacts bond fund negatively.

According to Morningstar data, over a one year period ending June 2022, less than a third (29%) of actively managed bond funds fared better than even the most average bond index funds. Active fund managers focusing on high-yield bonds and corporate bonds saw some of the lowest success rates.But those figures represent a very short time frame in a year that has been especially challenging for bonds.

For a 10-year period ending Dec. 31, 2021, Morningstar data analyzed by Fidelity suggests that most active bond funds have outperformed their benchmark index in several short and long-term bond funds categories. It is important to understand the context behind these numbers. The ten years represented by this data were years where interest rates were relatively low. Also remember, since long-term bonds are more sensitive to changes in interest rates, bond funds that have long-term bonds in their portfolio hurt more if interest rates rise.

The biggest takeaway from these numbers is that in theory, active management should enable the managers to add value through security selection, avoidance of losses, or the anticipation of rating changes to the bonds they hold in their portfolios. In reality, however, the numbers don’t show this to be true in all scenarios.

Active Funds Vs. Passive Funds: Which Strategy Is Right For Me?

There are a lot of factors that determine the success of your bond fund investment. Passive bond funds have lower fees and lower turnover compared to active bond funds, that's two things that won't eat into your returns.

On the flip side, active bond managers tend to veer away from the index-based portfolio of passive funds, taking risks that could deliver huge rewards. But economic conditions and the fund manager's competence determines the fund's performance. However, picking which manager will outperform in the next five to ten years is much more challenging. Keep this in mind as you’re selecting funds for your portfolio.

Frequently Asked Questions (FAQs)

What is a bond index fund?

A bond index fund is a bond mutual fund that matches its portfolio to a bond index in order to mirror the index's performance. Index funds are also called passive funds because their portfolio only changes when there is a change to the underlying index. This is in stark contrast to actively managed funds where a fund manager makes changes to the fund's portfolio. Bond index funds, typically, have lower fees and turnover compared to actively managed bond funds.

What is a high-yield bond fund?

A high-yield bond fund is a fund that invests in junk bonds. Bonds are loans that investors make to an issuer in return for interest. Bonds receive credit ratings based on the creditworthiness of the bond issuer (think credit scores for consumers.) The lower the rating, the higher the chance that the bond issuer will default on payment. Junk bonds are bond issues that have low credit ratings and therefore high risk. To compensate for the risk, such bonds offer high rates of interest or high yields.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Morningstar. "Market Volatility Hasn't Helped Active Funds Beat Their Passive Peers."

  2. Fidelity Investments. "Why Bond Investors May Benefit from Actively Managed Mutual Funds and ETFs," Page 2.

  3. Board of Governors of the Federal Reserve System. "Policy Tools."

  4. Investor.Gov U.S. Securities and Exchange Commission. "What Are High-yield Corporate Bonds?"

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