News

FA Center

Last Updated: July 15, 2024 at 5:07 p.m. ET

Bond managers, on average, lag the market over time regardless of whether interest rates are rising or falling

Actively managed bond funds are a bad idea even when interest rates are rising.

Several reader emails asked me if actively managed bond funds are more likely to beat the market during rising rate environments. In the case of each email, the reader’s financial adviser had made this claim to justify recommending an actively managed bond fund. I could find no theoretical or empirical support for it.

The claim does have a superficial plausibility. Interest rates have stayed higher for longer. If inflation remains stubbornly high, it’s entirely possible that the U.S. Federal Reserve will have to raise rates.

When rates rise, investors in passive bond index funds have little choice but to sit and watch their funds lose value. Investors in actively managed bond funds, in contrast, can potentially escape this fate because fund managers can opportunistically exploit interest-rate fluctuations to make money even when rates are rising.

One investment firm that prominently makes this argument is Fidelity Investments. In a client document entitled “Why Bond Investors May Benefit from Actively Managed Mutual Funds and ETFs,” the firm argues that the bond market is so large and complex that smart fund managers, when supported by a top-notch research department, can profitably exploit pockets of market inefficiencies.

According to the Fidelity report: “Active bond managers can use many strategies to help investors generate returns and manage risks, even within a rising-rate environment. … Interest rate changes can be very volatile at times, and often require substantial research and trading resources to help position a portfolio appropriately.”

No one disputes that an actively managed bond fund has the potential to beat a buy-and-hold. But it’s theoretically impossible for the average actively managed bond fund to do so, Lawrence Tint said in an interview. Tint is the former U.S. CEO of BGI, the organization that created iShares (now part of Blackrock).

Tint referred me to an influential article from more than 30 years ago by Nobel laureate William Sharpe, entitled “The Arithmetic of Active Management.” (At the time of that article’s publication, Tint and Sharpe together ran an investment consulting firm.) Sharpe wrote that “after costs, the return on the average actively managed dollar will be less than the return” of the overall market, and that this conclusion depends “only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”

In other words, active bond managers on average will always lag the market over time, regardless of whether interest rates are rising or falling.

Sharpe’s theoretical prediction is borne out by the data, as you can see from the chart above, which was constructed from data provided by S&P Dow Jones Indices’ “SPIVA U.S. Scorecard.” It focuses on the percentage of actively managed bond funds that lagged a buy-and-hold strategy over the five years through the end of 2023. I chose this five-year period because interest rates were significantly higher at the end of the period than at the beginning. As you can see, the majority of actively managed bond mutual funds and ETFs lagged buy-and-hold. The average of all bond-fund categories is 74% underperforming.

Almost identical results emerged from periods in which interest rates were falling.

The bottom line? Be my guest if you want to bet on a particular actively managed bond fund or ETF whose manager and approach attracts you. But just know that the odds are against you, regardless of whether interest rates rise or fall.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

Also read: High stakes for investors as Fed tries curing inflation without causing a recession