In recent years, passive management has made inroads versus active approaches. That’s hardly news. What may be surprising is that when it comes to fixed income investing for defined contribution (DC) plans, consultants and advisors support active management almost universally: Over 90% of retirement consultants surveyed by PIMCO earlier this year indicated that active management is important or very important for managing allocations in both U.S. and non-U.S. bonds. None of the consultants recommended a 100% passive approach in fixed income.
At PIMCO, we’re not surprised by these results. Empirical data has long affirmed that actively managed fixed income portfolios have, on average, outperformed passively managed portfolios over time. For instance, over the past 10 years the median active manager within Morningstar’s Intermediate-Term Bond category outperformed the median passive manager net-of-fees by roughly 40 basis points annualized. For the median top-quartile active manager, the return advantage over passive widened to 130 basis points annualized (see Figure 1).
Given current yields, we expect the Barclays U.S. Aggregate Index will produce returns in the neighborhood of 2% annualized over the coming decade. The prospect of increasing a DC participant’s bond return through active management by 50% or more net-of-fees should be sufficient to get investors’ attention.
Remember, too, that managing risk is just as important as generating returns, if not more so. The fact is, traditional bond indexes aren’t what they used to be. Unconventional global central bank policies have boosted levels of government debt and, more recently, driven yields into negative territory for over 30% of the global bond market. Many bond benchmarks today carry significantly higher interest rate risk, lower yields and diminished average credit quality than before the financial crisis.
These compositional shifts underscore the risks of a passive or indexed approach as well as the potential benefits of active management. In an index-based approach one blindly assumes the characteristics of the index.
In contrast, an active approach generally seeks to mitigate concentrated or poorly compensated risks and to capture value across global bond markets, without being constrained to the opportunity set within a given index.
To be clear, the decision to go passive is an active one. Plan sponsors must weigh the lure of lower fees against the potential for higher net-of-fee returns, robust risk management and better participant outcomes offered by a more active approach.
Richard Fulford is head of PIMCO’s U.S. retirement business.