• A record 27% of money in bond funds is now in index trackers
  • Low returns favor cheap funds as active managers warn of risks

If you’re a bond manager, you may think index funds are the headache of your stock-picking colleagues.

Think again. U.S. managers tracking indexes oversaw a record 27 percent of the money in taxable-bond mutual funds and exchange-traded funds as of Feb. 29, compared with 20 percent at the end of 2013, according to Morningstar Inc. While the proportion is smaller than the roughly 40 percent of equity-fund assets in passive products, the trend and the reasons -- cost savings and a poor performance of active managers on average -- are similar.

Bonds were slower than stocks to face the threat from indexing because their returns typically are lower and the difference in performance among funds is often modest. But as interest rates have plunged, even small expense savings can be meaningful to investors who switch to index funds. The growth in fixed-income ETF products has given those same investors more choices when they do convert.

“We are at a point now where every manager, whether in fixed income or equity, has to show value for the fees they are charging,” said Jeffrey Stakel, a partner at Casey Quirk & Associates, a consulting firm that works with investment managers. “Everyone is under the microscope.”

The shift has been gathering steam. As recently as 2012, active taxable-bond funds attracted three times as much money as passive ones. Since then, bond pickers have suffered outflows each year while index trackers have seen surging inflows.

Record Gap

The gap in 2015 -- a net $70 billion left active funds while $97 billion went into passive funds -- was the widest ever, according to Morningstar data. Pacific Investment Management Co. and Franklin Resources Inc. saw cash leave their active bond funds. Vanguard Group, the indexing pioneer, and BlackRock Inc.’s iShares unit, the biggest ETF provider, added money.

Pimco’s $88 billion Total Return Fund, whose outflows were exacerbated by the September 2014 exit of manager Bill Gross, is less than a third of its peak size. Franklin’s $50 billion Templeton Global Bond Fund, run by high-profile manager Michael Hasenstab, lost more than a fourth of its assets in the past year as performance slumped.

Clients are giving up on active funds in part because many can’t justify their higher cost. A majority of active taxable-bond funds failed to beat the benchmarks cited in their prospectuses in seven of the past 10 calendar years, Morningstar data show. Last year, only 25 percent of bond pickers outperformed.

‘Performance Matters’

Those that do beat their benchmarks are still reeling in cash. Jeffrey Gundlach’s $58 billion DoubleLine Total Return Bond Fund pulled in more than $10 billion in the 12 months ended Feb. 29, as did Daniel Ivascyn’s $56 billion Pimco Income Fund. Both managers beat the Barclays U.S. Aggregate Bond Index and at least 98 percent of their peers over the past five years at their main mutual funds, according to data compiled by Bloomberg.

“Performance absolutely matters,” said Ivascyn, Pimco’s group chief investment officer. “We as asset managers need to generate those risk-adjusted returns.”

These managers are warning that investors in index funds are at a higher risk of losses when interest rates go up. Active managers have the flexibility to adjust the duration, or rate sensitivity, of their holdings, if they anticipate higher rates, said Bonnie Baha, director of global developed credit at DoubleLine.

They can also pick the bonds they deem most attractive, whereas indexes are weighted to the biggest debtors rather than those with better credit or less interest-rate risk, Baha said. The Barclays Aggregate, the broad benchmark tracked by many managers, has crept longer in duration and lower in yield in recent years, making a less attractive risk-reward proposition, she said.

Investors ‘Complacent’

“For investors to be walking into passively managed fixed-income vehicles at this point in the cycle tells me they’re being complacent,” Baha said. “This is when you don’t want to be passively managing your assets at all.”

Yet with interest rates still stuck near zero eight years after the financial crisis, and 10-year Treasuries yielding about 1.7 percent, many investors are opting for the immediate benefit of cost savings.

“The odds are tremendously against active management, and today’s low-yield environment creates an even greater headwind,” said Randy Bruns, a financial adviser in Downers Grove, Illinois.

The largest U.S. fixed-income mutual fund, the $125 billion Vanguard Total Bond Market Index Fund, charges shareholders 5 cents for every $100 invested. The biggest active fund, Pimco Total Return, costs 46 cents. The Vanguard fund has returned an average of 2.2 percent over the past three years, compared with 1.4 percent for the Pimco fund. The index fund is also doing better over one year and five years.

‘Target-Rich Environment’

Ivascyn acknowledges the challenge, but points out that active fixed-income funds had some of their best years after the 2008 financial crisis as they found opportunities, such as mortgage-backed securities, outside benchmarks. Similar opportunities could be developing in emerging-market and corporate debt now, he said.

“I have no doubt this is going to be a very target-rich environment, particularly in the fixed-income universe,” Ivascyn said.

The proliferation of ETFs is speeding up the adoption of bond indexing. Investors poured a record $43.5 billion globally into fixed-income ETFs in the first quarter of this year, up 22 percent from the first quarter of 2015, BlackRock reported April 6.

Michael McKevitt, an adviser in Palatine, Illinois, who has been indexing his clients’ equity money since 2009, last year started doing the same with his bond portfolio. McKevitt, who helps oversee $150 million, said he wasn’t “thrilled” with the performance of the active bond funds he held -- or by the fact that the managers seemed to have little insight into the direction of interest rates.

“We thought if we can save 50 basis points, it would be a better play for our clients,” he said.

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