May 11, 2023
Jeffrey A. Johnson
Principal, Head of Fixed Income Product
After a brutal year for fixed income, I often hear two recurring themes in the industry—that bonds are back, and that 2023 will be the year when active management will truly shine. But both need caveats.
After a dismal 2022, it’s true that bond valuations are now lower, yields are up, and so are long-term expected returns. But central banks aren’t necessarily finished hiking interest rates, and a recession is still possible. All that means we’re not done with volatility over the short term.
Greater volatility can mean greater opportunity for active management. But greater opportunity does not necessarily guarantee greater outcomes. Before we go there, let’s look at what does put the odds in favor of active managers.
Setting the odds in favor of winning active fixed income managers
Vanguard believes in both active and passive investing, but our faith in active is contingent on managers meeting a number of criteria. Among them:
- A deep and experienced team, with expertise across sectors and global regions.
- A clear investment philosophy and robust investment process. If a manager cannot explain their approach, stay away.
- A true-to-label approach with transparency. Bonds are meant to be a defensive asset class. They should behave that way, with no surprises.
- Stringent and systematic risk controls, preferably with independent teams that can provide objective opinions and risk assessments.
- Relative consistency in performance and in the portfolio, not causing a whiplash experience for investors.
All the above should be packaged with low costs, as even the most talented managers cannot consistently overcome the hurdle of high operating and transaction costs. According to Lipper data as of year-end 2022, the average five-year annualized return for investment-grade intermediate fund category (which includes funds that we consider to be core holdings) lagged the return of the benchmark (the Bloomberg U.S. Aggregate Bond Index) by a mere 8 basis points, or 0.08 percentage point. According to the Investment Company Institute, the average expense ratio for bond funds in 2022 was 0.37%. Choosing funds with lower expense ratios by itself stacks the odds more in favor of active managers.
The challenges facing active management
If it was easy for active managers to outperform benchmarks in volatile times, then a larger share of managers would have outperformed their indexes not just in 2022, but also over longer periods that capture varying environments for interest rates and inflation.
Instead, at best, the record was mixed. The chart that follows shows the percentages of funds in select categories that underperformed their benchmark indexes over various periods as of year-end 2022. The longer periods include volatile years in the bond markets—among them 2008, 2013, 2015, 2020, and 2022. The results demonstrate that active managers who can add alpha are a shrinking minority over longer periods, even when opportunities abound in the form of market disruption and wider dispersion of returns.
Fewer active bond managers outpaced benchmarks over time
Notes: This chart illustrates the data for five representative categories from the last semiannual SPIVA U.S. Scorecard. The full scorecard had data for 17 fixed income fund categories and compared their performance against the relevant Bloomberg, Standard & Poor’s, or iBoxx indexes as benchmarks. Over one year, 11 out of 17 categories had a majority (more than 50%) underperform; over three years, 12 of 17 categories had the majority underperform; over five years, 16 of 17 categories had the majority underperform; and over 10 and 15 years, 16 of 16 fund categories had the majority underperform (one fund category did not have a full track record over 10 and 15 years).
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Vanguard, using data from the SPIVA U.S. Scorecard as of December 31, 2022.
The bottom line for investors
Identifying that shrinking minority in advance—the future elite among managers who beat their bogies over the long run—is the real challenge for investors who choose to go down the active route.
But it doesn’t have to be an “either/or” decision. There’s room for both active and passive investments. Ultimately, for investors, it’s a matter of preference. Some might prefer the predictability (relative to market benchmarks) of passive funds. Others have the appetite for potential outperformance and the risk tolerance to accept potential underperformance. Still others might hedge with both.
For those who want active management, whether wholeheartedly or partially, the outlook for active is supported by where we are in the economic cycle. As the economy slows and different sectors and issuers diverge in navigating the contraction, some disciplined active managers will successfully separate the winners from the losers and dynamically adapt to new information and new conditions.
Although outperformance is never guaranteed, investors who use a disciplined manager selection process, coupled with low costs, increase the potential for positive and consistent alpha over the long term. Investors should have the patience to let these factors play out, not just in 2023 but over the next decade.
- Vanguard’s disciplined approach to fixed income investing (article, issued March 2023)
- Investing over speculating (Bloomberg Intelligence podcast, issued April 2023)
- Yes, the credit risk premium is worth it (article, issued May 2023)
- The continuum from indexing to active investing (video, issued April 2022)
- The improved outlook for the 60/40 portfolio (article, issued March 2023)
For more information about Vanguard funds, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
All investing is subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
As a seasoned financial expert with extensive experience in fixed income markets, I find the article by Jeffrey A. Johnson, Principal and Head of Fixed Income Product, particularly insightful. Johnson delves into the nuances of the fixed income landscape, discussing the prevailing themes and challenges faced by the industry in 2023. Let me break down the key concepts and provide additional insights:
Market Overview and Outlook:
- Johnson acknowledges the challenges faced by fixed income markets in the previous year and highlights the prevalent industry sentiment that "bonds are back" in 2023.
- He notes that while bond valuations are lower and yields are up after a dismal 2022, uncertainties remain due to potential interest rate hikes by central banks and the looming possibility of a recession.
Active Management Opportunities:
- Johnson suggests that greater market volatility can create opportunities for active fixed income managers.
- He emphasizes that seizing these opportunities doesn't guarantee superior outcomes, and investors need to be cautious.
Criteria for Active Managers:
- Vanguard's perspective on active management is outlined, emphasizing specific criteria that active managers should meet for Vanguard to have faith in their approach.
- These criteria include having a deep and experienced team, a clear investment philosophy, transparency, stringent risk controls, and relative consistency in performance, all packaged with low costs.
Performance Challenges for Active Managers:
- The article acknowledges the historical challenges faced by active managers in outperforming benchmarks, especially during volatile periods in the bond markets.
- Data from the SPIVA U.S. Scorecard is presented, illustrating the percentages of funds in various categories that underperformed their benchmark indexes over different time frames.
- Johnson concludes by highlighting the real challenge for investors: identifying the minority of active managers who consistently outperform in the long run.
- The article suggests that it's not necessarily an "either/or" decision between active and passive investments, and investors can choose based on their preferences, risk tolerance, and investment goals.
Outlook for Active Management:
- Johnson expresses optimism for active management, especially in the current economic cycle, where disciplined managers can navigate sector divergences and adapt to changing conditions.
- The article emphasizes the importance of a disciplined manager selection process and low costs to enhance the potential for positive and consistent alpha over the long term.
This analysis provides a comprehensive overview of Jeffrey A. Johnson's expert perspective on fixed income markets and active management, offering valuable insights for investors navigating the complex financial landscape in 2023.