Active Funds Are Winning (in Bonds, That Is)

Active funds’ victory over the past year reflects their ability to foresee and adjust to the Federal Reserve’s interest-rate increases, experts say. And their superior performance over the longer periods reflects their ability to take greater risk than index funds in a growing economy and bull market for bonds.

“Active managers of core bond funds often have structural overweights that add value,” says Jeff Mills, co-chief investment strategist at PNC Financial Services Group. “This enables them to go to areas of the market not accessible to passive managers, such as high-yield [junk bonds] and emerging-markets debt.”

The Right Environment

As for 2018, bond-market interest rates rose sharply for the first 10-plus months of the year in reaction to the Fed’s own rate increases. In times of rising yields, short-term bonds usually fare better than long-term bonds. So funds with shorter durations outperformed funds with longer durations last year.

That played to the advantage of active funds, which have a duration of 4.4 years, compared with 4.9 years for passive funds, according to Morningstar. Duration indicates how much bond prices are likely to fall after a specific rise in interest rates. Treasury bonds, which increasingly have long-term maturities, make up 38.8% of the U.S. bond market’s benchmark index, the Bloomberg Barclays U.S. Aggregate Bond Index. And those Treasurys boost the index’s duration.

“Just by shortening duration, active management was able to outperform, given the sharp rise in yields last year,” says Collin Martin, director of fixed income at the Schwab Center for Financial Research.

Looking at the long term, active bond funds have benefited from rallies by investment-grade corporate bonds, high-yield bonds and emerging-markets bonds for much of the past 10 years. Investment-grade corporate bonds make up just 24.4% of the Bloomberg Barclays Index, emerging-markets bonds 1.7% and junk bonds aren’t in it.

“Active managers have more flexibility to do things differently” than their passive brethren, says Sarah Bush, director of fixed-income research at Morningstar. “In general they have used that flexibility to take more risk.”

Active managers usually outperform in periods when the economy is strong, rewarding bond investors who take credit risk. “But in periods when people are worried about the health of corporate America, passive has outperformed,” Ms. Bush says.

Investors choosing between active and passive funds face a major trade-off, Ms. Bush says. Passive funds have lower costs and take less credit risk, but active funds offer the opportunity for higher returns. Actively managed open-end bond mutual funds and ETFs sport an annual expense ratio of 0.785%, compared with 0.274% for passive funds, according to Morningstar.

The Passion for Passive

The outperformance of active bond funds compared with passive apparently hasn’t moved investors. Money flow into passive bond funds has surpassed that into active funds for each of the past five years, according to Morningstar. In 2018, passive bond funds saw a net influx of $116.57 billion, dwarfing the $20.89 billion for active funds.

“I don’t think the general trend toward passive is going away, despite the performance numbers,” says independent interest-rate strategist David Ader. “Investors say, ‘Why in a low-interest-rate environment should I be in an active fund when fees could be 75 to 80 basis points,” or 0.75 to 0.80 percentage point. In addition, he says, investors will be influenced by their financial advisers who have adopted the idea of passive investing almost as religion.

Going passive may actually be a good idea, Mr. Ader says. Some managers of actively managed bond funds will outperform, but he’s skeptical that they will continue to do so in general. “It’s difficult to broadly outperform over the long run, especially in a stable market,” Mr. Ader says. And he thinks we’re in a low interest-rate environment “for years to come.”

However, others are enthusiastic about actively managed bond funds. “Active is generally our preference,” says PNC’s Mr. Mills. “You’re adding risk, but done smartly, it’s a way to differentiate from the benchmark.”

He stresses the need for patience with active funds. “Anyone going in should realize even the best strategy in the world won’t work in every environment, but over time, these things add value.”

Mr. Weil is a writer in West Palm Beach, Fla. He can be reached atreports@wsj.com.