The debate between actively and passively managed equity mutual funds has raged for decades.  My position is that the only way that actively managed stock funds can outperform is either by fund managers picking winning stocks in advance or by timing market ups and downs, which requires the consistent ability to successfully predict the future. I do not believe in (and there is no evidence to support) anybody’s ability to achieve this.  Furthermore, actively-managed funds cost more money because the fund has to pay for the analyses underlying its future predictions. For these reasons I do not recommend actively-managed equity funds.

Bonds, however, are not the same as stocks. A bond’s future price and return are much more calculable at purchase than are those of stocks. As a result, fixed income fund managers (as well as financial planners) have a lot more tools available to them for generating additional returns as compared to index funds. Here is a brief summary of some of the ways active bond fund management can outperform.

One simple approach during a rising rate environment (such as the one in which we find ourselves today) is to reduce the overall duration of the bond funds in your portfolio through appropriate fund selection. Shorter-duration bonds have less price sensitivity to interest rate changes, and therefore will exhibit less volatility. Although the upside growth will also be more limited as compared to longer-duration bonds, since rising interest rates push bond prices down, the downside risk is higher during such periods.

Another strategy utilized by active bond fund managers is known as “rolling down the yield curve.”  The yield curve is a plot of the yields of bonds with similar credit quality on the vertical axis against their maturities on the horizontal axis, from short to long.  Yield curves are most commonly upward sloping, meaning the yields for shorter-maturity bonds are typically lower than yields for longer-maturity bonds.  This is because the closer a bond is to maturity, the less risky it is.  A ten-year bond after four years becomes a six-year bond, and if the yield curve is positive, its yield will have dropped and its price will have increased. As the bond ages and its risk declines, the fund manager can use the curve (and other bond attributes such as convexity) to determine the optimal time to sell the bond and collect the maximum risk premium that had built up. Through diligent yield-curve analysis, an active bond fund manager can generate total returns that exceed a traditional buy and hold-to-maturity approach.

Active bond fund managers can also utilize credit spread analysis to uncover value. Credit spreads are the yield differences between riskier and less-risky bonds. The yield on a ‘BBB’ rated bond, for example, would be higher than that of an ‘AAA’ rated bond, all else being equal, to compensate for the additional risk. Portfolio managers evaluating credit spreads may identify value in one credit tier relative to another and/or in one issuer as compared to others with similar credit quality.

Monitoring bond issuance and investor demand is another way to increase returns or manage volatility.  Supply and demand can affect bond prices in the same way that they impact prices of goods and services in any market-based economy.  For example, in today’s low-interest-rate environment, demand has increased for lower-quality bonds as investors look for opportunities to get higher yields.  On the supply side, in Q4 2017 there was a surge in bond issuance, driven in part by federal tax reform.  Such macro fixed income events are frequently indicative of bond price shifts of which fund managers can take advantage.

Maximizing returns from across the bond universe requires a level of sophistication that few individual investors have.  Unlike stock fund managers, who are largely guessing the future (despite the fancy analytical terminology they may use), active bond fund managers provide true value to bond investors in terms of higher returns or lower volatility than most investors themselves are capable of achieving.