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Investors are becoming passive, aggressively. While substantial inflows into funds that merely track a stock market index is not new, the trend is becoming increasingly powerful in bond markets too.

This raises a host of thorny issues both for bond buyers, as well as the community of active managers who stake their claim to command juicier fees on an ability to beat the performance of a benchmark or index.

Actively managed bond funds have lost a total of $13.6bn this year, while bond ETFs have captured more than $42bn of investors’ money this year, according to data from EPFR. 

The trend is particularly strong in the US, where bond ETFs have sucked in about $370bn, almost 10 per cent of the total invested in US bond mutual funds and up from 6 per cent just five years ago, according to data from the Investment Company Institute.

Including index-tracking funds, more than a quarter of US bond money is now in passive funds, according to Morningstar.

This year will be a “tipping point”, argues Stephen Cohen, head of fixed income beta at BlackRock, one of the dominant providers of ETFs.

“We are seeing a structural shift toward awareness, understanding and adoption of fixed income ETFs,” he says.

Daily trading volumes in HYG, BlackRock iShare’s flagship junk bond ETF, have climbed from $657m in the third quarter of 2015 to $1.2bn in the first three months of 2016.

LQD, the equivalent ETF for investment grade debt, had a daily average volume of 4.2m shares in the first quarter of this year, up from 3.3m in the last quarter of 2015, according to Bloomberg data.

Underscoring the shift, Vanguard’s Total Bond Market Index fund, a passive index-tracking bond vehicle, is now comfortably the world’s biggest fixed income fund after surpassing Pimco’s once imperious Total Return fund last year.

However, passive bond investing is not without its challenges — or critics. Bond ETFs, for example, tend to be more expensive than stock ETFs to reflect the more onerous work of managing them, as well as their less liquid underlying securities. HYG charges fees of 50 basis points while State Street’s SPY, which tracks the S&P 500, charges only 9.5bps. 

In addition, ETFs mostly track  indices weighted by market capitalisation like the S&P but in fixed income they are weighted by the amount of debt outstanding. 

chart: biggest outflows from active bond funds

This carries dangers, according to Gershon Distenfeld, director of high yield at AllianceBernstein, who maintains that active management provides better returns in high yield markets in particular.

“The more debt that an issuer issues the greater the allocation to the index,” he says. “The riskier a company becomes, the more exposure you get to it. Passive investing just doesn’t work in high yield.”

Some even argue bond ETFs are dangerous, offering the illusion of liquidity  while tracking debt instruments that may only trade occasionally.

Carl Icahn, the well-known activist, last year told Larry Fink, the chief executive of BlackRock that his products were “toxic”.

Critics’ concerns have been heightened with robust retail appetite for fixed-income ETFs in recent years, spurred as the Federal Reserve’s ultra-low interest rate policy forces investors to hunt for yield.

The shift to passive investment in bonds remains well short of that unfolding in the US stock market. Over 40 per cent of money in US stock market funds is in passive funds that simply track an index.

Nor is the move a clean trend. Analysts at Fitch point out that the acceleration in volumes may also stem from Wall Street banks retreating from their historic role as providers of liquidity in the corporate bond market, forcing investors to seek other ways of getting access to bonds. 

chart: flows leave bond mutual funds and head into ETFs

There’s also the travails of big name bond managers to consider. Pimco, the California-based bond behemoth, lost over $66bn from its actively managed funds in the 12 months to the end of February, still reeling from the exit of star bond picker Bill Gross.

The outflows account for roughly two-thirds of all outflows from taxable bond funds, according to Morningstar data. 

Even actively managed mutual funds now make up a sizeable chunk  of those using ETFs. For BlackRock’s Mr Cohen, this shows the melding of passive and active management, rather than a shift from one to the other. 

For example, Lance Humphrey, a portfolio manager at USAA, says the asset manager invests in ETFs but tend to use the product to augment their active investment strategy. 

“Particularly in the bond market there can be liquidity issues,” says Lance Humphrey, a portfolio manager at USAA. “In high yield, our core exposure is and will continue to be active management but if we want to make a quick move in or out it is more efficient for us to take that exposure with an ETF.”

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