Active Bond Managers Show Their Worth in a Turbulent Decade

Active Bond Managers Show Their

Worth in a Turbulent Decade

Key Takeaways

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A new Eaton Vance study found that actively managed funds in nine

major Morningstar fixed-income sectors collectively beat passive funds

over the 3-, 5- and 10-year investment horizons studied.

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Active managers also showed consistency in their outperformance:

They prevailed over passive funds in 84 rolling three-year periods ended

within the past 10 years, representing a winning batting average of 87%.

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The greatest outperformance by active managers occurred over the most

recent three-year period, which included the massive bond market selloff

of 2022. This highlighted the ability of active managers to mitigate

downside risk.

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Explanations for the underperformance by passive funds may include

their lack of flexibility to adapt to changing market conditions, and

self-limiting opportunity sets.

The growth of passive investing fundamentally re-shaped the market for

equity mutual funds. Since passive funds were introduced in the 1970s,

their assets under management have grown to $13.3 trillion, according to

Morningstar, as of December 31, 2023. Last year was notable in that passive

fund assets for the first time eclipsed the $12.2 trillion in active funds. For

the larger equity sectors, investors have mostly been rewarded for choosing

passive. For example, in the six largest Morningstar equity categories

, active

funds underperformed their passive counterparts for the 10 years ended

December 31, 2023 on an equal-weighted basis.

TOPIC PAPER | FIXED INCOME | May 2024

AUTHORS

Large-cap growth, large-cap value, large-cap blend, mid-cap growth, mid-cap value, mid-cap blend.

Past performance is no guarantee of future results.

CHRISTOPHER

REMINGTON

Managing Director

Product &

Portfolio Strategy

KATIE HERR

Managing Director

Fixed Income

JUN LI, CFA

Executive Director

Performance & Risk

Management

7 ACTIVE BOND MANAGERS SHOW THEIR WORTH IN A TURBULENT DECADE | MAY 2024

Unsurprisingly, passive fixed-income investing has also

surged in popularity in recent years. But a new study by

Eaton Vance of fixed-income mutual funds paints a different

picture. It shows that fixed-income active managers have

handily outpaced the passive ones, based on analysis of 327

funds with $2.2 trillion in AUM in nine major fixed-income

Morningstar categories.

As shown in Display 1, we found that actively managed fixed-

income funds collectively beat the passive ones over the 3-,

5- and 10-year investment horizons studied. Active managers

also prevailed in our analysis of 84 rolling three-year periods

ended within the past ten years. In other words, active

outperformance has been a consistent theme through time,

not one just buoyed by recent outperformance.

In this report, we outline the study’s key findings, and

explore some of the potential reasons why active fixed

income has consistently delivered superior results.

A record of active outperformance

As shown in Display 2, actively managed fixed-income funds

collectively beat the passive ones over the three investment

horizons studied. For the taxable universe, the active

advantage was an annual average of 121 bps over three years;

by 112 bps over five years; and by 68 bps for 10-years, ending

on December 31, 2023. For the municipal universe, the active

advantage was an annual average of 68 bps over three years;

by 53 bps over five years; and by 33 bps for 10-years. Over

that full 10-year period, active funds outperformed in eight of

the nine major Morningstar fixed-income categories.

Eaton Vance research based on Morningstar U.S. fund data, comparing actively managed fund net returns with passive funds, based on the lowest expense ratio

share class performance on an equal weighted basis, as of December 31, 2023.

The study considered a Morningstar universe comprising 793 active funds with $1,438 billion in assets under management (AUM) and 137 passive funds, with

$1,097 billion AUM, including both open end funds and ETFs, in nine well-defined and relatively homogeneous fixed income categories. (See Display 1 for list.)

We made several adjustments to ensure balanced and fair comparisons, starting with analysis of the benchmarks used by all funds – active and passive – within

a certain category. We then excluded funds benchmarked to indexes that don’t represent the general characteristics of the category. This included indexes that

generally did not match the category’s overall characteristics based on criteria such as credit, duration, geographic or asset class. We further applied an AUM

floor of $500M (as of 1/31/2024).

After applying the benchmark and AUM filters, the study’s universe included 289 active funds with $1,226 billion AUM, or 85% of the original, and 38 passive

funds with $982 billion AUM, or 90% of the original. Past performance is no guarantee of future results.

DISPLAY 1

Active fund managers outperformed over 10 years, but especially in the volatile past 3 years.

Average Annual Total Return (%) for periods ended 12/31/23.

Source: Eaton Vance research based on Morningstar U.S. fund data and categories, as of December 31, 2023. See footnote 2 for description of methodology.

Past performance is no guarantee of future results.

8MAY 2024 | ACTIVE BOND MANAGERS SHOW THEIR WORTH IN A TURBULENT DECADE

DISPLAY 2

Active outperformed by a meaningful margin in both taxable and municipal categories, over all periods.

Margin of outperformance by active managers in avg. annual return over period.

Source: Eaton Vance research based on Morningstar U.S. fund data and categories, as of December 31, 2023. See footnote 2 for description of methodology.

Past performance is no guarantee of future results.

The recent three-year period highlights an important

consideration in any discussion of active versus passive: the

flexibility of active managers to seek avoidance of downside

risk. Recall that those three years encompassed one of the

most traumatic episodes in modern bond market history.

In March 2022, the U.S. Federal Reserve began raising interest

rates, and did so 10 more times through July 2023, boosting

the Federal Funds rate to 5.50% from 0.50%. So, too, did

other major central banks join the global fight of inflation,

including the ECB, BOE and many others. Widespread carnage

in the bond market resulted, as major fixed-income indexes

like the Bloomberg Aggregate lost 13.0% in 2022.

Over the past three years, active outperformed passive in

all nine fixed-income sectors, with margins ranging from 251

bps to 18 bps. This analysis did not include data to determine

attribution of these excess returns with precision. But there

are clearly structural differences worth considering, and it’s

reasonable to assume it simply wasn’t luck.

It’s worth noting that three sectors produced positive returns

during the three years ended December 31, 2023, led by bank

loans, which have rates that adjust with changes in short-term

rates. The return of active bank loan managers was 4.98%—

96 bps higher than passive funds. The other two sectors in the

black over the most recent three years were High Yield and

Muni National Short (but in the Muni National Short sector,

only active managers had positive returns; passive lost 2 bps).

A better batting average for active

Our second broad analysis – often referred to as a “batting

average” – highlights the consistency of outperformance by

active managers. Display 3 shows how often actively managed

returns exceeded passive funds in 84 rolling 3-year periods

that ended over the course of the 10-year investment horizon.

Source: Eaton Vance research based on Morningstar U.S. fund data and

categories, as of December 31, 2023. See footnote 2 for description of

methodology. The batting average is a statistical measure of a manager’s

ability to consistently beat the market or competitive fund universe. In this

study, it is calculated by dividing the number of rolling 3-year periods in which

the manager beat or matched passive funds by 84 -- the total number of

3-year periods ended 12/31/23.

DISPLAY 3

Active fund managers consistently outperformed passive

over a long period.

Percentage of 84 rolling 3-year periods ended 12/31/23 in which active

outperformed passive.

10-YEAR BATTING AVG.

Emerging-Markets Local-Currency Bond 100%

Emerging Markets Bond 73%

Bank Loan 93%

High Yield Bond 95%

Intermediate Core Bond 96%

High Yield Muni 98%

Muni National Long 76%

Muni National Interm 60%

Muni National Short 91%

Overall: 87%

9 ACTIVE BOND MANAGERS SHOW THEIR WORTH IN A TURBULENT DECADE | MAY 2024

Morningstar, “Are High-Yield ETFs Junk?” May 8, 2017.

On average, active funds in all nine sectors outperformed

in 87% of the rolling periods, ranging from 100% for

Emerging Markets Local Currency to 60% for Muni National

Intermediate. The results suggest that the advantages active

managers displayed to the greatest extent during a distressed

market also were effective in more-normal environments.

Flexibility can be key to active fund alpha

As noted above, analysis of the numerous strategies

employed by active managers is beyond the scope of this

study. Thus, we can’t definitively point to the factors leading

to their consistent outperformance versus passive funds.

However, active funds – by definition – have flexibility

to proactively take advantage of opportunities that arise

as markets fluctuate. Passive funds make no attempt.

For example, a typical active emerging markets debt fund

may seek to generate alpha through country and security

selection, currency management, trading and execution,

and duration management. The first two may be the

principal focus, but the others give managers significant

leeway to seek other sources of return or manage risk

as market conditions change.

Management of currency and duration exposure, along

with cost-effective trading and execution, are important

considerations in emerging markets, but they are absent

by design in passive funds.

In stressed markets, active managers can manage credit

quality exposures, shorten or lengthen duration, or

emphasize defensive or opportunistic sectors. They

also have a broader investment universe, which can be

advantageous in any environment. For example, in the

emerging markets example, fund managers have the

ability to hold U.S. Treasury debt. Or, managers of bank

loan funds can allocate to high yield bonds and CLOs

(collateralized loan obligations) when they see value in

those sectors.

In short, active managers have discretion to take action

that seeks to improve returns, enhance yield or lower risk,

and this study suggests that, on balance, they have used

that discretion effectively.

The drag of passive inflexibility

A closer look at the indexes mirrored by passive funds

suggests that they may have an ongoing structural

disadvantage in competing with active funds, both in terms

of higher transaction costs and lower income potential.

When indexes change their composition, so must passive

funds, which effectively become forced buyers or sellers

– something that is not optimal in bond investing, as it

creates friction that can erode returns. As Morningstar

noted in a study of high-yield passive funds, “Index fund

managers can face particularly high transaction costs when

they mechanically trade to match index changes.”

As such,

many indexes have minimum liquidity requirements for their

component bond issues to ensure the funds will be able to

buy or sell when needed.

Bond portfolios limited to issues with greater liquidity may

sound benign or even preferred, but that constraint imposes

a cost. Less-liquid bonds generally offer higher yields – the

so-called “liquidity premium” that active managers can

capture but many passive funds must forgo, potentially

reducing their income stream.

To implement their liquidity requirements, most passive

funds indexes are constructed to emphasize the most highly

indebted issuers in the sector – the more debt a company

has on its books, the greater the index weighting. While

this may work to boost liquidity, portfolios that feature

companies with the highest debt loads may not be what

the average investor bargained for. This is especially true

for sectors like high yield bonds and bank loans, which, by

definition, are below investment grade.

Looking forward to the active advantage

The key takeaway for us is that the structure of passive funds

in fixed-income investing robs them of the flexibility to adapt

to changing markets. For the decade considered by our study

– including one of the worst bond market environments in

recent memory – active managers have shown their ability to

use that flexibility to benefit their investors.

Going forward, we suggest investors interested in the

potential of fixed-income sectors look beyond only the

superficial appeal of passive funds and consider where the

superior returns have actually been delivered.

eatonvance.com

IMPORTANT INFORMATION

Risk Considerations:

In general, equity securities’ values also fluctuate in response to activities specific

to a company. Investments in foreign markets entail special risks such as currency,

political, economic, and market risks. The risks of investing in emerging market

countries are greater than risks associated with investments in foreign developed

countries. Fixed income securities are subject to the ability of an issuer to make

timely principal and interest payments (credit risk), changes in interest rates

(interest-rate risk), the creditworthiness of the issuer and general market liquidity

(market risk). In a rising interest-rate environment, bond prices may fall and may

result in periods of volatility and increased portfolio redemptions. In a declining

interest-rate environment, the portfolio may generate less income. Longer-term

securities may be more sensitive to interest rate changes. Alpha refers to the

excess return generated by a fund manager relative to an appropriate benchmark.

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