Passive bond fund management is an oxymoron (or the case for the active management of bond funds)

Abstract

In sharp contrast to equity funds, the active management of bond funds has remained popular. The percentage of assets passively managed among equity mutual funds are more than double that among bond mutual funds. That difference can be explained by the exceptional difficulties of passive bond fund management and the strong relative performance of active bond funds. We find no evidence that the average active bond fund underperforms the average passive bond fund. We attribute that result, in part, to passive bond funds facing a difficult trade-off between tracking their benchmark and maintaining liquidity, which results in high levels of activeness and trading relative to passive equity funds. That result is also attributable, in part, to highly active bond funds—those with high active share in particular—substantially outperforming passive funds (0.74% per year, t-stat = 2.40). Highly active bond funds also exhibit a more convex flow-performance relation, consistent with the alleviation of investor run risk. Summarizing, actively managed bond funds have remained relatively popular because they tend to benefit investors.

Keywords: Bond, Mutual Funds, Active Management, Active Share, Alpha

JEL Classification: G10, G11, G14, G20, G23