Morningstar - Q3 2024 - 30

Spotlight: State of Active Investing
Why Active Investing Works
in Fixed Income
The very nature of bond markets creates
inefficiencies to exploit.
Eric Jacobson
ACTIVE BONDS
It's become conventional wisdom that passive
equity investing is superior to active. The
expectation that the same will eventually be said
about fixed income usually heightens right after
an announcement that someone is on the brink of
transforming bond markets with a new version
of electronic trading that will be the holy grail
of efficiency. This might happen, but it will require
much more than new electronic trading platforms.
It will demand massive changes in the landscape
and workings of fixed-income markets.
For now, there are still inefficiencies to exploit
in many sectors, and data suggests that
active fixed-income strategies generally have
outperformed passive ones. (Over three-year
rolling periods for the past 20 years, for example,
the cheapest share classes of intermediateterm
core open-end and exchange-traded funds
outperformed passive funds benchmarked
to the Bloomberg US Aggregate Bond Index,
according to data in Morningstar Direct.)
There are plenty of ways to examine the evidence
across bond sectors, though, and the results
can shift depending on time periods. Whether the
numbers support or refute the question of active's
superiority over passive, there are underlying
fundamental reasons why the bond market
still carries inefficiencies to exploit. That's why
asking whether active or passive is broadly
superior is the wrong question. It's more important
to understand why active bond investing often
works better than passive.
The Usual Suspects
Market fragmentation and infrequent, decentralized
trading are two of many factors. There are
roughly 55,000 stocks in Morningstar's database
from across the globe, compared with 6.2 million
bonds. Even bonds from the same issuers may
have multiple terms, conditions, and features that
distinguish them from each other. Meanwhile,
most bonds are each owned by a relatively small
number of large investors, which can limit the
number of buyers and sellers willing to transact.
Morningstar ran a study using 350,000 bonds in
the fund and ETF portfolios in our database,
representing the debt of more than 32,000 issuers.1
Of those 350,000 bonds, roughly 57% were held
in the funds of a single firm, 14% were held in
the portfolios of two firms, and 6% were owned by
three. Only about 23% of all the bonds in
Morningstar's database were held in portfolios
managed by more than three asset managers.
That dispersion means there is relatively little
trading outside of the newest or largest,
most liquid bonds. One way to gauge that is to
measure the average time between trades
using corporate bond data reported to regulators
via the Trace system. In the aforementioned
study, we found that of the 350,000 bonds
in the sample, fewer than half had at least one
trade in three days.
1 Jacobson, E., & Kowara, M. 2021. " Bond Pricing: Agreeing to Disagree. " Morningstar. Jan. 20, 2021.
30
Morningstar Q3 2024
While there are electronic trading tools that help
inject efficiency into the largest, homogeneous
bond sectors, most bonds are still traded
over the counter, sometimes facilitated by things
as simple as lists of bonds sent around by
trading desks to their clients. One reason is the
heterogeneity of their terms and features,
including embedded options, covenants, capital
structure placement, and redemption terms.
Footprints
There's also an issue with market coverage. The
US bond market had a value of more than
$57 trillion in late 2023, according to the Securities
Industry and Financial Markets Association.
By contrast, most broad market bond indexes cover
$25 trillion-$35 trillion of the market. That's not
an indictment of indexes, which have tremendous
utility and are invaluable when investors do
choose passive options. Information on indexed
bonds needs to be readily available and
monitored, however. When bonds are held by few
investors and never traded, they're much
harder to track, price, and include in an index.
For example, major indexes tend to cover around
80% of the agency mortgage market but only
60%-70% of the $670 billion-plus commercial
mortgage-backed securities market, according to
Sifma data. The trade group estimates the
asset-backed security market has a value of
around $1.6 trillion, and the average broad market
index covers less than one third of it.
Index Deserts
It can be difficult to gain access to some market
sectors passively because indexes don't exist
for them, no funds track them, or only a limited
number are available as investment options.
J.P. Morgan offers an index of collateralized loan
obligations, for example, but while 10 funds
invest in parts of the CLO market, all of them use
active strategies.
Among the most notable missing sectors are
nonagency residential mortgage securities issued
since the global financial crisis ( EXHIBIT 1 ).
Fannie Mae and Freddie Mac have used a mix of

https://www.morningstar.com/content/dam/marketing/shared/research/foundational/Bond_Pricing_2021.pdf

Morningstar - Q3 2024

Table of Contents for the Digital Edition of Morningstar - Q3 2024