The Bill Gross Effect: Are Bond ETFs Better Than Managed Funds?


Originally published in The Street

By  Sanjoy Ghosh

When “bond king” Bill Gross abruptly left Pimco last month, many fixed income investors — usually a risk averse and restrained lot — bolted in all directions. Billions of dollars poured out of the actively managed funds Gross created, much of it going into exchange-traded funds (ETFs).

That touched off a debate: Does passive ETF investing in bonds work as well as it does in stocks?

For an individual investor, knowing the answer to this question is critical. Fees charged for active fund management can eat away at your returns, especially if you’re investing long-term for retirement. If bond ETFs can outperform actively managed bond funds, there’s no sense in paying fees for active management.

So what do the numbers tell us? For starters, Pimco’s $200 billion-plus Total Return Fund, the largest bond fund in the world and the one Gross used to run, charges fees and has lagged its own Barclay’s benchmark so far this year. Even for the “bond king,” consistent outperformance is really tough.

Seizing on Pimco’s moment of weakness, Vanguard founder and passive investing patron saint Jack Bogle said in interviews that investing in bond ETFs is a more profitable path for individual investors than chasing actively managed bond funds.

But is that the case? Looking at the data, the answer is not so clear. The reason: There are many different types of bonds.

Aye Soe, an S&P Dow Jones Indices analyst who tracks passive vs. active performance across a range of asset classes, says there are corners of the bond market where passive trumps active, such as junk bonds. But in tax-exempt municipal bonds, the data illustrate that active often wins, says Soe.

And — highlighting the difficulty in predicting the path of interest rates — a significant majority of the actively managed funds in the longer-term government and longer-term investment-grade corporate bond categories under-performed their benchmarks in the 12 months ended June 30. But these were the very categories that had shown the largest percentage of outperformance in the calendar year 2013.

However, bond investors shouldn’t go too deeply into the woods here. With the difficulty of trying to predict when interest rates will rise in the coming years, there is also a hybrid approach: tactical asset allocation using fixed income ETFs as your building blocks.

“It’s not just an active vs. passive debate,” said Roger Neustadt, who manages the Chantico Fixed Income portfolio, in which he uses ETFs but actively moves in and out of bond segments. “If the high-yield market is crashing, you simply don’t want to be there – active or passive.”

In his portfolio, he uses ETFs to get access to corners of the fixed income universe, adjusting from one bond segment to another based on rules and data, rather than emotion — something known in the industry as tactical asset allocation.

Of course, even when using ETFs as the way to execute this strategy, this model is also providing a layer of active management. And for this you will be charged a fee. Most importantly, you will need to understand and believe in the approach being taken by the manager.

Sanjoy Ghosh is the chief investment officer of Covestor, an online investment-management company with offices in Boston and London.