Perceived by investors as a relatively safe haven in a storm of political turmoil and market volatility, fixed-income funds have surged to $9.4 trillion through June 2019.1 According to Morningstar, taxable-bond funds took in $40.2 billion in July 2019 alone, with two-thirds ($27.0 billion) going to actively managed funds.2 We believe this trend reflects the recognition that an active approach to intensive credit research and security selection has the potential to add value to fixed-income portfolios.
Yet within the leveraged credit sectors of the income markets, it's been a different story. So far this year in the high-yield space, index ETFs have received a greater share of inflows than active mutual funds, while floating-rate loan funds have experienced steady redemptions - despite their solid yield and risk/return characteristics. To those advocates of indexing who claim that the case for passive investing applies equally to equities and fixed income, here's our response.
Claim #1: The largest weights in fixed-income indexes tend to be large, blue chip companies, similar to broad equity indexes.
Unlike equity indexes weighted by market capitalization, fixed-income index weights are usually based on each issuer's outstanding debt - so the more debt, the greater the weight in the index. By definition, the constituents of high-yield bond and floating-rate loan indexes are companies rated below investment grade, certainly not "blue chip" by any standard. With such lower-quality income investments, we think it makes even less sense to have the highest exposures to the most indebted issuers, yet that's how high-yield bond and floating-rate loan indexes tend to be constructed.
Claim #2: Index ETFs can be used as building blocks to construct custom portfolios.
Our research has found that actively managed mutual funds of high-yield bonds, floating-rate loans and other income asset classes have historically outperformed index ETFs.4 When custom portfolios can also be constructed with active funds, using index ETFs as building blocks may have negative consequences for portfolio returns.
Claim #3: Index ETFs can closely replicate benchmark returns without owning all the index constituents.
Broad-market fixed-income benchmarks are generally not investable. While index ETFs may use a "sampling" approach to index replication that helps to reduce transaction costs, this flexibility pales in comparison to the arsenal of tools and strategies that active fixed-income funds can tap to seek improved returns.
Claim #4: Indexing transforms fixed-income investing by providing standardized, predictable and efficient exposures that greatly simplify portfolio construction.
Einstein once said that "everything should be made as simple as possible, but no simpler," and we share this view. As we see it, if simplification can erode investor returns by removing the potential to exploit the frequent pricing inefficiencies in credit markets, that's not progress.
Bottom line: From our perspective, index ETFs have inherent construction and performance drawbacks that argue against their widespread use in leveraged credit. With limited exceptions, we believe actively managed mutual funds may have advantages for investors seeking exposure to high-yield bonds and floating-rate loans.
Payson Swaffield, chief income investment officer for Eaton Vance