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Fund Watch

Active Bond Funds on a Winning Streak

Active bond funds have an edge over stock-focused peers.

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Index funds have looked unstoppable lately. They’ve raked in new money in recent years while their actively managed competitors—the funds whose managers hand-pick stocks and bonds rather than tracking a market index—hemorrhage assets and struggle to beat their benchmarks.

SEE ALSO: Should You Invest in Actively Managed or Index Funds?

But there’s a bright spot in this bleak picture for active managers: bond funds. Eight out of 10 active intermediate-term bond funds and more than seven out of 10 short-term funds beat their benchmarks in 2016, according to S&P Dow Jones Indices.

An even more flattering picture of active bond funds emerges when you compare their performance against passively managed funds rather than market indexes. More than half of active funds beat their median passively managed competitors in most bond categories over the past one, three, five, seven and 10 years, according to a recent study by fund firm Pimco. Active stock funds, meanwhile, have largely lagged their passive peers over those periods.

Does this make active bond funds a slam-dunk for investors? Hardly. Because fund fees reduce returns dollar for dollar, the cheapest index funds have a formidable low-cost advantage. They’re “effectively starting at the 90-meter mark in a 100-meter dash,” says Ben Johnson, director of global exchange-traded fund research at investment-research firm Morningstar. But if you’re willing to do some homework and focus on the lowest-cost active funds, you have at least decent odds of finding a bond manager who can beat his passive competitors.

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Look Beyond Benchmarks

Some of the most damning evidence against active managers comes from Standard and Poor’s semi-annual scorecard comparing stock- and bond-pickers against indexes. In every fund category tracked by S&P, well over half of active funds lagged their benchmarks over the past decade. But investors don’t have a choice between active funds and “market benchmarks,” which are generally not investable. They have a choice between active funds and index funds, which charge fees that eat into their returns and don’t always precisely mimic their benchmarks—a point S&P concedes. Measuring active managers against their passive competitors would be “a more direct comparison,” says Ryan Poirier, senior analyst at S&P.

SEE ALSO: 3 Actively Managed Funds That Beat the S&P 500

By that measure, active bond managers have had far more success than their stock-picking peers. To understand why, you have to look at the types of investors swimming in each pool. In the bond market, “noneconomic” investors—those who have motives other than maximizing their total returns—make a lot of waves. These include pension funds, which may need to buy longer-term bonds to match their liabilities, and central banks, which “buy a lot of bonds for all kinds of reasons that have nothing to do with profitability,” such as driving down interest rates or boosting economic activity, says Jamil Baz, global head of client analytics at Pimco.

These noneconomic investors account for nearly half of the global bond market—making them a far greater presence in fixed-income markets than in the stock market, according to Pimco. Because they’re not driven to maximize returns, they leave more bargains on the table for active managers to snap up.

Another factor giving active bond managers an edge over their stock-focused peers: Turnover in bond indexes tends to be much higher than in stocks, largely because of new bonds coming to market. While passive managers may buy those bonds indiscriminately, active managers “have hordes of quants and credit analysts analyzing the actual price of those new bonds,” Baz says, and that helps active managers ferret out the best values.

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The composition of the Bloomberg Barclays U.S. Aggregate Bond Index—the benchmark tracked by many plain-vanilla bond index funds—also plays a role in active managers’ success. That index focuses on investment-grade bonds, and many active managers have beaten the index-trackers by venturing into lower-credit-quality debt.

If active management works in the bond market, should you choose the most active managers you can find—those whose funds are far different from their benchmarks? Pimco’s study argues that “it may pay to deviate.” But Johnson isn’t so sure. “It’s not enough to be different from the benchmark,” he says. “You have to be right.”

One fund attribute that will boost returns: low fees. Nearly 60% of the lowest-cost intermediate-term bond funds survived and beat their average passive competitor over the past 10 years, compared with just 33% of the highest-cost funds in the category, according to Morningstar. “It behooves all investors, whether selecting index funds, ETFs or active managers, to keep a close eye on expenses,” Johnson says.

SEE ALSO: 6 Bond Funds to Boost Your Income