Bond Funds: Passive or Active?

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GuyLafleur
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Bond Funds: Passive or Active?

Post by GuyLafleur »

Hi all,

My dad has about $100,000 he wants to invest in bond funds, likely split in some proportion among a TFSA, RRSP, RESP, and a non-registered account. He will likely not be touching the money for at least 10 years. We've heard from a family friend (disclosure: she works for Phillips, Hager & North) that active management generally works better than passive management for bond funds even after fees because there are more inefficiencies to be exploited. She also said we should look into investing in bonds of countries other than Canada, or pursuing dividend income stocks instead of putting all of the money into a bond fund.

I was just thinking of putting the $100,000 into Vanguard's VAB ETF and letting it sit over the next 10-however many years. Would it be more prudent to look at active management, e.g., some of PH&N's bond funds, or look into international diversification for these bonds?
zeno
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Re: Bond Funds: Passive or Active?

Post by zeno »

Hi Guy,

I think it will help to know why your dad is looking at bonds. I assume that his goal is capital preservation and whatever growth he can get is a bonus.
Given that he doesn't anticipate touching the money for next years and all the investment is in tax advantaged accounts, individual bonds or GICs are also an option. The yield on a 10yr provincial strip is about 3%. That's a pretty good indication of what sort of growth I can expect with the lowest risk. Your dad's 100k would be 130k in 2027. If interest rates rise in the next ten years, you might, of course, be leaving money on the table with a 10yr strip. Another common approach is to build a GIC ladder. 5yr GICs will currently get you 2%, but you'd be doing this on the assumption that interest rates will be higher when it comes due.
I quote these numbers to give you an idea of what modest growth prospects there are in fixed income. Would a bond fund have better growth potential than individual bonds and GICs? Maybe. I'll let more knowledgeable investors weigh in on that.
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Peculiar_Investor
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Re: Bond Funds: Passive or Active?

Post by Peculiar_Investor »

GuyLafleur wrote:We've heard from a family friend (disclosure: she works for Phillips, Hager & North) that active management generally works better than passive management for bond funds even after fees because there are more inefficiencies to be exploited.
Over the years I've heard this argument made many times but have never seen data from any fund company that supports the claim, particular after fees. And even if they do, the alpha tends to be relatively small.

For example, although this is an old article (1999) Beating the Canadian Fixed Income Market | Canadian Investment Review states
The difference between first and third quartile fixed income managers is relatively small at 50 basis points, compared to the difference between first and third quartile Canadian equity managers at 150 basis points. Bond managers are demonstrating relatively small value added, in contrast to equity managers. Further, in fixed income management, a first quartile manager beat the market benchmark by less than 40 basis points. In contrast, in Canadian equities first quartile performance resulted in over 150 basis points in value added against the TSE 300 total return index.
A more recent article from Morningstar (2015) Have Canadian Bond Fund Managers Earned Their Keep? hints of manager skill, but fees take heavy toll.
Morningstar (with my bolding) wrote:A large number of active managers beat their benchmarks before fees over the long term.

<snip>

Most funds in our study lagged the passively managed competition. Net success ratios in the investment-grade categories landed in the low single digits (or worse) over all periods.
But wait, it gets better (or worse)
Morningstar (again with my bolding) wrote: The Case of the Vanishing Alpha

From the investor perspective, it’s the net-of-fee experience that matters most. Managers with only gross-of-fee success have captured their added value for themselves, leaving fundholders with subpar returns after fees. Unfortunately, that’s exactly what happened across most funds in our study.

<snip>

Our argument isn’t so much against active management but against paying too much for it. If a large cohort of managers outperform before fees, there must be some price where these managers would outperform after fees. At the right price, skilled management can add value. And in less-efficient markets, such as high-yield, the odds of doing so are higher. The question isn’t so much whether manager skill exists, it’s more whether fundholders reap any of the benefit.

That brings to mind the question, Where are the Customers' Yachts? One of my favorite lines:
Fred Schwed, some 75 years ago wrote:One can’t say that figures lie. But figures as used in financial arguments, seem to have the bad habit of expressing a small part of the truth forcibly, and neglecting the other part, as do some people we know.
As zeno rightly mentions, check your objectives for including bonds and other fixed income products in your asset allocation. I don't believe the goal is outperformance, its risk management and capital preservation.

I'd generally recommend going with the lowest cost provider of a broad-based bond index fund unless their are specific liability and/or increase stream requirements. After all, costs matter and they're the only thing that's under the investors control.
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Re: Bond Funds: Passive or Active?

Post by gobsmack »

GuyLafleur wrote:She also said we should look into investing in bonds of countries other than Canada...
Interest rates across much of the developed world are very low. If you invest in bonds outside of Canada, there is a good chance that currency movements will dictate most of your returns. I do not think this is a good idea. You can get better yields in emerging markets but that comes with a lot more risk. I think it makes sense to stick with Canada.
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Re: Bond Funds: Passive or Active?

Post by Peculiar_Investor »

One further point, IIRC, PH&N High Yield Bond Fund has tended to be been a long term outperformer. But high yield bond funds are a niche segment sof the fixed income market, not a broad-based product more suited as the major portion of a fixed income asset allocation. I won't put more than 10% of the total fixed income allocation into this fund. You can use this Google search to find previous discussions of this fund.
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Re: Bond Funds: Passive or Active?

Post by OnlyMyOpinion »

To OP, Make sure it makes sense to buy across accounts as you are suggesting. Buying interest income in a non-registered account will not provide much on an after-tax, after-inflation basis. It generally/may make sense to hold preferentially in one of the sheltered accounts.
I know that others may argue the opposite - shelter the highest income/cg assets.
We recently bought some VSC in a TSFA.
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