In the wake of the stock market's stomach-churning roller-coaster ride of recent years, many investors have simply decided they'd rather not play that game. Assets have been flowing out of the equity markets at a furious pace, headed for the perceived safety of bonds. Billions of dollars have been stuffed into bonds since the onset of the financial crisis, as weary investors seek solace from the storm. Unfortunately, on some fronts, bond managers are starting to feel the pain of their stock-picking counterparts.
Hurry up to catch up
Bill Gross of PIMCO fame has one of the best long-term track records around in the bond world, yet even he has been taking his lumps lately. Gross's flagship PIMCO Total Return Fund (PTTAX) has stumbled a bit this year, thanks in large part to a premature move by Gross. Earlier this year, Gross moved out of U.S. Treasuries, just in time to miss one of the biggest quarterly rallies in the sector since 2008. As a result, the fund is having its worst run since 1995 and now ranks behind 92% of all intermediate-term bond funds year-to-date. After pulling in roughly $90 billion in 2008-2010, Total Return has seen nearly $3 billion in redemptions so far this year, according to Morningstar.
But don't think that investors are suddenly moving en masse back into stocks -- they're not. Instead, money has been departing for another corner of the bond market -- index-tracking funds. Morningstar data shows that passively managed funds have attracted 39% of all new bond money this year, up from 22% just two years ago. Many investment managers are now predicting that their clients will increasingly turn to indexed bond products rather than stick with active managers like Gross. The trend that started in the equity markets several years ago -- active managers who lost ground to products such as ETFs -- looks as if it may overtake the bond market before long.
A losing battle
It's hard to argue that exchange-traded funds and other passive investments aren't a huge threat to actively managed bond funds. They're typically cheaper and more tax-efficient. ETFs are growing by leaps and bounds, with well over 1,000 such products on the market today. But I think the outflows at Total Return, as well as those experienced at active stock funds in recent years, are being largely driven by something other than burgeoning investor desire for passive products. More specifically, I think we're just seeing a lot of performance-chasing going on here.
Investors are notoriously fickle and tend to abandon their actively managed funds at the first sign of trouble, hence the outflows at PIMCO Total Return. I can't argue that most actively managed funds, whether of the stock or bond variety, won't underperform the market. But there are select managers who can get a leg up on the market over the long run, and I think Bill Gross is one of them. Investors are letting a few months of poor performance detract from the bigger picture of excellent long-run returns. Investing with active managers isn't always easy -- there will be periods of lagging short-term performance. But the goal here is to stick with your good managers over time and not bail when the fund makes a minor misstep here or there.
Tale of two investing styles
Now, there's absolutely nothing wrong with moving into passive-managed fixed income vehicles. Folks who want broad, cheap exposure to bonds could definitely do worse. But it's a losing game to ditch solid active managers for passive ETFs every time active funds have a losing year. The key here is knowing which investing style fits your personality, outlook, and individual goals. Are you content to earn the market rate of return? Is paying the least amount possible for your investments a priority? Or do you want the opportunity to do better than just tracking the market? Do you want to put some of the smartest minds in the business to work for you? Answering these questions honestly should give you greater insight into whether active or passive investing is right for you.
The key to passive bond investing is similar to passive equity investing -- think broad and think cheap. Some of the most inexpensive and well-diversified bond ETFs include Vanguard Total Bond Market ETF (NYSE: BND ) , iShares Barclays Aggregate Bond ETF (NYSE: AGG ) , and Schwab U.S. Aggregate Bond ETF (NYSE: SCHZ ) . Looking further afield, investors in search of global bond exposure should consider iShares S&P/Citi International Treasury Bond ETF (Nasdaq: IGOV ) or SPDR Barclays Capital International Treasury Bond (NYSE: BWX ) . For folks concerned about inflation protection, Schwab U.S. TIPS ETF (NYSE: SCHP ) and iShares Barclays TIPS Bond ETF (NYSE: TIP ) are good, cheap options.
Actively managed bond funds may continue to lose assets to ETFs and index funds in the near future, but it won't take much of a turnaround in active fund performance for investors to suddenly come flooding back in. Passive and active investing styles can go in and out of favor in the market for years at a time. Although passive investing has the upper hand today, don't be surprised to see the tables turn at some point down the road. But no matter which approach seems most in fashion, make sure you pick the one that's right for you in all market environments -- and stick to it.