IMAGINE A WORLD in which the stockmarket has only two constituents: Gurgle, a firm that has risen quickly, and Genial Motors, a mature company. Both have 100m of shares outstanding, each worth $1. That gives the market a value of $200m. Further imagine that there are two investors of equal size in the market. Both own the same no-cost index fund. Each has wealth of $100m, split between Gurgle and Genial stock.
After a year Gurgle triples in value to $3 a share, while Genial stays at $1. The market has doubled to $400m. Three-quarters of its value is in Gurgle stock. Both investors still hold 50m shares of each firm. Their total holdings are now worth $200m each: $150m-worth of Gurgle; $50m of Genial. They have shared in the market’s surge. This is a quality of passive investment in an index weighted by value. If some stocks soar in price, you share proportionately in their success.
But say our investors were active rather than passive, with one holding 100m shares of Gurgle and the other 100m of Genial. The Gurgle investor triples his wealth; the Genial investor’s wealth is unchanged. Simple maths mean that if one active investor beats the index, another must be beaten by it. And since active equity managers have higher fees than passive ones, active investing is on average a losing game in real life. Few beat the index consistently. But there is a twist. This does not hold for active bond investors. Most beat the index. There is a kink in the logic of index investing that active bond investors are able to exploit.
In an idealised version of passive investing, the universe of securities remains unchanged from start to finish. But in the real world the index changes from time to time. New firms come to the market via initial public offerings (IPOs). Existing firms may issue more stock or retire some. A few are taken private. And a benchmark like the S&P 500 is not the whole market, but the largest listed firms in it. An index fund must occasionally buy stocks that gain enough mass to qualify for the index and sell stocks that fall out of it. So it is not entirely passive. Index funds must trade—and active investors can trade ahead of them.
In practice, the turnover in stocks within equity indices is not large enough to handicap the passive funds against active managers. IPOs are increasingly rare. Traffic in and out of indices is light.
Bonds are different. A share is a perpetual security, but bonds have finite lives. Most of them are quite short: the average maturity of a Treasury bond is six years. So there is a lot of movement in and out of a bond index. An index fund has to trade a lot just to match the index.
There is simply more scope in bond markets for winning investors to find willing losers to bet against. A lot of institutional investors are constrained in what kind of bonds they are allowed (or need) to hold. They may be barred from holding corporate bonds or bonds that are not rated investment grade. Or they may need to hold bonds of certain maturities for regulatory reasons.
The managers of foreign reserves, for instance, prize liquidity, so hold mostly short-term bonds. Banks face capital charges on corporate bonds, so prefer to hold government bonds. Insurance companies have long-lived promises to policyholders to live up to. That creates a particular thirst for long-dated bonds. In all, there are a lot of bond-buyers with goals other than beating the index from one year to the next. An analysis* by Jamil Baz, Helen Guo, Ravi Mattu and James Moore of PIMCO, a giant bond-fund manager, put the proportion of bonds held by such “non-economic” players at around half. Active managers can win by holding maturities that are less in demand, by tilting towards corporate bonds in the index, or by making off-index bets on junk bonds—in short by doing all the things constrained bond-buyers cannot, or will not, do.
A tragic flaw of bond indices is that they reward profligacy. Big issuers of bonds have a bigger weight. So high-debt Italy looms larger in global bond benchmarks than thrifty Germany. In equity indices there is some relationship of weight in the index to economic success—or at least to investor enthusiasm. Gurgle-like shares enter the index and make up more of its heft; Genial Motors-like shares diminish in weight, until eventually they slip out. Smart active investors can trade ahead of such entries and exits. But it is slim pickings. With bonds, there are more opportunities for active investors to win.
* “Bonds are different” (April 2017)
This article appeared in the Finance & economics section of the print edition under the headline “Benchmark blues”