The many rewards of actively-managed bond funds

I have always maintained that one area of your portfolio where costs really matter is with fixed-income sleeve. And with bond returns expected to be flat or even negative for the near to medium term, I have been asked a few times why I still recommend bond funds that carry higher MERs than low-cost index ETFs.

For example, my top pick at the moment, PH&N Total Return Bond Fund, carries an MER of 1.16% for the advisor-sold units, while my other favourites, TD Canadian Core Plus Bond, and Dynamic Advantage Bond Fund both carry MERs that hover around 1.5%. In comparison, the iShares Canadian Universe Bond Index (TSX: XBB) has an MER of 0.3%. With such a difference in costs, how could I still recommend one of the mutual funds over the ETF?

There are actually a few reasons.

Cost– Hear me out on this one. If you are a do-it-yourself investor, then the cost posted for the ETF is the cost you pay, plus any trading costs. In that case, a lower-cost ETF may end up being the best solution. However, if you are working with an advisor, there will likely be a management fee added, which can close the cost gap pretty quickly. For example, many advisors are charging 1%, which will bring the cost of XBB up to at least 1.33%. Add in HST, and you could be at 1.46% in Ontario, which is only a smidge cheaper than my expensive mutual fund picks.

Duration management– An active bond manager has a number of tools available to try to add value and preserve capital. One such strategy is to actively manage the duration profile of the fund, lengthening it when they believe rates will fall or remain flat, and shorten it when they are expected to rise. This will allow the fund to benefit from the rate outlook. In comparison, the passive ETF has the duration of the underlying index, which in the case of the FTSE/TMX Bond Universe is north of 7 years, meaning that for every 1% move in rates, there is a move of approximately 7% in the opposite direction.

Security selection– The ETF that tracks the index must look like the index, which means that it will invest only in investment-grade bonds, and will be about two-thirds government bonds, with the rest in corporate bonds. In comparison, an actively managed bond fund can potentially invest across the quality spectrum. For example, each of my bond picks can invest a portion in non-investment grade bonds.

Furthermore, actively managed bond funds are often able to dramatically alter the mix between government and corporate bonds. The TD Canadian Core Plus Bond Fund has nearly 60% invested in corporate bonds, PH&N Total Return Bond has about a third, while the Dynamic Advantage Bond holds about 45% in corporates. The higher corporate and non-investment grade exposure allows the funds to generate higher yields and offer higher return potential in most market conditions.

Trading strategies– An active bond manager may engage in a number of trading strategies that can be used to generate higher returns. One example is a relative value strategy where the manager exploits mispricing in the bond market, selling overvalued bonds and buying bonds that appear to be undervalued.

Another example would be to try to take advantage of the mispricing between bonds of different maturities. In the manager’s credit review process, they may find that one maturity may offer a more attractive risk-adjusted return than another. In that case, they would sell the overpriced bond and buy the underpriced bond.

Still another strategy is known as “curve roll down,” employed by Dynamic’s fixed-income manage Bill Kim. In very simple terms, this strategy involves holding a bond for one year, and selling it at a profit, after collecting the year’s coupon payment. The proceeds are then reinvested in another bond and the process is repeated. In current market conditions, Dynamic estimates they can generate approximately 5% on each one of these trades over the course of a year. Any of these strategies, if executed correctly, is expected to generate a return that is in excess of the yield.

Bottom Line

When an active bond manager is able to effectively implement these strategies, it is likely that they will be able to generate returns that are comparable to the index, with lower levels of volatility. The end result is stronger risk-adjusted returns.

In my analysis, I have found that a high-quality actively-managed bond fund is more likely to earn its management fee in an environment where yields are expected to rise, or even stay flat. This is where the additional return from the active strategies can add return or reduce the downside. However, when yields are falling, and bond prices rising, most active managers have not been able to keep pace.

Looking ahead, with the fixed-income environment likely to remain extremely challenging, I am favouring high-quality, actively-managed bond funds over low-cost passive options.

Courtesy Fundata Canada Inc. © 2016. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.