Forget trying to beat the market.
Investors have been doing it for years with their stock funds, content to get simply the market average with index funds — and to pay their correspondingly low fees. Now, more investors are making the move with the bond part of their portfolio as well.
They're pulling their savings out of actively managed bond funds and moving instead into mutual funds and exchange-traded funds that track bond indexes. The trend began in 2013, when the U.S. bond market had its first losing year in more than a decade. It's grown steadily enough that $27 of every $100 in bond funds is now in an index fund, according to Morningstar. That's a record percentage. Bond index funds controlled only about half that as recently as 2008.
It's a big shift in philosophy for many investors, who have long entrusted star bond managers to steer what's supposed to be the safe, income-generating parts of their portfolios. Bill Gross, Jeffrey Gundlach and others have built big reputations as bond mavens over the years.
Several actively managed bond funds are still drawing dollars. Mr. Gundlach's DoubleLine Total Return Bond fund attracted nearly $11-billion in net investment in the 12 months through March, for example. Some market watchers also doubt that index funds will grow as popular with bonds as they've become for U.S. stocks, where index funds control about $42 of every $100 invested. Critics say the way bond index funds are constructed will hurt them when interest rates begin rising.
But the tide is very much heading toward index funds, for now at least. Just over $71-billion left actively managed bond funds in 2015. Nearly $96-billion, meanwhile, went into bond index funds.
A key attraction is the low fees that index funds charge. Bond index funds overall keep $10 of every $10,000 invested annually to cover their expenses, according to the Investment Company Institute. Actively managed bond funds keep $60.
"It's hard to justify the cost of active management in fixed income with yields as low as they are," says Stephen Janachowski, CEO at Brouwer & Janachowski, a financial advisory firm that manages $1.3-billion in assets.
The yield on a 10-year Treasury note is just 1.74 per cent, down from 5 per cent a decade ago and 15 per cent in the early 1980s. It's important to keep as much of that slim amount as possible.
Mr. Janachowski uses bond index funds as the core for many of his clients' bond portfolios, with the possibility of adding smaller investments in actively managed bond funds in more niche areas, such as high-yield bonds.
Bond index funds have also performed relatively well recently, which has helped draw more dollars. Just 6 per cent of funds that invest in investment-grade, intermediate-term bonds were able to match or beat a corresponding index last year, according to S&P Dow Jones Indices.
Active managers' performance looks better when looking at three-year or 10-year returns, where nearly 46 per cent of funds at least matched the benchmark. Bond fund managers who constructed their portfolio in anticipation of higher interest rates — a widespread expectation — have been hurt by persistently low yields.
Anyone considering a move into bond index funds, though, should first pay close attention to what's in the index.
Many are heavy in Treasurys and other government debt. These bonds will likely hold up best when the stock market is tanking, but they also have the lowest yields in an already low-yield universe. The largest bond index mutual fund and ETF both have close to 40 per cent of their portfolios in Treasurys, for example.
That's because bond indexes give the greatest weight to borrowers that have the most debt outstanding. That means banks and utilities also are heavily represented in many bond index funds. Some critics say they'd rather decide what to own based on how credit-worthy a borrower is, rather than how much debt it has.
In the end, many investors use a mix of index and actively managed bond funds. And the starting point for deciding whether to buy a fund should perhaps be whether it charges high or low expenses, rather than whether it employs an active manager.
More than any other factor, a fund's expense ratio "is the most proven predictor of future fund returns," a recent study by Morningstar found. The cheapest funds more often end up being among the successful ones, regardless of what they invest in.