Fixed income: when should you grab the steering wheel?

For equity investors, that approach has often worked well. Tracker funds are typically low cost, transparent and straightforward to understand. 

It is no surprise that bond exchange-traded funds (ETFs) and passive fixed-income funds have also grown rapidly in recent years.

But bonds are not simply shares with coupons attached. Fixed-income markets operate differently, particularly when trading conditions become more challenging. 

Investors should understand when a passive approach is sufficient and when a more active hand on the wheel may add value. 

Why go passive?

A passive bond fund follows an index rather than trying to outperform it. Investors gain broad market exposure without paying a manager to make active decisions on interest rates, economic growth or individual issuers.

The appeal is clear. Costs are generally lower, the approach is easy to understand and performance can be measured against a transparent benchmark. In large and liquid markets, that may be entirely appropriate.

Passive investing is not a wrong turn. The key questions are whether the index provides the exposure you want and whether a fund can track it efficiently once costs and market frictions are taken into account. 

When the biggest borrowers lead the index

This is where bond indices differ from equity indices. 

An equity index generally assigns larger weights to companies with greater market value. A conventional corporate-bond index assigns larger weights to issuers with more debt outstanding.

In other words, the more debt a company issues, the larger its presence in the index can become. That does not make it a poor investment, but it does mean index weights are determined by debt issuance rather than an assessment of relative attractiveness.

A passive fund must broadly accept those weights. An active manager, by contrast, can decide whether the compensation offered by a particular issuer is sufficient for the risks involved or select a more attractive bond from the same company.

That flexibility matters because a single issuer may have numerous bonds outstanding, each with different maturities, yields, currencies and positions in the capital structure. 

Tracking is harder than it looks

Bond indices can contain thousands of securities. For example, a global investment-grade benchmark can include more than 18,000 bonds, while a global high-yield benchmark can contain more than 3,000. [1] 

Replicating those benchmarks precisely is neither simple nor inexpensive.

Most passive bond funds therefore hold a representative sample rather than every constituent. Their managers must also deal with new issuance, rating changes, maturing securities and regular index rebalancing.

Unlike equities, corporate bonds do not generally trade on a central exchange. Liquidity varies significantly across securities. Some bonds trade frequently; others can be difficult or costly to transact.

As a result, passive funds may lag their benchmark before fees are deducted. In stable markets that gap may be small. In more volatile periods, when liquidity becomes scarcer, implementation can become more challenging. 

High yield: the bumpier road

Passive investing faces some of its biggest challenges in high yield, where issuers have lower credit ratings.

The market is typically less liquid and more diverse than investment grade. The financial strength of individual borrowers matters more, as does avoiding companies that may ultimately default.

In high yield, avoiding one major loser can sometimes be as important as identifying several winners.

Historical evidence also suggests that passive high-yield ETFs can deliver less than the return of their benchmark while still taking tracking risk (see Chart). [2]

That does not mean active managers will consistently outperform. Poor decisions, excessive risk-taking or high fees can erode any advantage.

The important point is that credit selection matters. Investors should understand how returns are generated, how risks are controlled and whether outcomes justify the costs involved. 

That said, the choice is not always simply passive or active.

A middle lane: systematic investing

The passive-versus-active debate is not always a two-lane road.

Some investors seek a middle ground: retaining broad market exposure while pursuing modest improvements in returns.

This is where systematic investing comes in.

Think of it as active investing with a detailed rulebook. Rather than relying heavily on individual judgement or large macroeconomic calls, systematic strategies use a consistent framework to identify bonds that appear more attractive than their peers.

The objective is not to deviate materially from the market, but to make a series of disciplined decisions that may add value over time.

For investors who appreciate the transparency of passive investing but want something more than pure index exposure, systematic approaches represent another option. 

As with any investment strategy, outcomes are not guaranteed and different signals will perform better in some environments than others. 

So, passive, active or a bit of both?

Passive bond funds can be an effective solution for investors seeking low-cost, diversified exposure to liquid markets.

Active management may have a stronger case where liquidity is less abundant, credit selection is more important and avoiding weaker issuers can be as valuable as finding stronger ones.

For investors who do not see the debate as an either-or choice, systematic strategies sit somewhere between a traditional tracker and a conventional active fund.

Ultimately, the right approach depends on what you want your bond portfolio to achieve.

Cruise control is useful on a clear, open road. But when conditions become more complicated, it pays to know who is steering.