Hello, YieldAlley readers! In this issue:

🎲 Gamblers Now Bet on AI Models Like Racehorses (WSJ)

🎥 Drive-in movie theaters saw a surge in customers during the pandemic (CNN)

3️⃣ Tripling Your Net Worth in 5 Years (A Wealth of Common Sense)

🧠 Fees predict performance (Jeffrey Ptak)

📉 The share buyback’s rise sees the dividend’s demise (Robeco)

The question of whether to choose actively managed bond funds or passive index funds represents one of the most nuanced debates in fixed income investing. Unlike equity markets where passive indexing has largely won the performance battle, the bond market presents a more complex landscape where active management can potentially add meaningful value.

We cite analysis from MyPlanIQ that highlights several fundamental issues with traditional bond indexing. The most significant concern is that capitalization weighting in bond indices creates counterintuitive investment outcomes. When governments or corporations issue more debt, their bonds receive larger weights in the index, essentially rewarding entities for borrowing more money.

This structural flaw becomes particularly problematic during periods of heavy government borrowing. As Treasury bond prices have risen and the government has issued more debt, these securities have come to dominate popular indices like the Bloomberg U.S. Aggregate Bond Index (which underlies funds like Vanguard's Total Bond Market Index Fund). The analysis also notes that this benchmark has minimal exposure to high-yield bonds (less than 1%) and excludes municipal and foreign bonds entirely, potentially limiting diversification benefits.

The fixed income market's structure creates several opportunities for skilled active managers to outperform:

Market Inefficiencies: Bond markets are often less efficient than equity markets, particularly in sectors like municipal bonds, corporate credit, and emerging market debt. Active managers can exploit pricing discrepancies and capitalize on temporary market dislocations.

Sector Rotation: Active managers can tactically adjust exposure to different bond sectors—shifting between government bonds, corporate credit, high-yield securities, and international debt based on relative value opportunities and market conditions.

Credit Analysis: In corporate and high-yield bond markets, fundamental credit analysis can be particularly valuable. Active managers can identify improving or deteriorating credit situations before they're fully reflected in prices.

Yield Curve Positioning: Skilled managers can adjust duration and yield curve positioning to take advantage of interest rate expectations and term structure movements.

Interestingly, even Vanguard, the pioneer of index fund investing, has embraced active fixed income management. In a recent Morningstar interview, new CEO Salim Ramji highlighted the firm's success in this area, noting that 98% of Vanguard's active fixed-income funds are in the lowest price decile, while 91% have outperformed their peers over the past decade.

Ramji emphasized that the active versus passive debate often misses the real point: price. When active management is available at reasonable fees, it can potentially deliver superior risk-adjusted returns without the structural limitations of cap-weighted bond indices.

The MyPlanIQ analysis provides compelling historical evidence for active bond management through 2016. Their research shows that several actively managed total return bond funds had consistently outperformed the Vanguard Total Bond Market Index Fund over 15-year periods. For example:

The 2016 analysis also demonstrates that tactical allocation among top-performing active bond funds could have generated over 3.7% additional annualized returns compared to index investing over a 16-year period ending in 2016.

The fixed income landscape presents a more compelling case for active management than equity markets. The structural issues with cap-weighted bond indices, combined with the proven ability of skilled managers to add value at reasonable costs, suggest that investors shouldn't automatically default to passive bond investing.

However, success in active bond investing requires careful manager selection, attention to fees, and realistic expectations about the additional complexity involved. For many investors, a hybrid approach combining low-cost active management in certain sectors with index exposure in others may provide the optimal balance of performance potential and cost efficiency.

As Vanguard's evolution demonstrates, even the strongest proponents of indexing recognize that bond markets may require a more nuanced approach than their equity counterparts.

Government Money Market Funds (7-Day Yields)

Brokered CD Rates (6-Month Rate)

ETFs (30-Day Yields)

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