If there's one thing investors know by now, it's that actively managed funds often fail to outperform the market. In the bond market, however, that view may not be entirely true.

More than two-thirds of active bond funds outperformed their index counterparts in the 12 months through June, according to a recent Morningstar comparison of active and passive strategies. The performance was even more pronounced for key bond funds, the cornerstone of many investors’ portfolios: Nearly three-quarters of intermediate-term core bond funds outperformed similar index funds, Morningstar found.

How do these funds do it? Active funds typically take on more credit risk but have shorter durations than comparable index funds. This gives them the flexibility to respond to a strong economic environment while the Federal Reserve remains on the sidelines. (Duration is a measure of interest rate risk associated with a bond's maturity, yield and other factors.)

Morningstar also analyzed the long-term performance of active bond funds. Over the past decade, 46% of intermediate-term core bond funds outperformed similar passive funds. This is much better than it might seem at first glance.

To arrive at that number, Morningstar tracks every fund in the category—from $50 billion giants to emerging funds with only a few years left in their lifespan. Only 56% of the 134 funds that were founded a decade ago eventually completed the 10-year cycle. The good news is that most investors tend to cluster in larger, more reputable funds, which typically have better brands and performance records.

If the performance of active bond funds is calculated on an asset-weighted basis, they outperform given the weighting of large funds - similar to the way indexes such as the S&P 500 are tilted toward large-cap stocks.

Over the past decade, the average asset-weighted return of intermediate-term core bond funds was 1.6%, beating the 1.3% return of index funds. In other words, while less than half of active bond funds outperformed index funds, investors who invested in active bond funds generally received better returns.

That’s far better than the performance of large-blend active U.S. stock funds, with only about 15% of such funds beating index funds over the past decade, while the group’s asset-weighted returns lagged passive funds by 1.3 percentage points.

There are many reasons why active bond funds succeed where stock funds fail.

“The characteristics of the fixed-income market are very conducive to active management,” said Gregory Hall, head of U.S. global wealth management at Pacific Investment Management Co. (Pimco). “The complexity of the bond market is an order of magnitude higher than that of the stock market.”

Another reason is that, as mentioned above, stock indexes are typically weighted by market value, so companies such as Apple (AAPL.O), Nvidia (NVDA.O) and Microsoft (MSFT.O) make up the largest holdings in popular index funds.

Bond indices are weighted by the total value of the issuers’ outstanding debt. This is not necessarily a bullish message: Governments issue bonds for political and macroeconomic reasons, while weak companies may have billions in outstanding debt and healthy ones may have none.

As a result, index funds tend to invest heavily in Treasuries while ignoring other bonds that could offer higher yields. The iShares Core U.S. Aggregate Bond ETF has about 45% of its assets in government bonds, while funds in the Morningstar Intermediate-Term Core category have an average of just 31%. The practice has hurt investors: The iShares fund has a return of 3.4%, while similar active funds have a return of 3.7%.

Bond indexes also face practical problems. Most companies offer only a single class of stock, while bonds often have a variety of different maturities and terms. Morningstar's database contains 55,000 stocks and more than 6.2 million bonds.

As a result, bond indices are at best crude approximations of the fixed-income market, and some important areas, such as collateralized loan obligations and non-agency residential mortgage securities, are not included in popular bond benchmarks and lack passive funds that can track them.

So how can investors find bond funds that are set to win over the long term? To answer that question, we asked Morningstar for a list of all active bond funds with a ten-year track record in the intermediate-term core and intermediate-term core-plus categories. (Core-plus funds follow the same investment mandate as core funds but have more flexibility in areas such as junk bonds, bank loans and emerging-market debt.)

We then ranked the funds based on their performance relative to the Bloomberg U.S. Aggregate Bond Index.

Who are the ultimate winners? The Eaton Vance Total Return Bond ETF, with $2.3 billion in assets, has an average annual return of 3.4% over the past decade, far outperforming the index's 1.84%. The fund was originally a traditional mutual fund operated by Morgan Stanley Investment Management, but was transformed into an ETF in March 2021 after Morgan Stanley acquired Eaton Vance.

Some well-known bond giants also made our list: the $8.5 billion Dodge & Cox Income Fund returned 2.91%, and the $4.1 billion Fidelity Total Bond Fund returned 2.68%.

Article forwarded from: Jinshi Data