Active management is at the heart of fixed income strategy, says Morningstar

A shift towards passive management strategies that have been growing in some areas of the investing landscape have created challenges for wealth managers.

But while equity mutual funds have seen increased pressure from the rise of passive while ETFs appear to be headed in the opposite direction, the choice of strategy in fixed income is less hazy, according to a new report from Morningstar.

It highlights that the structure, trading behavior, and complexity of the bond market make it inherently more suited to active management.

For example, bonds are often held by a concentrated group of large institutions, with the research discovering that 57% of bonds in mutual fund and ETF portfolios were held by only one asset manager, and fewer than 25% were held by more than three.

With this limited ownership comes suppression of liquidity and hinders consistent price discovery. This gives active managers the opportunity to capitalize on inefficiencies that passive strategies cannot easily navigate.

The complexity of the bond market is a compelling reason for active management, the report says.

Bonds vary significantly in terms of structure, seniority, maturity, optionality, and embedded features. Securitized products like collateralized mortgage obligations (CMOs), asset-backed securities (ABS), and credit risk transfer (CRT) notes are often customized and opaque, making them difficult to evaluate without rigorous analysis.

There is also a lack of comprehensive indexes and bonds’ individuality makes it tricky to manage effectively using rules-based strategies.

Unlike equity indexes, which reward success and size, bond indexes give more weight to issuers with the most debt, often those that are more financially vulnerable, meaning that passive investors may unknowingly take on heightened credit risk or interest rate exposure.

And despite the US bond market exceeding $50 trillion, most bond indexes cover only $25–35 trillion of it, with some key sectors, such as nonagency residential MBS and CLOs, lacking viable passive investment options altogether.

The report notes that while innovations like credit default swap baskets, ETFs, and portfolio trading have improved liquidity in certain segments, they do not address the broader market’s fragmentation.

However, active managers can sift through the complexities, select bonds based on fundamental analysis, and avoid overexposure to distressed or illiquid securities.

Over the past two decades, actively managed intermediate-core bond funds outperformed the Bloomberg Aggregate Index in 59% of rolling three-year periods, far exceeding the 17.6% outperformance rate seen in active equity funds versus the S&P 500.