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CHARACTERISTICSAs a first step it is probably useful to remindourselves of the respective merits anddrawbacks of active and passive bondmanagement.

Active managers attempt to ‘beat’ the market,as represented by the benchmark, by using skilland insight.

Key advantages: ■ Potential for significant outperformance; and ■ Potential to mitigate losses in the event of a

market downturn.

Key drawbacks:■ Higher investment fees (but these can be off-

set by higher performance); and■ Can return less than the market (though the

additional risk introduced by active management relative to total risk is typically small).

Deciding which approach is the mostappropriate will largely depend on the efficiencyof the specific market at a given point in timeand the ability of trustees to select consistentlyoutperforming active managers.

Passive managers try to match theperformance of a market index by holding abroad cross-section of the market based ontheir belief that markets are efficient and thatmanagers cannot ‘beat’ the market over thelong term.

Key advantages: ■ Limited risk for a portfolio to underperform

the market significantly (albeit that costs mean there is inherent underperformance);

■ Lower governance burden; and■ Lower fees.

Key drawbacks:■ No potential for absorbing costs through

outperformance; and■ Mechanistic approach with no scope for

cushioning market falls through manager skill and judgement.

SPECIFIC ISSUES ASSOCIATED WITH PASSIVE BONDMANAGEMENTThe generic drawbacks and advantages of bothapproaches also apply in the bond market. Inaddition, the constantly evolving nature of bondmarkets, with individual bonds being replacedcontinually with different or new issues, meansthat passive bond managers incur relatively

In this edition of Trustee MasterClass, we review the long-standing active versus passive debate in thecontext of bonds and, in particular, credit portfolios.

ACTIVE VERSUS PASSIVE BOND MANAGEMENT

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ENGAGEDT H E T R U S T E E M A G A Z I N E

in association with

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higher rebalancing costs. Over time this cantranslate into meaningful underperformance inrelation to the market. Passive credit managemententails further challenges1:

➤ Avoidance of loss is key in managing bondportfolios:A single default can severely dent the value of a corporate bond portfolio. The creditanalysis done by credit managers and their abilityto anticipate defaults are therefore essentialelements to corporate bond strategies. Passiveinvestment on the other hand is wholly reactive,albeit that the impact of a defaulting bond tends tobe lessened by a higher degree of diversification.

➤ Passive managers are forced to increaseexposure to companies gearing their balancesheets:In debt markets, an issuer’s market capitalisationis not related to the performance of the underlyingcompany. The converse is in fact often true.Companies issuing debt naturally increase theirgearing (and hence risk). While an active managercan determine participation based on the reasonsfor the debt issue, passive managers have toincrease exposure to companies as the quality oftheir debt deteriorates.

➤ Anticipating rating changes:Bond benchmarks often have quality restrictions.If a specific bond is downgraded and falls out ofthe investment universe passive managers need tosell it. However, this is done after the downgradeand the associated loss in value has alreadyoccurred. This problem might be aggravated whenpassive managers only adjust their holdings at theend of the month and become in effect forcedsellers/buyers. This can be particularly painful indistressed market conditions. Credit analysts ofactive managers, on the other hand, can often

1Recently, we have also seen wider usage of exchange traded funds orcredit derivatives such as credit default swaps (CDS) to gain passiveexposure. However, they bring specific issues in relation to diversificationand tracking error and in the case of CDS, liquidity, collateralisation andcounterparty risk.

anticipate these events through in-depth creditanalysis.

➤ Replication techniques of passive bondmanagers can be problematic:The small lot size of many corporate bond issuesadds to rebalancing costs, particularly in aliquidity-constrained market. Many passivemanagers therefore use sampling techniques.However, this introduces a bias towards largeliquid issues, which are often from highly gearedcompanies.

➤ Rating agencies focus can be different frominvestors’ focus:A passive approach entails total reliance upon theofficial rating agencies to define the bonds that areeligible for an index and hence in which the fundis able to invest. However, rating agencies areprimarily concerned with ‘probability of default’rather than ‘loss in investment value’ and hencetrustees are relying on a source whose objectivesare not entirely aligned to protecting the value oftheir portfolio.

Taken together, these factors may reduce theappeal of passive management in (corporate)bonds. However, trustees need to be confident thatthey are able to pick active managers who havethe resources to consistently outperform.

CONCLUSIONThere are various factors to consider whendeciding to go active or passive. However, the finalanswer will depend on each scheme’s specificcircumstances and should take into account thescheme’s overall risk/return profile, the expertiseand risk appetite of the trustee board and theoverall governance resources available to thetrustees.

Issued by BlackRock Investment Management (UK) Limited, authorised andregulated by the Financial Services Authority. Registered office: 33 King WilliamStreet, London, EC4R 9AS. Tel: 020 7743 3000. Registered in EnglandNo.2020394. For your protection telephone calls are usually recorded.BlackRock is a trading name of BlackRock Investment Management (UK)Limited. This material is for distribution to Professional Clients (as defined by theFSA Rules) and should not be relied upon by any other persons.

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