“The strongest of all warriors are these two—time and patience.”
-Leo Tolstoy, War and Peace
Recently, there’s been a lot of talk about rising interest rates and what that means for bond investors. One “solution” (suggested mostly by active fund managers) is to use active management for the bond portion of your portfolio. The argument goes that active funds are better in a rising-rate environment because they can shorten their duration, reducing losses from rising rates. What they don’t point out is, for this strategy to work, the manager has to get four things right: when rates go up, how much rates go up, the shape of the yield curve, and when rates stop going up. A miss on any of the four can turn a possibly successful strategy into a losing one. That’s a lot of things to get right or, looked at another way, a lot of things that can go wrong.
So, how good are active managers at forecasting these? According to Vanguard research, not very. Vanguard found that, regardless of the type of bond we looked at (corporate or government) or the duration tilt (short or intermediate), in the vast majority of rising-rate environments from 1981–2015, active bond managers underperformed their benchmarks, as shown in the charts below.
Note: The yellow line on the graph represents the point at which 50% of active funds have underperformed their benchmark. If the bar is above this line, it indicates that more than half of active managers underperformed their benchmark for that time period; below the line means that fewer than 50% underperformed.
It’s worth mentioning that in our analysis, we used prospectus benchmarks, rather than style benchmarks. This stacks the deck in active management’s favor, because it ignores style drift and benchmark overweights. So, if an active manager achieved above-benchmark returns by incorporating high-yield bonds into an investment-grade portfolio, we counted that manager as outperforming, basically providing the “best case scenario” for active management. Despite this built-in advantage, active management still underperforms much more often than it outperforms, especially when short term rates are rising.
The chart below shows both the 2-year Treasury yield and the 10-year Treasury yield since 1981, and how active bond managers performed against their indexes. Whether rate increases were seen just in the short-term rates, just in the intermediate-term rates, or both, active managers consistently underperformed, despite us stacking the deck in their favor.
So, if active management isn’t the answer, what is? Time and patience. Rising rates benefit bond investors by increasing yields. And, over time, the initial principal loss is recovered as the bonds in the portfolio move closer to maturity. The trick is to let time and patience do their work so you don’t miss out.
Few battles are won without a strategy. Once your strategy is in place, your “warriors,” time and patience, can fight the battle against rising rates.
I’d like to thank Josh Hirt of Vanguard Investment Strategy Group for his invaluable contributions to this blog.