Why Use Actively Managed Bond Funds?

A reader writes in, asking:

“I saw an article on your blog about passive funds beating active ones. But then why do Jack Bogle and Rick Ferri use the actively managed Vanguard funds? For example, wouldn’t a muni ETF be a better option if it beats the active manager 95% of the time? I’m a full time indexer but I don’t understand why these legends use active bond funds. Can the same be said for corporate bond funds?”

The key point about indexing isn’t that there’s anything magical about the indexing itself but rather that it is a very low-cost way to run a diversified mutual fund. Or, to look at it from the other direction, most actively managed funds have a very difficult time overcoming their much higher costs.

In some cases, however, the actively managed funds have costs that are approximately as low as (or sometimes even lower than) the costs of index funds (or ETFs) in the same category. This is especially common with Vanguard’s bond funds. Many of them are not technically index funds, because they do not specifically track an index. But they have low expense ratios because the fund’s investment strategy is still very passive. That is, the fund isn’t trying to do any of the (expensive) things that many actively managed funds do in their attempts to outperform their benchmarks.

For example, Vanguard’s Intermediate-Term Investment-Grade Fund is technically actively managed. But the Vanguard website describes the fund’s investment strategy as follows: “This fund provides diversified exposure to medium- and high-quality investment-grade bonds with an average maturity of five to ten years.” Nothing about trying to pick bonds with unusually high performance. Nothing about trying to predict interest rate movements. It’s basically just, “We’re going to buy a bunch of bonds with investment-grade credit ratings and maturities of 5-10 years.” Very boring and, importantly, inexpensive to implement.

Similarly, in the muni bond category, Vanguard’s funds are technically actively managed. And their expense ratios range from 0.12% (for Admiral shares) to 0.2%. By way of comparison, if you take a look at a list of muni bond ETFs (here or here, for example), you’ll notice than none are less expensive than Admiral shares of Vanguard’s non-index muni funds.

The triumph of index funds is really a triumph of inexpensive funds over expensive funds. When an actively managed fund has very low costs (and there’s no reason to think that the manager is going to do something stupid with your money), such a fund can be a perfectly good option for inclusion in a low-cost, diversified portfolio.