Finance Research Seminar - Jaewon Choi

Passive bond fund management is an oxymoron (or the case for the active management of bond funds) 

Jaewon Choi (University of Illinois at Urbana-Champaign)

K. J. Martijn Cremers (University of Notre Dame)

Timothy B. Riley (University of Arkansas)

In sharp contrast to equity funds, passive bond funds underperform the majority of active bond funds. First, bond indexes include numerous illiquid bonds, making passive investing a near-impossible task. Facing a difficult trade-off between tracking their benchmark and maintaining liquidity, passive bond funds become active and hold relatively liquid bonds, while sacrificing performance. Second, the lack of positive skewness in bond returns reduces the advantages of holding a broad-market index. Holding individual bonds frequently outperforms the benchmark, making passive investing less attractive. Consistent with these two channels, the average active bond fund outperforms the passive counterpart, while the most active ones—those with high active share in particular—substantially outperform passive funds (0.74% annually, t-stat = 2.40).