Passive index investing triumphs in bonds

The news that the passive Vanguard Total Bond Market Index has overtaken the total assets of Pimco's Total Return Fund, long the flagship of famous investor Bill Gross and long the world's biggest bond fund, signals that passive index investing, already victorious in the fight for investors' money in equities, has now triumphed in bonds.

Put simply, the US investing public has lost its confidence in investment managers - not just Mr Gross - and their ability to generate returns through skill. But this shift is all the more dramatic because the case for indexing in bonds is far less clear than it is for stocks.

One argument against bond index funds: their performance is erratic. In equities, a comfortable majority of active funds fail to match the index each year, so that after a decade barely any have managed to outperform.

In bond funds, much rests on a manager's central call on the direction of interest rates. They tend to move in packs on this, and whenever the consensus is right, many managers beat their benchmark.

Thus, in 2013, S&P Dow Jones' SPIVA database, found that only 10.1 per cent of long government bond funds were beaten by their index, compiled by Barclays. That year saw the "taper tantrum" and managers correctly called that yields would rise.

Last year, when the consensus was shocked to see yields fall once more, 97.7 per cent of active funds underperformed their index.

A second concern is what is known in the jargon as the "bombs effect". Weighting an index according to the amount of bonds an issuer has outstanding means weighting it towards those who are most indebted - and therefore the most risky.

Critics complain that indexing therefore encourages risky and profligate behaviour, and that it should be possible to find simple ways to allocate to bonds that can beat an index.

In bonds, the active-passive debate could therefore have much further to go. For now, passive management is in the ascendant.

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