Do actively managed bond funds have an advantage over bond index funds when interest rates rise?

Many investors assume they do. After all, everyone knows when interest rates climb, bond prices fall—resulting in poor returns. Active managers are free to go to cash and/or switch to bonds with shorter maturities (which are less sensitive to rate increases). In other words, active managers can use their resources and expertise to maneuver their holdings in anticipation of higher interest rates. In a rising rate environment, they should perform better than bond index funds which are obligated to simply “buy and hold,” right?

Vanguard’s Investment Strategy Group found evidence to the contrary.[1] They examined the past seven periods of rising rates going back to 1981. On average, the majority of active bond funds failed to beat their benchmarks. The research illustrates interest rates are no easier to predict than other market movements.

The period of rising rates we are experiencing currently is no exception. Treasury bond rates have risen just over 1.25% over the past 15 months. Meanwhile, 81% of active bonds funds have underperformed their benchmarks by an average of 1.8%—a large margin in the relatively subdued world of bonds.

History has taught us that even when investors’ widely-held expectations for higher interest rates were met, strategic changes provided no advantage for most bond funds. The lesson is it’s not enough to anticipate the direction of interest rates—it is also crucial to correctly guess the timing, the magnitude, and the duration of interest rate changes. As usual, the surest path to successful, long-term results avoids short-term investment predictions of any kind.
[1] Kinniry, Fran. “Rising rates shine a dull light on active bond funds.” The Vanguard Group. September 2013.