Passive bond funds’ fatal flaws

Passive fixed income funds took in $303bn of new money last year, compared with $237bn for active strategies. Although this reads like good news for passive strategies, it isn’t. The more capital that is funnelled through these options, the greater the opportunity for active managers to take advantage of mispricing errors. Passive bond funds tend to hold the same securities, so when markets fall and sell-offs occur, fundamentally safe bonds fall to appealing prices. These funds also end up most exposed to the most indebted issuers because they weight holdings by the amount of debt outstanding,...