Active equity strategies suffered outflows in recent years as the shift to passive strategies gained momentum. Indeed, active equity strategy performance appeared to justify this shift. Take large-cap value equities as one example. In 2017, the median active manager performance was –179 basis points versus the S&P 500, according to eVestment, which maintains a database offering investment performance and other metrics. On a seven-year basis, this strategy lost 98 basis points per year versus the index. On top of that, managers charged a median fee of 51 basis points.

In the world of fixed income, however, investors have been rewarded for pursuing active strategies. Core fixed-income active managers generated a median excess return of 49 basis points in 2017, compared with median reported fees of 26 basis points. Top-quartile core managers generated 82 basis points of excess return during 2017. Over a seven-year period, the median excess return was 56 basis points per year, versus –2 basis points for passive core strategies.

Another fixed-income strategy where active managers have typically outperformed passive has been in global inflation-linked bonds. During 2017, active managers generated a median excess return of 63 basis points versus reported fees of 30 basis points. Top-quartile managers generated 126 basis points of excess returns in 2017. Over a seven-year time period, median excess returns were 66 basis points per year. Note, fewer managers report in this category — seven benchmarked to the full Bloomberg Barclays World Government Bond Index, unhedged and denominated in U.S. dollars, compared with 240 managers reporting core fixed-income data.

So what makes fixed-income unique? Compared with stocks, bonds offer more strategies that an active manager can use to enhance return. Think of it as levers managers can pull to shape their portfolios to match their views, or to take advantage of market opportunities as they arise. Suppose, for example, a manager likes a particular bond issuer. She can choose a bond from a specific maturity on the yield curve that looks attractive versus other points along the curve. Or, in the case of global bonds, she may choose currency exposure by not hedging a foreign-currency-denominated bond. In a passive strategy, such divergences from the index are usually not allowed.

Ironically, the rise in passive investing actually creates dislocations in the bond market. Buyers of the benchmark index drive up prices of its constituents. They also become forced sellers when a bond drops out of the index. Bond indexes weight the issuers by the market value of their outstanding debt, a decidedly different methodology from equity indexes. This means the most heavily indebted issuers are the largest constituents, leaving passive investors more heavily exposed to potentially deteriorating credits. In addition to these negatives, passive strategies typically struggle to match the performance of their benchmarks because of trading costs.

With rates so low and spreads so tight at this stage of the economic cycle, investors need access to all the various fixed-income levers. An active manager can adjust duration relative to the index to help mitigate price declines as rates rise. Within a core fixed-income strategy, active managers may make an allocation to reduce the quality of their bond holdings, or seek bonds of companies that are repairing, rather than inflating, balance sheets. They may emphasize issuers in sectors likely to benefit from rising inflation, or from a weaker dollar. They may avoid sectors subject to expected merger-and-acquisition activity if that activity might increase a company’s leverage ratio. An active strategy might also look at broader opportunities that may have low correlations with the index and, therefore, improve the portfolio’s risk profile. Depending on client guidelines, the manager may choose inflation-linked bonds or non-dollar bonds, to name a couple. In addition to being potential sources of outperformance, these sectors may offer diversification benefits, particularly considering the Bloomberg Barclays US Aggregate Bond Index is so heavily dominated by U.S. Treasuries.

Whether it is credit risk, duration, term structure, sector allocation or other levers, fixed-income investors are wise to maintain the flexibility of active management to navigate the economic and interest-rate cycles.

Ellen Safir (research@ncallc.com) is founder and CIO of New Century Advisors.