Swiss bonds: why active investing deserves a second look

Debates over investment strategies are often conducted in a very dogmatic way. Providers of active solutions naturally need to demonstrate that they can generate added value relative to the benchmark. Advocates of passive investing argue – sometimes rightly – that this added value is only achieved over a specific time horizon and is inconsistent, or that it is often wiped out by cost of fees. We aim to provide a more nuanced answer to the question: which is better, active or passive?

Efficient or inefficient?

Passive investors essentially assume that capital markets are ‘efficient’. Efficient means that no one can achieve excess returns by analysing a specific market or security, because all information is immediately reflected in prices. This perspective assumes that there is no proprietary, profitable information available for investors to exploit – prices always reflect value accurately. 

To tackle the active/passive question properly, we first need to examine the idea of efficiency. Is it really true that markets are efficient? Are there different levels of efficiency? And how efficient is a given investment category or the corresponding investment universe? 

Read also: What might 2025 have in store for Swiss bonds? 

While it does seem difficult to refute the efficiency hypothesis in very liquid investment areas, not all investment categories are highly liquid. And where liquidity is limited, it’s harder to argue that all information is instantly reflected in prices. 

The Swiss bond market, for example, is generally perceived as not very liquid. The bonds can be traded daily, and more than CHF 500 million in volume changes hands during an average trading day. However, there are also certain types of Swiss bonds that trade less frequently, or only with price discounts or premiums once a certain volume is reached. Of course, illiquid investment areas do not guarantee successful active strategies; but they do create the kinds of opportunities those strategies rely on.  

Different from equities 

Bond markets also exhibit structural differences compared with equity markets. For example, bond index compositions typically change monthly, which can lead to an annual market-driven turnover of up to 40%. In contrast, equity indices tend to have a very stable composition over time. Bond markets are also often influenced to a large degree by participants whose motivations are not purely economic, such as central banks and insurance companies. These entities must align their investment decisions with accounting, capital and other regulatory requirements. 

The combination of these factors results in inefficiencies and information asymmetry – in other words, a wide range of opportunities for qualified active managers to identify and exploit in bond markets to generate excess returns. Specific knowledge (particularly credit expertise) and good access to capital markets are absolutely essential. Only those with reliable access to the primary and secondary markets can, for example, build up or reduce suitable investments with the necessary volumes in the Swiss bond market.

Furthermore, investment horizons and investors’ loss aversion are central to active investment solutions. Because the absolute and relative return expectations for Swiss bonds are lower than those for equities, for example, investors expect to pay lower fees and are significantly more averse to losses. This leads to many active investment solutions in the Swiss bond space taking on little active risk.

The benefits of volatility

Since 2020, Swiss bonds have shown unusually large return fluctuations due to volatility in both interest rates and credit risk levels. If active investment solutions had few relative return fluctuations during this period, it would indicate either very good timing by portfolio managers or comparatively low active investment risks.

Yet even in the highly volatile past five years, added value could be gained through active management in the Swiss bond space. It is true that higher volatility often leads to more cautious investing; yet we must stress that a more volatile investment environment can offer particularly fertile ground for opportunities, benefiting active solutions.

Long-term commitments 

Although many investors claim to have long investment horizons, these timeframes can suddenly shrink in the face of loss aversion. However, active investment solutions require longer investment horizons. 

Read also: Does the market rally reflect the risks?

To illustrate this, let’s suppose there is a skilled portfolio manager with an information ratio of 0.5. The volatility of the active Swiss bond portfolio is 4%, that of the benchmark is 3.5%, and the correlation between the portfolio return and the benchmark return is 0.9. All these assumptions are empirically plausible and would result in a very good active bond portfolio. The question then becomes: how long would this skilled active portfolio manager need to outperform the benchmark with a 90% probability? Theory shows it would take about seven years¹. 

The following chart shows the probability of outperforming the benchmark with different information ratios if the investment horizon is fixed at five years. To outperform with more than 90% probability, the portfolio manager would need to have an information ratio of 0.6 or higher.

FIG 1. Relationship between information ratio and probability of outperformance over time¹ 

The higher the information ratio, the fewer years it takes to outperform the benchmark with 90% confidence, as shown below¹. 

Number of years needed for the manager to beat the index with 90% confidence:

Active solutions can work

Though passive management seems appropriate in some investment areas, active solutions can certainly work and make sense for other asset classes. 

Successful active management requires: 

• an investment universe with opportunities
• specific expertise combined with a solid investment process
• a sufficiently long investment horizon – which presupposes trust in the portfolio management team.
   

Hunting for active investment opportunities can be worthwhile, particularly during periods of heightened market volatility. Active management in bonds does not necessarily mean generating high turnover. Rather, it is more about taking deliberate medium- to long-term strategic risks.