Default Risk Factor

Active vs. Passive: A Deeper Look into Fixed Income

Default Risk Factor

"The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices."         

-Standard & Poors Indices versus Active Funds (SPIVA ®) Scorecard1



SPIVA Fixed Income Bar Chart 2011


This past March, we published an overview of S&P's year-end 2011 scorecard which illustrated the continuing dismal performance of active managers, as seen in the table below:

Percentage of Active Funds Outperformed by Benchmark


Calendar Year 2011

5 Years Ending 12/31/2011

Domestic Equity Funds



Real Estate Funds



International Equity Funds



Fixed Income Funds



We also showed how the SPIVA study debunks the myths that small cap managers are more likely to outperform their benchmark than large cap managers and active managers achieve higher performance than index funds in bear markets. Although a glance at the table above would suggest otherwise, there is a persistent popular belief that the concept of market efficiency applies to equities only and not to fixed income. The table below shows the subpar performance in every category of fixed income that was analyzed in SPIVA.


Percentage of Active Funds Outperformed by Benchmark


5 Year Ending 12/31/2011

Government Long Funds


Government Intermediate Funds


Government Short Funds


Investment-Grade Long Funds


Investment-Grade Intermediate Funds


Investment-Grade Short Funds


High Yield Funds


Mortgage-Backed Securities Funds


Global Income Funds


Emerging Markets Debt Funds


General Municipal Debt Funds


California Municipal Debt Funds


New York Municipal Debt Funds


With odds like these, one has to wonder why anybody would purchase an actively managed bond fund. To make matters worse, these numbers exclude the impact of sales loads and deferred loads. According to Morningstar, the average front-end load of their largest category of bond funds (Intermediate-Term) is 3.84% (Class A shares only). This amount is comparable to an entire year's worth of expected return. While this might be a wonderful arrangement for the fund company and the commission-collecting broker, the hapless investor who is taking 100% of the risk does not fare well.

The reason behind the sorry numbers shown above is not difficult to understand. Management fees plus the hidden costs of running an active fund represent an insurmountably high hurdle. With bonds, essentially one of two things can happen: either they pay what was promised or they default. Unlike equities, there is little possibility for a manager to get lucky and beat his benchmark. In the few instances where it did happen, it is commonly a result of the manager taking on a different risk profile (either term risk or default risk) than his assigned benchmark.

As we have said on many occasions, manager picking is a mug's game. When it comes to fixed income, however, we may have been too generous.