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Latest Research Points to Passive Investing's Allure in Bonds

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A common refrain by active managers is that bonds offer greater opportunities to beat their respective indexes. The facts, however, just don't support such an urban legend. (See the latest SPIVA scorecard and DFA's extensive 2018 Mutual Fund Landscape report.)

Now comes another research piece pointing to active managers’ futility in beating passive fixed-income investing. In "Finding Bond Funds that Can Beat their Benchmarks after Fees," a trio of Morningstar analysts crunch numbers across 25 different categories and 5,000-plus bond funds. Those include European as well as U.S. bond fund managers covering a period from January 2002 to October 2017.

The result, per Morningstar: In a combination of three-year rolling periods studied over that nearly 16-year span, the average active manager lagged his (or her) category benchmark by a full percentage point, net of fees.

 

Active Bond Funds Vs. Respective Benchmarks
Net Return Medians of Rolling Three-Year Periods Compared with Category Index*
Category   Net Returns,
Median*
Latest
3-Year
Period*
 EAA Fund EUR Corporate Bond  -0.66 -0.43
 EAA Fund EUR Diversified Bond  -1.16 -0.90
 EAA Fund EUR Government Bond  -0.91 -0.86
 EAA Fund EUR High Yield Bond  -2.44 -1.07
 EAA Fund GBP Corporate Bond  -0.49 -0.94
 EAA Fund GBP Government Bond  -0.71 -0.62
 EAA Fund Global Bond  -0.67 -1.05
 EAA Fund Global Emerging Markets Bond  -1.83 -2.63
 EAA Fund Global Emerging Markets Bond - Local Currency  -2.98 -0.56
 EAA Fund Global Emerging Markets Corporate Bond  -0.44 -0.39
 EAA Fund Global High Yield Bond  -1.69 -1.98
 EAA Fund USD Corporate Bond  -1.11 -1.07
 EAA Fund USD Diversified Bond  -1.03 -0.76
 EAA Fund USD Government Bond  -0.82 -0.66
 EAA Fund USD High Yield Bond  -1.55 -1.50
 US Fund Corporate Bond  -0.04 -0.23
 US Fund Emerging-Markets Local-Currency Bond  -1.91 -1.01
 US Fund Emerging Markets Bond  -0.74 -1.05
 US Fund High Yield Bond  -0.90 -1.17
 US Fund Inflation-Protected Bond  -0.63 -0.48
 US Fund Intermediate-Term Bond  -0.19 -0.12
 US Fund Long-Term Bond  -1.19 -0.63
 US Fund Long Government  -0.35 -0.61
 US Fund Short-Term Bond  -0.27 -0.19
 US Fund Short Government  -0.40 -0.37
 Median  -0.82 -0.76
 Average  -1.00 -0.85

*Over rolling three-year periods covering 15-years and 10-months through Oct. 2017.
Source: Morningstar Direct

 

The return gaps in domestic funds were most acute on a median basis for U.S.-based managers focused on emerging markets local currency debt (-1.91%) and domestic long-term bonds (-1.19%). When European and U.S. active bond funds were compared to their respective benchmarks in the latest three-year rolling timeframe, the average net return gap was -0.85%

Although they admit "the typical active fixed-income fund manager struggles to beat the fund's benchmark after fees," the report's analysts argue that they can present a "framework" for making educated guesses about where bond pickers might have the best "opportunities" to game debt markets. The researchers come up with something they call "success ratios," which measure the percentage of funds that “survived” and outperformed in any given period.  

On a "gross" basis, these Morningstar analysts find reasons for optimism. Mainly, such data messaging falls in-line with past research by active management proponents who point to illiquid and highly opaque parts of fixed-income as providing the best chances for winning against a representative index.

But when comparing instances of excess returns on a net basis, the “odds of outperformance drop significantly,” the authors concede. Besides paying up for active management, the report lists several items as weighing on bond fund managers. Among these are:

  • The ill-effects of higher transaction costs. Unlike active managers, "the index ignores transaction costs, giving it a structural advantage," the study points out.
  • In the nearly 16 years tracked, "many bond managers have not been able or willing to increase" portfolio durations, which is a measure of interest rate sensitivity. Morningstar data show in that period, an average active fund "in most categories" had a lower duration than its corresponding benchmark. This resulted in "leading them to miss out on a large part of the performance of the index" at exactly the wrong time, the study adds, noting that this 15-plus year timeframe was marked by a "broad decline in core government bond yields."

In spite of such evidence, these three analysts are hopeful that in the future "managers can tactically adjust risk exposures" in their bond funds "thanks to the growing availability of derivative products such as futures and credit default swaps."

Yuck. Apparently, this study's authors are appealing to investors who didn't live through the global financial crisis in 2008, which was led by speculative use of derivatives and various forms of default swaps.

These analysts also postulate that active managers can "add value" going forward by boosting "off-benchmark exposures" to high-yield debt for investment-grade portfolios and emerging markets bonds to a "predominantly developed-markets portfolio."

By our standards, style drift is a fairly lowbrow approach to managing client assets. (The dangers of such a practice are chronicled in detail by Mark Hebner in step six of his book, "Index Funds: The 12-Step Recovery Program for Active Investors.")

As IFA’s founder and president writes, taking style drift out of the equation in objectively evaluating active management in fixed-income has led to a fairly ubiquitous conclusion: "there is no evidence that the bond market suddenly became inefficient."

Active Bond Funds Vs. Respective Benchmarks