The typical active fixed-income fund manager struggles to beat the fund’s benchmark after fees. As low-cost passive options become more available in the fixed-income space, investors need to be able to assess the relative merits of active and passive bond funds to make informed investment decisions. What are an investor’s odds of selecting an active fund that is likely to outperform its benchmark after fees?
In which categories is it preferable to choose a low-cost passive option instead? Results show that, although the median active manager can beat the benchmark in several categories before fees, after fees average returns were negative in all 25 Morningstar bond fund categories.
Unfortunately, most bond funds are priced to fail. Many fixed fees are in line with, or sometimes even above, funds’ historical outperformance, thereby destroying the value added by managers. The percentage of funds that managed to perform at least as well as the index ranged from a meagre 10.5% to 49% depending on the category.
A further complication arises from fund mortality. Survival rates in the categories covered by our study ranged from 39% to 94%, an additional challenge for investors looking to choose an active bond fund for the long term. However, there are large differences among categories.
Factors Other Than Fees
Before diving into our results, it’s useful to consider the factors other than fees that lead fixed-income funds to trail their benchmarks so often. The first factor is the weight of transaction costs. In contrast to equity indices, which are often rebalanced annually or quarterly, the majority of bond indices are rebalanced monthly to capture new bonds that are issued, others reaching maturity or being “called”, and bonds that no longer comply with the index’s inclusion rules.
This results in a significant level of index turnover: from 2014 through 2016, the average turnover rate for the Bloomberg Barclays US Aggregate Bond Index was 40% a year. This is in contrast to an annual turnover rate of less than 5% for the S&P 500.
A portfolio seeking to fully replicate the performance of the fixed-income index would incur significant transaction costs when buying and selling securities at each monthly rebalancing. Moreover, the performance of the index itself ignores transaction costs, giving it a structural advantage. This also makes it more difficult for ETFs in these categories to track their indexes.
The second factor is behavioural, and it is linked to the challenges that the current environment of low yields poses for bond funds. While our study spans 15 years, that period has been characterised by low interest rates, with only short bouts of moderate interest-rate hikes.
Many fund managers, especially those with a cautious mandate or whose mandate includes capital protection, have sought to protect their portfolio from a sudden rise in interest rates, leading them to miss a large part of the performance of the index that has been driven by a broad decline in core government bond yields.
Where Do Active Managers Add Value?
There were only eight categories in which funds in the top 20% outperformed the benchmark index over a three-year period, and only one category, GBP government bond funds, where the outperformance was more than than 1 percentage point a year.
Returns against passive offerings are, however, more encouraging: In 16 categories, active funds in the top 20% outperformed the most relevant ETF after fees. For example, in the EAA fund EUR high yield category, while even the best active managers lagged the index, investors would not have been better off buying an ETF.
The stringent liquidity criteria applied by passive funds, as well as the inherent transaction costs of this less-liquid market, typically led the ETFs to miss an even greater proportion of the index’s returns.
In another example, despite underperforming the benchmark index, funds in the top 20% of the EUR high-yield bond category outperformed a representative ETF, iShares EUR High Yield Corp Bond ETF, by more than 1% in the average three-year rolling period from December 2012 to 0ctober 2017.
Active funds in the USD high-yield category performed equally well against a representative ETF. High-yield ETFs typically filter out the smaller bonds in the universe for liquidity reasons, and active managers have numerous opportunities to add value by investing in smaller, less-liquid bonds that offer higher compensation for that illiquidity.
Strong fundamental research can also pay off if active managers are able to exploit informational inefficiencies in this market.
Results by Categories
In four of the categories; EAA fund EUR diversified bond, EUR government bond, GBP government bond and USD diversified bond, the typical active fund consistently underperformed the category index even before accounting for fees. There was also little dispersion between the best and the worst active funds. This makes a strong case for low-cost investments.
It makes sense for investors in these categories to focus on passive funds and the small number of active funds that charge fees lower than those of comparative passive funds.
In the other categories; EAA EUR corporate bond, USD government bond, US fund inflation protected bond, US fund long government, and US fund short government, the typical active fund outperformed the category index before fees, but only by a very narrow margin. These categories make a strong case for low-cost passive options, though they might provide slightly greater opportunities than the previous group for cheap active funds.
Some categories fall in a middle ground, where the average underperforms but there is much diversity within the category. A low-cost passive fund seems like a reasonable option for investors, but there is a greater dispersion between the best and the worst active funds, and returns of funds in the top 20% of their peer group were encouraging.
For example, the top 20% of funds in the GBP corporate bond category outperformed its category index by more than 1.5% before fees in the typical period covered by our study.
Finally, we’ve identified a group of categories in which the median fund’s returns deviated dramatically from the benchmark index over time, sometimes by more than 5 percentage points. Mostly, these deviations were on the downside, driving down the average return into negative territory for five of these seven categories.
In several of our high-yield and emerging-markets debt categories, passive funds fell short of the performance of market indexes, but so did most active managers. In areas where the benchmark index has little value as a guideline, investors should ultimately pit active and passive funds against each other to determine their relative merits.
Within the global high-yield universe we find that active managers outperformed their passive counterparts, suggesting that investors are typically better off choosing an active fund, even if it’s just an average one.
On the other hand, within the emerging-markets bond universe, the picture is bleaker. We find that most active funds end up squandering their theoretical gross-of-fees advantage over ETFs by charging excessive costs.
The median active managers in the EAA global emerging-markets bond, EAA global emerging-markets bond local currency, US fund emerging-markets bond, and US fund emerging-markets bond local currency categories lagged their passive counterparts by a significant margin, after fees, over the three-year rolling periods.
More strikingly, even funds in the top 20% of these categories underperformed their comparable ETFs after accounting for fees, suggesting that passive funds remain a compelling option here.
Investors Take Note
Dispersion between the best and worst active funds is very large, and some funds exhibit active bets and biases that will cause their performance to deviate massively from that of the average fund. Similarly, in some market conditions, active managers may do better as a group, only to fall behind the ETF in the following period.
While such short-term movements are hard to predict, and manager skill can be difficult to identify, ultimately fees remain a key factor of differentiation between active funds and a key predictor of future long-term performance. Thus, as a general rule, even in categories that appear to be more lucrative for active managers, investors should not turn a blind eye to costs.
