The common wisdom in the investment industry is that whilst passive investing may work for equities, fixed income is a completely different ball game. Various reasons are given for why active management should work better in fixed income, including that bond indices overweight the most indebted companies, bond markets are less efficient, and that there are many investors in the bond markets who aren’t looking to maximise profits (e.g. central banks controlling growth and inflation). Whilst the evidence is not as conclusive as it is for equities, active managers still don’t shine in fixed income, and the case for traditional active management is far from compelling.
Summary
- In the vast majority of geographies and credit types studied, well over 50% of active funds underperformed their benchmark after fees.
- Fees were a major reason for active funds’ underperformance.
- There were pockets of outperformance where active management has been able to add value.
- However, academic studies tend to conclude that the majority of any outperformance from active funds comes from taking on additional risk and other factor exposure rather than genuine alpha.
Section 1 of this post focuses on 2 sources of data: the Morningstar Active/Passive Barometer and the SPIVA reports. Both reports are updated every 6 months, and are cited widely in the industry as being the “scorecard” for assessing the performance of active funds. Both studies are conducted independently using their own separate data sets.
Section 2 contains a selection of other recent relevant studies that also contribute to the active/passive performance debate. Despite not being updated as regularly as the Morningstar and SPIVA reports, their conclusions are equally worth reading.
Section 1
The Morningstar Active/Passive Barometer and the SPIVA reports
This section summarises the performance of active funds investing in bonds over the last 10-20 years, relative to their passive benchmarks. There is considerably more data in the underlying reports, which can be found here, here, and here.
Highlights
- USA. According to S&P, the majority of funds in all 13 active fixed income categories underperformed their benchmarks over 15 years. The percentage of funds that underperformed ranged from 69% (global income funds) to 98% (high yield funds and government long funds), with an average of 85%. Morningstar showed similar data, with 76% of intermediate-term bond funds underperforming their benchmark over the last 20 years. However, over the last 10 years, only 38% of corporate bond funds underperformed.
- Europe (Morningstar data only). The majority of active bond funds in Europe underperformed their benchmarks, in all 12 categories. Over 80% of active funds underperformed in 9 out of 12 categories –including GBP corporate bond funds and GBP government bond funds (84% underperforming and 88% underperforming respectively).
- Emerging markets (S&P data only). 92% of both Brazil corporate bond and government bond funds underperformed over the last 5 years. 95% of Indian government bond funds and composite bond funds underperformed over the last 10 years, as did 74% of Australian bond funds – 69% on a risk-adjusted basis. Results were better in South Africa, with 22% of short-term bond funds underperforming over 5 years, and 51% of diversified/aggregate bond funds underperforming over the same time period.
- Survivorship in US funds ranged from 35% to 78% according to S&P, with an average of 51% of active fixed income funds surviving over the last 15 years across their categories. Morningstar shows 33% survivorship for intermediate-term bond funds over 20 years, but 96% survivorship for corporate bond funds over 10 years.
- Survivorship of European funds ranged from 29% (JPY bond funds) to 75% (USD corporate bond funds), with an average of 45% of funds surviving after 10 years across their categories.
Performance
NB: S&P Dow Jones compares active funds’ performances against their S&P-assigned costless benchmark, based on the funds’ Lipper classifications. Morningstar compares active funds’ performances against a composite of actual passive funds – their “benchmark” reflects the actual, net-of-fees performance of passive funds.
Section 2
Further evidence from other sources
Dimensional Fund Advisors
DFA’s 2018 Mutual Fund Landscape report shows that over 15 years, just 13% of active US bond funds survived and outperformed their benchmark:
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Vanguard
Vanguard’s research paper, ‘The case for low cost index-fund investing’ shows on page 9 that over 75% of active bond funds underperformed their benchmarks over the last 15 years across global, UK, US, and European bonds:
Key chart:
S&P Dow Jones Indices
Alongside the SPIVA Scorecards, S&P Dow Jones also periodically release a research paper called ‘SPIVA® Institutional Scorecard: How Much Do Fees Affect the Active Versus Passive Debate?’. They found that results were mixed in fixed income, but fees mattered hugely in whether funds underperformed or not. 5 mutual fund categories out of 14 had the majority of funds underperforming gross of fees, which rose to 14 out of 14 (all of them) underperforming net of fees. The effect was less pronounced for institutions (which is understandable given their lower fees). 8 out of 13 categories had the majority of funds underperforming gross of fees, and 9 out of 13 net of fees.
Key chart:
Morningstar
Alongside the Active/Passive Barometer, Morningstar published a research paper in May 2018 entitled, “Finding Bond Funds That Can Beat Their Benchmarks After Fees: High Fees Eat Away at Bond Funds’ Excess Returns.” They find that whilst some categories outperformed before fees, every category underperformed their benchmark net of fees.
Key quotes:
“The largest explanatory factor for the chronic underperformance of bond funds versus their indexes is the impact of fees. As is shown in Exhibit 1, net-of-fees median returns were negative in all 25 categories studied.”
“Results show that, although the median active manager can beat the benchmark in several categories before fees, success ratios drop dramatically after fees and fund mortality are taken into consideration. Categories fare considerably differently, however, in how funds perform against category benchmarks and passive investment vehicles.”
“Unfortunately, most bond funds are “priced to fail”: their fixed fees are in line with, or sometimes even above, their historical margin of gross-of-fees outperformance, thereby negating or even destroying the value added by managers.”
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AQR
AQR published a research paper in December 2017 entitled “The Illusion of Active Fixed Income Diversification”. The paper found that active fixed income managers have managed to outperform their benchmarks simply by taking on more risk (buying riskier bonds) than their benchmark. After accounting for increased credit risk, as well as other factor exposures, almost all of the alpha disappears. In addition, AQR argued that those managers who beat their benchmarks by taking on more risk are increasing their funds’ correlations to equity markets, which reduce their diversification effect, and reduce the chances that their bond funds will provide positive expected returns when equity markets fall.
Key quotes:
“The problem is that any perceived alpha has been, at least to a great degree, due to a passive long-term overweight of credit. If we found equity managers out-performed largely because they were strategically, not tactically, higher beta than their benchmarks, would you get excited and pay a lot for that? I hope not. For fixed income managers, the credit exposure doesn’t necessarily eliminate all of their alpha, but once you account for the credit exposure, fees and other simple factor exposures (for example, short volatility exposure) there may not be much left.”
“It gets worse. The reason most invest in fixed income is because it’s a positive expected return asset that offers diversification from equity risk, which dominates most investors’ portfolios. Well, credit is the part of fixed income that is highly correlated with equities. As a result, not only is there less alpha than people think, the whole premise for investing in fixed income is compromised on account of the average active manager’s passive overweight to credit as it non-trivially raises fixed income’s correlation to equities.”
Vanguard (no. 2)
Vanguard’s paper, “Global active bond fund returns: a factor decomposition” backs up AQR’s findings, providing further evidence that common factor exposures provide most of bond funds’ alpha. After accounting for factor exposure, genuine alphas were “statistically indistinguishable from zero”.
Key quotes:
“We found that the average fund return variation could largely be explained by common bond factors such as term and credit, as expected. However, currency and high yield exposures also contributed significantly. The majority of the 15 fund types generated statistically significant positive average gross alphas on both equal-weighted and assetweighted bases. On a net basis, alphas were generally statistically indistinguishable from zero. With all else equal, funds with lower expense ratios will have higher net alpha.”
“We analyzed the time series returns of several categories of active bond fund managers. We found that return variation could be explained predominantly by four factors: term, credit, high yield, and currency. Average gross alphas were generally positive; net alphas were statistically no different from zero.”
Morningstar (no. 2)
Consistent with the 2 papers above, Morningstar conclude that active managers appear to outperform the aggregate bond index, but in reality are just taking more credit/duration risk. For those that wish to allocate towards active managers, Morningstar recommend using low-cost managers whose performance hasn’t come solely from factor exposure.
Key quotes:
“The investment-grade bond market isn’t rife with mispricing. While the Aggregate Index is an easier benchmark to beat than most broad U.S. equity indexes, many managers who earn higher returns than that index do so by taking greater risk—often fishing outside the index. That risk doesn’t always pay off, and investors can often get it more cheaply through low-cost ETFs that track riskier areas of the investment-grade universe, like corporate bonds. After controlling for risk, most active managers have not survived and outperformed the index over the long term, and that pattern will likely continue. So indexing isn’t a bad starting point.”
“Yet, there are many active managers who do outperform, even after controlling for exposure to common sources of risk. While they may be taking other types of risks, it is difficult to replicate their performance with passive options. Investors who decide to hire an active manager can improve their odds of success by screening for those with low fees and strong performance that doesn’t come from loading up on credit, duration, and other forms of market risk. Screening for Morningstar Medalists with Positive Process and Price Pillar ratings is a good place to start.”
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University of Augsburg
Martin Rohleder, chair of Finance and Banking at the University of Augsburg, examined the performance of active fund managers in his December 2017 study, “Bond Fund Performance: Does Management Activity Pay?” He found that increased activity in bond funds detracts from performance, and hence the higher activity from active management does not add value.
Key quotes:
“For corporate bond funds, gross alphas were about zero. However, net alphas were strongly negative, and thus due to costs. For government bond funds, the results were slightly worse in both gross and net returns.”
“The bottom line is that active management is just as much, if not more, of a loser’s game in fixed-income markets as it is in equity markets—with the result being that the prudent strategy (the one most likely to allow you to achieve your financial goals) is to have your bond investments in low-cost, passively managed vehicles.”
PIMCO
PIMCO, one of the world’s largest active bond fund managers, provide data from Morningstar showing that the majority of active bond funds outperformed their passive peers over the past 1, 3, 5, 7, and 10 years.
Key quote:
“More than half of the active bond mutual funds and ETFs beat their median passive peers in most categories over the past 1,3,5,7, and 10 years, with 63% of them outperforming over the past 5 years… Taking the three largest categories within fixed income for the same 5-year period, 84%, 81%, and 60% of active funds and ETFs outperformed their median passive peers in intermediate term, high yield, and short-term categories, respectively.”
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Larry Swedroe
Larry Swedroe, writing for ETF.com, provides references for a number of academic papers showing that active bond managers fare no better versus their benchmarks in bond markets than in equity. One study shows that the average actively managed bond fund underperforms its benchmark index by 0.85% per year, and another shows that only 16% of a sample of 800 bond funds beat their benchmark over the 10 year period he covered.
Key quotes:
“We even have evidence from a 1993 study, which covered a period when, arguably, the markets were less efficient than they are today. Christopher Blake, Edwin Elton and Martin Gruber, authors of the study “The Performance of Bond Mutual Funds,” which appeared in the July 1993 issue of the Journal of Business, examined the performance of 361 bond funds and found that the average actively managed bond fund underperforms its benchmark index by 0.85% per year.
In addition, Kevin Stephenson, author of the study “Just How Bad Are Economists at Predicting Interest Rates?”, which appeared in the Summer 1997 issue of the Journal of Investing, found that only 128 out of 800 fixed-income funds (or 16%) beat their relevant benchmark over the 10-year period he covered.”