For a While, Bond Funds Were an Exception to the Indexing Rule
A December rally in bonds as stocks were plummeting turned a really bad year into something a little less painful for investors in core bond funds that are the centerpiece of many portfolios.
According to Morningstar Direct, the average core index bond fund lost just 0.14 percent in 2018, and actively managed core bond funds slid 0.39 percent on average.
Until late fall, active fund managers, on average, were actually outperforming their index fund counterparts, and had been doing so for quite some time.
S&P Dow Jones Indices runs a semiannual check of how many actively managed funds do better than their target index. In the three years through June, the Spiva report found that nearly 70 percent of actively managed core bond funds beat their index. (Spiva is an acronym for S&P Indices Versus Active.)
Popular actively managed core funds like MetWest Total Return, Pimco Total Return, DoubleLine Total Return and Dodge & Cox Income all had higher three-year annualized returns through December than the Vanguard Total Bond index fund and the iShares Core U.S. Aggregate Bond E.T.F.
Yet when you widen your gaze toward even longer-term performance, the case for active management becomes less clear.
The Spiva scorecard adjusts for “survivorship bias” by including the performance of funds that have been merged or shut down, typically because of poor performance. Fewer than half the actively managed core bond funds from 15 years ago were still in business in June. S&P Dow Jones Indices calculated that fewer than 30 percent of actively managed core bond funds survived the entire 15 years and beat their target index over that stretch.
A 2017 Morningstar report gave much the same picture. It tracked performance over 154 rolling three-year periods that began in 2002 and ended in the fall of 2017, and adjusted for survivorship bias.
Morningstar found that active management is typically “priced to fail” as the cost of annual fees typically wipes out gross excess returns. Active core funds charge an average annual expense fee of 0.6 percent, compared with 0.2 percent for core index funds, according to Morningstar Direct. Fewer than 40 percent of active core bond funds in the study had a median return, net of fees, over all those periods that was higher than the Bloomberg Barclays U.S. Aggregate index.
Sure, that’s more than a fighting chance, yet when active funds beat index funds in the United States, it typically wasn’t by much. Morningstar found that if it generously assumed an investor had the ability to invest in top-performing funds in each rolling three-year period since 2012, the median net excess return was 0.25 percent — or 25 basis points — above the index, and 0.3 percent ahead of the return of the iShares Core U.S. Aggregate Bond E.T.F.
“If you are willing to spend the time and effort and do the due diligence of active managers in hopes of generating a few extra basis points of excess return, there is some room to do that,” said one of the authors of the study, Mara Dobrescu, associate director of fixed income strategies at Morningstar France.
But because the potential payoff is typically close to peanuts, Ms. Dobrescu’s message for D.I.Y. investors is “it’s not worth expending all that time and effort.” Finding an active fund that persistently outperforms is no small hurdle, and today’s low-rate environment makes it tough to generate outsize excess returns without piling on a lot of risk.
“If your point is to own bonds for defensive purposes and your aim is to hold long term and to minimize cost, then definitely passive is the way to go,” Ms. Dobrescu said.
As chief investment officer at Huber Financial Advisors, Philip Huber is in the due diligence business. While the investment management firm tends to stick with index funds for equities, Mr. Huber said, he prefers active managers such as Pimco Total Return and DoubleLine Total Return for bonds.
“I don’t have any problem with people wanting to index their bond portfolio,” he said, “but if you have the resources to research and understand what an active manager is doing, bonds is one area where active can work.”
That said, it’s important to understand what has been driving the recent outperformance for fund managers: avoidance of low-yielding but, in some ways, ultrasafe United States Treasury issues.
Core index bond funds typically track the Bloomberg Barclays U.S. Aggregate index. This index owns a mix of Treasuries, agency bonds (mortgage-backed securities) and high-quality corporate bonds in proportion to each bond segment’s share of the American market.
Over the last decade, as the United States government has issued more and more debt, Treasuries have grown from 22 percent of the index (and index funds) to 40 percent. The index’s Treasury stake is likely to increase in the coming years because the new tax law has reduced corporate tax revenue and a growing federal budget deficit will require more Treasury debt to pay the country’s bills.
The average active core manager has 17 percent invested in Treasuries, according to Morningstar Direct. Among the largest actively managed funds, MetWest Total Return has the biggest stake, at 19 percent. Pimco Total Return and Dodge & Cox Income have less than 15 percent invested in Treasuries. DoubleLine Total Return’s stake is below 5 percent.
Snubbing low-yielding Treasuries and investing in higher-yielding corporate and securitized bonds — and, in some instances, international and emerging market bonds — has paid off during the extended economic recovery. Moreover, Treasuries often take the biggest hit when interest rates rise. And that has been the script lately; the yield on the 10-year Treasury note has risen from 1.6 percent in the summer of 2016 to 2.7 recently.
But Larry Swedroe, director of research at Buckingham Strategic Wealth and author of “The Only Guide to a Winning Bond Strategy You’ll Ever Need,” suggests that a longer-term perspective is needed.
“Treasuries are exactly what bond investors should want to own,” he said. “When stocks get hammered, Treasuries tend to go up in value, in the flight to quality. Other bonds don’t.”
Among those other bonds are corporate issues. Active managers also have a bigger stake, on average, in BBB-rated corporate bonds, the riskiest segment of the investment-grade bond market. According to Morningstar Direct, the average core fund has 18 percent invested in BBB-rated corporate bonds, compared with 13 percent of the index. Active funds can also own junk bonds and international bonds, both of which are excluded from index funds tracking the Bloomberg Barclays U.S. Aggregate index.
Because active managers typically are light on Treasuries and own other types of bonds that don’t provide as much counterweight to stocks, they tend to underperform just when you need them most.
In 2008, when stocks were cratering, the average active core bond fund lost 2.3 percent. The average core index fund gained 4 percent.
Mr. Huber said he was willing to absorb periods of underperformance like that because some actively managed bond funds beat bond index funds over longer periods.
“There may be too much focus on trying to avoid a repeat of 2008,” he said.
Still, consider the performance of the Vanguard Total Bond Market Index fund during the financial crisis, when it seemed that nearly all assets were losing value. In 2008, the Vanguard bond index fund did just what it was intended to do: It gained more than 5 percent.
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