Swedroe: Active Fails In Fixed Income

March 02, 2018

There is a myth that active bond fund managers want and need you to believe. It goes something like this: “Sure, active stock picking isn’t likely to work, but in fixed income, active management really shines.” This is a strange argument to make, because:

  1. Active management is a zero-sum game before expenses (and a negative-sum game after expenses). Thus, you have to be able to exploit the mistakes of others to generate alpha.
  2. Even more so than in equity markets, trading activity in bond markets is dominated by large, institutional investors. Thus, it’s hard to identify a likely supply of the necessary victims to exploit.
  3. The academic research has found that the vast majority of returns to fixed-income portfolios are well-explained by two common factors: term (duration) risk, and credit (default). In other words, any outperformance by active managers against benchmark indexes is likely to come from simply having greater exposure to these two common factors—not from security selection or market timing (two sources of true alpha).

With the sharp cyclical decline we have experienced in interest rates since the global financial crisis, active managers could claim to outperform a benchmark by constructing a portfolio with more duration than the declared benchmark.

Of course, you don’t need active management to have longer duration. Just increase your allocation to longer-duration indexes and invest in lower-cost, passively managed mutual funds and ETFs. The term premium (the difference in returns between long-term U.S. government bonds and one-month Treasury bills) from January 2009 through December 2017 was 4.1% per year. In contrast, over the prior period 1926 through 2008, the term premium was 2%.

The same is true for credit risk, which also has been well rewarded since 2009. The credit premium (the difference in returns between long-term corporate bonds and long-term U.S. government bonds) from January 2009 through December 2017 was 3.1% per year. In contrast, over the prior period from 1926 through 2008, the credit premium was 0%. The default premium over that same period was about 11.6% per year (based on the Bloomberg Barclays US Corporate High-Yield Index).

Again, if you desire exposure to credit risk, you can obtain it in lower-cost, passively managed mutual funds and ETFs. In other words, you don’t have to pay the typically high fees of active management to gain exposure to these factors.

Making matters worse is that the primary reason for investing in fixed income should be to dampen the overall risk of the portfolio to an acceptable level, and while safe bonds offer effective diversification from the equity risk that dominates most investors’ portfolios, credit risk is more highly correlated with equities. The lower the credit rating, the higher the correlation becomes.

The Evidence

Fortunately, we have plenty of evidence to help dispel the myth that active management is likely to generate alpha in fixed-income markets. The most recent comes from S&P Dow Jones Indices, which has published its S&P Indices Versus Active (SPIVA) scorecards, comparing the performance of actively managed mutual funds to their appropriate index benchmarks, since 2002. The 2017 midyear report, the latest available, includes 15 years of data on the performance of active bond funds.

Following is a summary of the results:

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