Swedroe: Active Fails In Fixed Income

March 02, 2018

  • The worst performance was in long-term government bond funds, long-term investment-grade bond funds and high-yield bond funds. In each case, just 2% of active funds beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, long-term government bond funds underperformed by a shocking 3.5%age points (3.0%age points), long-term investment-grade bond funds underperformed by 2.6%age points (2.2%age points) and high-yield bond funds underperformed by 2.3%age points (1.7%age points).
  • For domestic bond funds, the least poor performance was in intermediate- and short-term investment-grade funds, where 76% and 71% of actively managed funds underperformed, respectively. On an equal-weighted basis, their underperformance was 0.5 percentage points and 0.7 percentage points, respectively. However, in both cases, on an asset-weighted basis, they outperformed by 0.3 percentage points. This result possibly could be explained by the funds having held longer maturities (that is, taking more risk) than their benchmarks.
  • Active municipal bond funds also fared poorly, with between 84% and 92% of them underperforming. On an equal-weighted (asset-weighted) basis, the underperformance was between 0.6 percentage points and 0.7 percentage points (0.2 percentage points and 0.4 percentage points).
  • Actively managed emerging market bond funds fared poorly as well, as 67% of them underperformed. On an equal-weighted basis, their underperformance was 1.4 percentage points. On an asset-weighted basis, their underperformance was 0.4 percentage points.

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.

Is Past Performance Predictive?

Being a loser’s game does not mean there aren’t some winners, offering the hope that somehow we can identify the few winners ahead of time. Unfortunately, the evidence suggests that believing this is possible in a reliable way would be the triumph of hope over experience.

For example, in his 1994 book “Bogle on Mutual Funds,” John Bogle studied the performance of bond funds and concluded that “although past absolute returns of bond funds are a flawed predictor of future returns, there is a fairly easy way to predict future relative returns.”

He continues: “The superior funds could have been systemically identified based solely on their lower expense ratios.” Other studies on the subject, including those on municipal bond funds, all reach the same conclusions:

  • Past performance cannot be used to predict future performance.
  • Actively managed funds do not, on average, provide added value in terms of returns.
  • The major cause of underperformance is expenses; there is a consistent one-for-one negative relationship between expense ratios and net returns.

The results of a December 2004 study by Morningstar’s Russel Kinnel, “Time to Clear Out the Dead Wood,” further demonstrate the importance of costs and that the past performance of actively managed funds is a poor predictor of future performance. Kinnel tested funds with strong past performance and high costs against those with poor past performance and low costs. He writes: “Sure enough, those with low costs outperformed in the following period.”


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