In a July 2017 Q&A with WealthManagement.com, Western Asset Management CIO Ken Leech asserts that passive investing is unlikely to play as large a role in fixed income as it does now in equities, because active managers outperform their benchmarks much more in the bond market than they do in the stock market.
While the trend toward passive/index investing has been just as strong in the bond market as it has in the stock market, with passive bond mutual funds and ETFs experiencing a net inflow of $185.8 billion during the 12 months through May, according to Morningstar data cited in the article, Leech claims we’ve “been fortunate that the record of active beating passive is strong in fixed income.”
He added: “The index is around the bottom quartile of the active community, in terms of performance. We’re hopeful that evidence is compelling, and that active management will continue to play a dominant role.”
When asked why active strategies have done better in the bond market than in the stock market, Leech responded: “Government and government-sponsored agency bonds make up more than half of indices. Most studies suggest that overweighting high-quality bonds with higher yields than Treasuries gives you a powerful advantage over time compared to indices.”
Let’s see if Leech’s claims hold up to scrutiny, or if they are—like most claims about the success of active management—nothing more than what journalist and author Jane Bryant Quinn called “investment porn.”
Checking In With SPIVA
While the poor performance of actively managed equity funds is well-known, the performance of actively managed bond funds tends to receive less attention. To check Leech’s assertions, we will look to the S&P Dow Jones Indices year-end 2016 SPIVA U.S. Scorecard, which has 15 years of performance data on actively managed bond funds.
Following is a summary of the report’s findings:
- The worst performance was in long-term government bond funds and long-term investment-grade bond funds, as just 3% of active funds in those categories beat their respective benchmarks. On an equal-weighted (asset-weighted) basis, active funds underperformed the index by a shocking 3.3 percentage points (2.7 percentage points) and 2.2 percentage points (2 percentage points), respectively. Active high-yield funds didn’t fare much better, with just 4% outperforming. On an equal-weighted (asset-weighted) basis, the outperformance was an also-shocking 2 percentage points (1.7 percentage points).
- For domestic funds, the least-poor performance was in intermediate investment-grade and short-term investment-grade bond funds. In both these cases, “only” 73% of actively managed funds underperformed. On an equal-weighted basis, the underperformance in both categories was 0.3 percentage points. However, on an asset-weighted basis, they managed to outperform by 0.7 percentage points and 0.3 percentage points, respectively. That is possibly explained by their holding longer maturities and/or holding lower-rated bonds (taking more risk) than the benchmarks. A factor regression would provide us with that evidence.
- Domestic high-yield bond funds performed almost as poorly as long-term government bond funds and long-term investment-grade bond funds, with just 4% of actively managed funds outperforming their benchmarks. On an equal-weighted basis, the underperformance was 1.9 percentage points. On an asset-weighted basis, they managed to outperform by 1.6 percentage points.
- Emerging market bond funds also fared poorly, as 76% of them underperformed. On an equal-weighted basis, the underperformance was 1.4 percentage points. On an asset-weighted basis, the underperformance was 0.2 percentage points.
Believe Vs. Evidence
Contrast the actual performance of active fund managers with Leech’s assertion that indexes were in the bottom quartile of performance: Leech was right about one thing—the evidence is compelling, just not in the direction he meant.
Even though the SPIVA scorecards clearly provide powerful evidence on the persistent failure of active management’s ability to generate alpha (risk-adjusted outperformance), active managers continue to claim otherwise.
As author Upton Sinclair noted: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.” The claim that active management works in the bond markets is just as much a canard as the claim that it works in emerging markets (as I show in another recent article) or, for that matter, any other market.
The actual evidence provides compelling support for Charles Ellis’ observation that while it’s possible to win the game of active management, the odds of doing so are so poor that it’s imprudent to try—which is why he called it the “loser’s game.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.