If so, the industry’s leaders must perform better.
The Logical Question
In 2000, the consensus view of stock mutual funds was very different from what it is today. At that time, investors favored pricey funds that were actively managed. Funds carrying expense ratios that were greater than 1% attracted considerably more assets than those with expense ratios of under 0.5%. And while Vanguard’s index-fund business was growing handsomely, the company had not yet assumed the industry lead.
That all changed during the ensuing decade. By 2010, actively managed equity funds were suffering redemptions, passive stock funds enjoyed inflows, and Vanguard was the world’s largest fund provider. Investors had lost confidence that they could identify winning actively managed stock funds before the fact.
However, they retained their faith in active fixed-income management. True, investors were beginning to discover bond index funds, which registered $70 billion of net inflows during 2009. However, actively managed bond funds posted $250 billion of net new sales during that same year. One might think with their greater volatility, and thus greater possibility of excess returns, that equities were better suited for active management. But fund investors believed otherwise.
They now appear to be adjusting that opinion. Over the past 12 months, net sales of bond index funds have exceeded those of actively run fixed-income funds, although that race remains tight. This leads one to wonder: Will active bond funds endure the same fate as their equity-fund cousins? Or are their conditions somehow different?
The Land of the Giants
Indirectly, Morningstar’s Russ Kinnel has addressed that query, in “What’s Behind the Strong Performance of Big Funds?” On the surface, it appears that rather than index, equity investors could have profited by purchasing the industry’s largest funds. Of the 41 actively run equity funds that currently possess more than $20 billion in assets, 10 carry top-decile returns over the past decade, when compared with other funds in their categories. Meanwhile, none have landed even in the bottom quartile, never mind the bottom decile.
Sadly, that apparent success was a mirage, because–as you may have already noted–Russ was playing his readers. His article’s initial logic was circular. The largest funds became that way, at least in part, because of their strong 10-year returns. When Russ ran the study properly, measuring fund size not by current assets but instead by those of a decade ago, he found that the big funds had only slightly outgained the norm. On average, that group’s 10-year category ranking is a moderate 41.
This advantage disappears entirely after accounting for the effect of expenses. Because their size permits them to offer volume discounts (and also because investors no longer buy expensive funds; this logic is circular as well), the largest stock funds tend to be cheaper than most. After adjusting for that difference, the average 10-year category ranking for the giants lands almost exactly in the middle of the pack, at 49. In contrast, Vanguard Total Stock Market Index’s (VTSMX) ranking is 24.
Russ also evaluated fixed-income funds using the same approach. Predictably, the largest funds as assessed by current assets have shone–even more brightly, it turns out, than have the largest stock funds. The 10-year category rankings for the 20 largest active bond funds average a spectacular 21, with only one of those 20 funds (ironically, a Vanguard offering, Vanguard Intermediate-Term Investment-Grade (VFIDX)) placing in its group’s bottom half. Score one for active management!
But of course, that outcome was once again an illusion, for the same reason as the initial equity-fund results. Once more, Russ revised his study, now assessing how 2010’s biggest funds performed. This time, the actively managed bond funds continued to show well. The average category ranking was just below 30, indicating that the typical industry leader from 2010 subsequently placed in its group’s top third.
Thus, at least as gauged by the showing of the industry’s biggest funds, investors were correct to prefer actively managed bond funds to actively managed equity funds. However, even more than with equity funds, the superiority of the large actively run bond funds owed solely to their relatively low costs. On a pre-expense basis, their average 10-year category ranking was a sluggish 56.
Not Good Enough
That’s a problem. When rank-and-file investors realize that “star” bond-fund managers haven’t been more successful than their equity-fund counterparts at beating their compatriots–thereby demonstrating the level of skill that is required to beat the benchmarks over time–they will inevitably switch to index funds. This process may take some while, particularly as bond funds are now receiving high inflows, but the outcome looks to be inevitable.
Not helping matters have been the struggles of the two best-known bond funds, Pimco Total Return (PTRRX) and DoubleLine Total Return Bond (DBLTX). Once-dominant Pimco Total Return has shed three fourths of its shareholders in recent years due to stretch of weak results, accompanied by (unnecessarily) dire headlines. For its part, DoubleLine’s fund was terrific coming out of the gate, but it has lagged 90% of its rivals over the trailing five years. Such patterns are depressingly familiar to those who invest in active equity funds.
There will always be room for small, opportunistic bond funds that can exploit niche opportunities. Unfortunately for active management’s fortunes, though, such funds cannot support the brand. The only way that fixed-income active management can forestall its index-fund competition is by getting strong, well-publicized performance from the industry’s leaders. The biggest bond funds must do better. In recent years, they simply have not been good enough.
Originally Posted on November 16, 2020 – Can Bond Funds Repel the Indexers?
John Rekenthaler (firstname.lastname@example.org) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
John Rekenthaler does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal, or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from Morningstar and is being posted with permission from Morningstar. The views expressed in this material are solely those of the author and/or Morningstar and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.