Does Active Management Pay in Bond Markets?

Larry Swedroe examines a new study that highlights the negative relationship between activity and performance in bond funds.

Does it pay to be active in fixed-income markets? To help answer that question, Martin Rohleder, chair of Finance and Banking at the University of Augsburg, examined the performance of active fund managers in his December 2017 study, “Bond Fund Performance: Does Management Activity Pay?”

Study Results

His data set included more than 600 corporate and government bond funds, and covered the period 1987 to 2015. The performance measurement model Rohleder used adjusted for exposure to risks that included duration, default, optionality (such as exists in mortgage-backed securities) and equity risk. Following is a summary of his findings:

• Regressions robustly show a nonpositive and often even significantly negative relationship between activity and performance in corporate and government bond funds. This finding holds in the cross section, as well as over time within funds.
• The finding of a negative relationship was stronger for corporate bond funds than for government bond funds.
• The impact of timing activity was strongly negative, while selection activity was mostly unrelated to performance.
• For corporate bond funds, gross alphas were about zero. However, net alphas were strongly negative, and thus due to costs. For government bond funds, the results were slightly worse in both gross and net returns.
• Corporate bond funds with high flow risk suffered more from higher activity, consistent with forced, liquidity-motivated corporate bond trading.
• Corporate bond funds use complex investments, like derivatives, more intensively, especially with net long holdings, and display a less negative activity/performance relationship.
• Over time, growing funds become less active, consistent with them indexing a high percentage of the new money. In other words, investors are paying high active fees for gross benchmark performance.

Rohleder concluded there is consistent and robust empirical evidence that the relationship between activity and performance in bond funds (corporate and government) is, in fact, overall negative, and that this is especially the case for timing activity. He also found that his results were strongest in the most recent period. Hence, he writes, “management activity does not pay in this growingly important asset class.”

That the strongest negative results came in the most recent period is consistent with the findings on active equity managers. The logical explanation for this is that markets are becoming ever more efficient over time due to increasing informational efficiency and the competition’s greater level of skill. If you are interested in reading more on this subject, I’d recommend my book, “The Incredible Shrinking Alpha.”

Another interesting finding was that expensive bond funds and funds that increase their expenses have subsequently more active managers. The logical explanation is that such funds must attempt to overcome their higher expenses. Unfortunately, Rohleder found that the higher activity did not produce higher returns.

SPIVA Comparison

Rohleder’s findings are entirely consistent with those from the S&P Dow Jones Indices Versus Active (SPIVA) scorecards, which have compared the performance of actively managed mutual funds to their appropriate index benchmarks since 2002. The 2017 midyear scorecard, the latest available, includes 15 years of data on the performance of actively managed bond funds. Following is a summary of the report’s results:

• The worst performance was in long-term government bond funds, long-term investment-grade bond funds and high-yield 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 percentage points (3.0 percentage points), long-term investment-grade bond funds underperformed by 2.6 percentage points (2.2 percentage points) and high-yield funds underperformed by 2.3 percentage points (1.7 percentage points).
• For domestic bond funds, the least poor performance was in intermediate-term and short-term investment-grade bond funds, where 76% and 71% of active 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).
• Active emerging market bond funds fared poorly as well, with 67% of them underperforming. On an equal-weighted basis, the underperformance was 1.4 percentage points. On an asset-weighted basis, the underperformance was 0.4 percentage points.

Summary

The bottom line is that active management is just as much, if not more, of a loser’s game in fixed-income markets as it is in equity markets—with the result being that the prudent strategy (the one most likely to allow you to achieve your financial goals) is to have your bond investments in low-cost, passively managed vehicles.

This commentary originally appeared January 31 on ETF.com

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