Expenses are particularly important to consider for fixed-income funds. With yields near historic lows across bond markets, fees have eaten up an even larger share of funds’ returns, leaving less for fund investors to pocket.
It is no surprise that in this context, investors have increasingly turned to the expanding menu of low-cost passive index and exchange-traded funds for their bond exposure.
In many bond categories, it is preferable to choose a low-cost passive option, but there are also areas in which investors have reasonably good odds of selecting an active bond fund that is capable of beating its benchmark after fees.
Although there is some variation among categories, the general observation is that fees are the largest driver behind most bond funds’ chronic underperformance against their indices. This becomes evident when comparing gross of fees excess returns and net of fees excess returns of funds against a representative market index and an exchange-traded fund (ETF).
In 13 out of the 25 Morningstar fixed-income categories, the median fund typically outperformed its category’s index on a gross of fees basis, suggesting that at least in some cases active management has added value.
However, once fees are factored in, odds of outperformance drop dramatically. In fact, in none of the 25 categories studied does the median fund beat the category benchmark after fees.
But even these numbers slightly overstate the actual returns that investors can realistically achieve, as funds can be liquidated or merged during the observation period – a major phenomenon in Europe.
For example, only 61 per cent of the funds that were included in Morningstar’s Sterling Government Bond category in October 2012 were still alive in October 2017. Investors’ actual experience is better reflected by success ratios, which measure the percentage of funds having both survived and outperformed the category index in a given period. Success ratios for categories range from 9 per cent to 49 per cent, with some of the lower success ratios being found in high yield and emerging market bond categories.
Lower-risk bond categories are more suitable for indexing, while more adventurous categories provide more lucrative opportunities for active managers.
On a more granular level, we have identified a subset of categories in which costs have, on balance, a greater impact on net returns than does manager skill, making the case for low-cost passive investments. These are mostly investment-grade government or diversified bond peer groups, where returns are lower and there is comparatively little dispersion between the best and the worst active funds.
In more diverse peer groups, a low-cost passive option is often superior to the typical active fund, but there is still room for manager skill to add value – if fees are reasonable. For example, in Morningstar’s global bond category for European-domiciled funds, the median active fund fails to impress, but top-quintile active funds have delivered much more encouraging results, typically outperforming the Bloomberg Barclays Global Aggregate Bond index by morethan 100 basis points annualised net of fees.