Why active funds offer no edge in fixed income

While active equity managers have been finding it difficult to justify their high fees to investors, their counterparts in the fixed-income space have had an easier time; it’s been generally accepted that active managers shine in the fixed-income arena. However, one expert argues that that isn’t true.

“Active management is a zero-sum game before expenses,” said Larry Swedroe, director of research for the US-based BAM Alliance of independent investment advisors, in a piece for ETF.com. “[Y]ou have to be able to exploit the mistakes of others to generate alpha.”

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Swedroe explained that the fixed-income space is dominated by large institutional investors, which are difficult to outmatch or exploit. He added that fixed-income funds’ outperformance of their benchmarks can be largely explained by duration risk and credit risk — the favourable exposure to which can be achieved through low-cost passive funds — rather than market timing or security selection.

To support this point, he cited a December 2017 report by AQR Capital Management titled The Illusion of Active Fixed Income Diversification. Researchers looked at monthly manager and benchmark performance among institutional managers from 1997 to 2017.  They found that while active fixed-income managers have outperformed their benchmarks on a returns basis, the majority of their returns can be explained by exposure to credit markets, with credit tilts being “consistently positive and do not vary significantly over time.”

“Making matters worse is that the primary reason for investing in fixed income should be to dampen the overall risk of the portfolio,” Swedroe said. Credit risk tends to be correlated with equity risk, so increased credit-risk exposure within fixed income can undermine the point of portfolio diversification.

He also cited the recent SPIVA 2017 midyear report, which looked at 15 years of data on active bond funds. Based on the data, only 2% of long-term government bond funds, long-term investment-grade bond funds, and high-yield bond funds beat their benchmarks. Among domestic bond funds, short-term investment-grade funds showed the least poor performance with 71% of active funds underperforming. Between 84% and 92% of active municipal bond funds underperformed, as did 67% of emerging-market bond funds.

Past work done by John Bogle, Morningstar, and other researchers, he said, showed bond funds’ past returns cannot predict future performance; active funds do not, on average, provided added value in terms of returns. The major cause of return underperformance, they found, is expenses.

“The bottom line is pretty simple,” he said. “There is an overwhelming body of evidence that active management in fixed-income markets is even more of a loser’s game than it is in equity markets.”