Is active or passive better in bond investing?

-- | 31/08/2018

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Do active bond fund managers actually exhibit skill, or have they simply made profitable bets on risky areas? Joining me to discuss some research on that topic is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's start with a basic question. A lot of investors compare their active, say, intermediate-term bond fund with the Bloomberg Barclays Aggregate Index. But that's maybe not such a great benchmark for comparison, right?

Bryan: That's right. The Bloomberg Barclays Aggregate Bond Index, otherwise known as the Agg, weights its holdings based on market value. What that does is it tilts it pretty heavily toward low-yielding US Treasury securities as well as agency mortgage-backed securities.

Those two areas of the market actually account for about two thirds of the Agg Index. If you think about the way that most active bond managers in the intermediate-term bond category invest, they tend to take a bit more credit risk as a way of earning higher returns. The benchmark isn't necessarily representing the waters where active managers are fishing.

Benz: You did some research where you attempted to look at what kind of risk-taking is going on. You mentioned that overweight in credit is one of the common ways that active managers try to get ahead. But let's talk about how you were systematic in assessing where the active fund managers were taking risks.

Bryan: What I did was I looked at the performance of all active managers in the Morningstar intermediate-term bond category. I tried to explain their performance as a function of a few different common types of risk exposures that they might take.

For example, looking at credit risk and interest-rate risk to see if those types of common sources of risk could explain the returns that we see active managers earning over time.
What I found was that in fact active managers did tend to take a bit more credit and interest-rate risk over the last 10 and 15 years than the Barclays Aggregate Bond Index as you would expect.

Now, they have dialed down their interest-rate risk a bit over the last five years as you might expect as a lot of managers are concerned about rising rates, but they still have a pretty big structural overweight to credit risk. They are not necessarily taking the same types of risk that the benchmark is.

Benz: Your idea, your goal, in doing this research was to assess whether active bond fund managers have actually exhibited skill, or have they simply made profitable bets on risky areas that paid off well for them. What was your overall conclusion?

Bryan: If you look at the performance of active managers against the Barclays Aggregate Bond Index, their performance has actually not been that bad. It's actually been an easier benchmark to beat than most broad equity market indexes.

For example, if you look over the last decade or so, about 47 per cent of all active managers that existed as of May of 2008, went on to survive and beat the index. Now, if you control for the risk using the model that I've built, that outperformance rate falls from 47 per cent to about 35 per cent.

There are a lot of managers out there that did exhibit some skill, but that number of managers is actually smaller than the number of managers who were able to beat the benchmark.

Because a lot of managers who beat the benchmark did so with very consistent structural overweights to credit risk, and that's not necessarily skill; that's just taking on more risk. Sometimes, that pays off as it has over the last decade, but it may not always pay off.

The more important point is that if I want to structural overweight to credit, I can get that more cheaply with an ETF that overweights riskier areas of the bond market such as corporate bonds, for example.

Benz: When you look at this research, who does it say to you in terms of the counsel that you would provide to investors who are attempting to decide--should I just buy some sort of a bond market index fund and call it a day, or should I buy an active bond fund?

Bryan: Starting out with the broad index fund for exposure to bonds is not a bad starting point. It tends to be less risky than what you get most active bond managers. If you are looking for a more defensive way of diversifying away from equities, something like the Bloomberg Barclays Aggregate Bond Index is not a bad starting point.

Now, that being said, if you are looking to do a little bit better in terms overall returns or performance, there are active managers out there that do have skill. But it's important to go beyond just looking at their track record, because a lot of the returns can from risk-taking.

Like I said, that doesn't always pay off. It's important to look at the types of risks that your active manager is taking and assess whether or not the manager is actually providing some value-add beyond just taking greater credit or interest-rate risk.

One way that I would advise investors who are considering an active manager to go about screening these managers is look for managers who have a decent track record, but who also have a positive Morningstar Analyst Rating, who have a positive process pillar rating.

We are looking for managers that have a differentiated way of investing where they are able to generate higher returns not just from risk-taking but doing things that you can't replicate on your own through lower-cost index options.

You can be successful either with an active fund or with an index fund, but if you are going to hire an active manager, you really need to pay attention to the types of risks that you are getting and make sure that the manager is not just loading up on risks that have paid off well over the last five years or so.

Benz: Right. And of course, keeping an eye on costs is important if you are going with an active fund, too.

Bryan: Exactly, yes. Costs absolutely still matter here. Even if you are able to identify a skilled manager, if the price of the fund is too high, you may end up giving away all of your excess returns. It's very important to look for low-cost funds. Those tend to give you a better chance of success.

Benz: I know in previous research we found a correlation with higher costs and greater risk-taking?

Bryan: Yes, that's actually not surprising because in order to make up that expense ratio you'd have to earn higher returns. One of the easiest ways to do that is to take more risk because over time that tends to work out but not always.

Benz: Thank you so much for being here. Great research.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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