Bond-Fund Managers Enjoy a Happier Hunting Ground

The Easier Route "Looking for Easy Games in Bonds," published last week by Michael Mauboussin of Blue Mountain Capital Management, posits that taxable bond-fund managers are fortunate. Whereas the Paradox of Skill has eroded equity-fund managers' opportunities, by raising the level of competition so that few active investors can succeed, the bond market has been kinder. Its professionals enjoy prospects that stock-fund managers do not.

Mauboussin supports his claim both directly and indirectly.

The direct evidence is straightforward: Whereas only 10% of active large-company U.S. stock funds have outgained their style-adjusted benchmarks over the trailing 10 years, more than half of intermediate-term, corporate, and high-yield bond funds have accomplished the task. That is a sizable discrepancy.

The indirect approach asks not how funds performed against the indexes, but instead against each other. If the difference between the top and bottom funds has declined over the years, that presumably reflects increased competition. The investment industry no longer contains .400 hitters, not because today's batters are worse, but because today's pitchers are better.

Again, Mauboussin finds that what applies to equity funds does not to bond funds. Whereas the gap between the most- and least-successful large-cap U.S. stock funds (as measured by risk-adjusted returns) has continually shrunk since the 1970s, the gap for taxable bond-funds has remained steady. The strongest funds have maintained their margin of superiority.

Room to Maneuver There is another difference between the two fund types: index construction.

The Wilshire 5000 Index gives U.S. large-cap stock-fund managers little room for escape. The benchmark contains all the stocks that they could possibly own, in roughly the same proportion. True, managers can distinguish themselves by emphasizing smaller firms (with the danger being that Morningstar might reclassify their funds) or foreign securities (ditto), but both of those strategies would have backfired in recent years, as U.S. large companies have thrashed all comers.

Most bond-fund managers, on the other hand, compete against easily gamed benchmarks. For example, the dominant investment-grade index, the Bloomberg Barclays U.S. Aggregate Bond Index, places more than half its assets in U.S. government securities. Under normal market conditions, when credit spreads aren't widening because of economic fears, intermediate-term bond managers can beat the Aggregate Index solely by downplaying Treasuries--which most have done, over the past decade.

Also, unlike the leading equity indexes, fixed-income indexes have their quirks--blind spots, if you will. Morningstar's Eric Jacobson writes, "None of the major bond-index providers offer nonagency mortgage coverage. And while that sector was behind so much of the 2008 financial-crisis carnage, it was also the trade of the lifetime afterward."

Indeed. The best recent performance for intermediate-term bond funds against the Aggregate Index was from March 2009 through late 2010, when nonagency mortgages--housing loans not guaranteed by a U.S. government agency--rebounded from their 2008 woes. The funds looked stupider on the way down and smarter on the way up. In truth, they were neither. Just different.

Bond indexes don't necessarily hold every security, either. The Aggregate Index does contain asset-based securities, unlike with nonagency mortgages, but (per Jacobson) "the minimum deal sizes" of the index's ABS are "relatively high." As a result, intermediate-term bond fund managers who purchase smaller ABS pools hold investments that are outside their benchmark.

Further Considerations Mauboussin suggests several additional advantages for bond-fund managers:

1. Index fund tracking error.--Today's leading S&P 500 (or Wilshire 5000 Index) funds mimic their benchmarks almost perfectly. Not so for bond index funds, because the fixed-income market is so diffuse. Even after pruning its buy list, by eliminating some sectors and holding only the larger/more recent deals with others, the Aggregate Index contains 17,000 securities. Consequently, index fund managers sample the Aggregate Index rather than duplicate it, thereby inducing tracking error.
2. Noneconomic trades.--Central banks, private banks, and insurance companies are sometimes price-takers. They swap bonds not for profit, but instead to achieve an objective (such as central banks, with quantitative easing) or for regulatory purposes. Actively run fixed-income funds may profit from such opportunities by taking the other side of those trades.
3. Relative value trades.--Within each stock's exchange (across exchanges the story might be different), one share of Exxon Mobil XOM costs the same as the next. One cannot buy a particularly cheap sleeve of Exxon. With bonds, however, some tranches offer higher yields than others. They might mature on similar dates, carry the same credit rating, and sometimes even be issued by the same company, but their yields diverge.
4. Negotiation.--Bonds aren't purchased on commission: Their prices are negotiated over the counter. This condition doesn't help fixed-income managers to compete against the theoretical indexes, but it can help when combating actual index funds, because, owing to their investment restrictions, index funds might be pressured into making trades that actively run funds would skip.

Summing Up In short, bond-fund managers have more tools at their disposal than do their equity-fund rivals. To be sure, most of their decisions are distinctly small-time. Unless they court significant interest-rate risk, which their managers generally avoid, bond-fund trades typically consist of picking up nickels, not scooping up dollars. But every little bit helps.

The question is, do they help enough to overcome the burden of fund expenses? The answer there is, "It depends." For most intermediate-term bond funds, they have done so, once the additional advantages of being light in Treasuries and owning nonagency mortgage bonds are considered. Even after paying their costs, 75% of intermediate-term bond funds have outgained the Aggregate Index over the past decade.

Remove the tailwind of sector exposure, and the after-cost victory disappears. As there is no bond index that matches how intermediate-term bond funds invest, I created a custom benchmark that echoes the intermediate-bond Morningstar Category's credit-quality averages. That benchmark trails before expenses, but it beats the typical actively managed fund on an after-cost basis.

Of course, there are exceptions to the general rule. As Mauboussin points out, larger bond funds tend to perform somewhat better than smaller ones, meaning that several of the biggest funds have outgained the index by all measures. Nonetheless, the usual lament with active mutual fund management must be intoned: It can be good, but only at the right price.

John Rekenthaler 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.