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What Are the Effects of Bond Fund Fees on Performance?

The typical active fixed-income fund manager struggles to beat the fund’s benchmark after fees

Mara Dobrescu

 

What are an investors' odds of selecting an active fixed-income fund that is likely to outperform its benchmark after fees, and in which categories is it preferable to choose a low-cost passive option instead?

To answer these questions, we looked at expected excess returns for fixed-income funds based on historical excess return distributions in 25 Morningstar Categories. The study spans a period of nearly 16 years, from January 2002 to October 2017, and includes funds from Morningstar's U.S., Europe, Asia, and Africa categories.

Let’s look at some of the highlights of our study:

Bond funds’ fees are the largest driver behind most chronic underperformance against their indexes

We found that in 13 out of the 25 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 did the median fund beat the category benchmark after fees, a dismal picture for the active bond fund investor.

When assessing probabilities of outperformance over long periods of time, a further complication arises from funds being liquidated or merged during the observation period. So, success ratios—which measure the percentage of funds having both survived and outperformed the category index in a given period—are a better reflection of investors’ actual experience. Success ratios for categories in our study ranged from 9% to 49%, with some of the lower success ratios in high-yield and emerging market bonds categories.

Lower-risk bond categories are more suitable for indexing

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’s 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’s still room for manager skill to add value—if bond fund fees are reasonable.

For example, in some corporate bond categories, the median active fund fails to impress. But active funds in the top quintile have delivered much more encouraging results, at times outperforming their category index by more than 100 basis points annualized net of fees.

Sometimes, both active and passive funds fall short of the index

In universes where volatility and transaction costs are high, we found that both active and passive funds struggle to keep up with the index, but for different reasons.

Within high-yield bonds, passive funds, which typically focus on the largest, most-liquid issuers, have missed out on a very large portion of the benchmark’s returns. Active managers, meanwhile, are somewhat better armed to exploit the market’s inefficiencies and illiquidity premiums. Thus, even if it fails to beat the benchmark index, the median high-yield active fund is still preferable to a passive vehicle.

Meanwhile, within emerging-market bonds, most active funds are simply too expensive to succeed. Even funds in the top quartile of these categories have underperformed a comparable exchange-traded fund after fees, suggesting that passive offerings are relatively more compelling even if they are not able to exactly match the index’s returns.

Download the full paper "Finding Bond Funds That Can Beat Their Benchmarks After Fees."

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