Christine Benz: Hi, I'm Christine Benz for Morningstar. Can bond funds grow large more gracefully than stock funds? Joining me to share some research on this topic is Russ Kinnel. He's Morningstar's director of manager research and editor of Morningstar FundInvestor. Russ, thank you so much for being here.
Russ Kinnel: Glad to be here.
Benz: Russ, in the latest issue of Morningstar FundInvestor, you delved into a topic that was based on an observation you had, you noticed that bond funds seemed to be able to get very large and maintain their performance perhaps better than stock funds. So let's talk about what the data say today when you look at performance of very large bond funds. How do they do relative to their peers? Then let's contrast that with what's going on in the stock fund universe.
Kinnel: What I did was I looked at actively managed funds--this isn't an index fund issue--with assets over $20 billion. I began simply by looking at their trailing 10-year return. Looking at assets today, and looking backwards, sure enough, if you do it that way, the average big bond fund had top 21%, so top-quartile performance, equity funds were top 29%. Definitely an edge for bond funds, but looking at it from that perspective, both groups did pretty well.
Benz: You decided to take a look backward, though, because in some respects, the data you were looking at conflates asset size and fund returns. So let's talk about why you decided to go back 10 years and looked at how funds that were large 10 years ago subsequently did.
Kinnel: That's right. Because when you look at assets today and you're looking at returns going back, you have to recognize that of course assets today reflect past returns. So a fund that appreciates more is more likely to be big, but also it's going to get a lot of assets coming in. So really when you look at big funds today, to a degree you're kind of looking at a winners list. A little more scientific way is to instead say, "What if I started with a list based on AUM 10 years ago?" Because that's what I would have had to look at. If I was choosing a fund based on AUM 10 years ago, it would have been using the assets 10 years ago. So it's better to go back to the funds that were big 10 years ago and then look at the returns over the ensuing 10 years.
Benz: What did you see when you did that? When you looked at very large bond funds 10 years ago, as well as very large stock funds 10 years ago, how did they end up doing? It sounds like the returns were a little less impressive relative to their peers?
Kinnel: Exactly. They still outperformed as a group, but not as impressively as my original look. So the typical bond fund was top 30%, and the typical big equity fund was top 41%. So definitely an edge to bond funds--again, backing up my observation that it seems like big bond funds handle asset growth a little better than big stock funds.
Benz: So the next step in your research process was to try to disentangle to what extent bond funds outperformed, because they had very low expenses, which sometimes are associated with larger funds. Let's talk about what that exercise yielded in terms of research findings.
Kinnel: As you said, the bigger a fund, generally the cheaper, because fees come down as funds get bigger. What happens is the fund companies share some of their economies of scale with investors. Other than Vanguard, they don't share them all, they keep some of that as profit or maybe a lot of that as profit, but fees do come down.
So of course the question is, is it simply a matter of having lower costs or is there something more to it? My final screen is go back to assets 10 years ago, but then look at gross returns over the ensuing 10 years. Gross returns are what we call returns where you add expenses back in. Essentially, the portfolio return regardless of fees. When we do that, all of a sudden the big picture becomes very different. The typical bond fund's--average big bond fund's--gross return is top 55%. In other words, slightly below average. The typical equity fund's is 49%, right at the average. So what that tells me is that in fact fees accounted for all of that performance edge. So, yes, big funds have delivered pretty good results, but all of that was caused by low fees.
Benz: What are the takeaways for investors from this? I'm guessing that one of the big ones is just to keep on focusing on fees, like you're always telling people to do. Anything else that people should take away?
Kinnel: I think you're right that for sure, this tells me to look for low fees, regardless of AUM. It also tells me that big funds don't have much of an advantage. To a degree, I think it means that fund companies could probably do a better job of sharing those economies of scale. Certainly I'm looking at active funds here. Over this 10-year period we look at, look at what's going on with index funds, they're racing to cheaper fees. So I think index funds are raising the bar, and I think it really behooves the fund companies of these big active funds to offer a better deal to investors. Either, if you think assets are hindering returns, then close sooner; if they're not, give your investors more of those economies of scale and cut fees more aggressively so that you can still deliver strong returns.
Benz: Okay Russ, really interesting research. Thank you so much for being here to share it with us.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.