Why Bond Funds are So Bad
As stocks continue to suffer through increased volatility, many investors are turning to the safety of bonds. Despite last summer’s downgrade by S&P, U.S. Treasury securities are still the destination of the world’s flight to safety. While larger investors build bond portfolios, individual investors generally rely on bond mutual funds. Not only are they easier to buy and price, they also provide immediate diversification across a wide range of holdings and maturities.
It’s a pity then that managed funds’ performance tends to be less than adequate. As you’ll notice from the chart below, actively managed intermediate government bond funds – as measured by the Morningstar Intermediate Government Category – have consistently trailed the unmanaged Barclay Intermediate Government Index throughout its 37-year lifespan. In other words, an index fund or ETF would have been better than the comparable actively managed fund.
Why have actively managed bond funds performed so poorly? First, you have to realize the Morningstar’s Intermediate Government Category represents the return of the average fund. Analysts on the other hand, profess to find above average funds which, of course, would look better. Yet studies show managers fail to consistently outperform their unmanaged indexes over periods longer than one or two years. Not only would the analyst need to find the best fund this year, he or she would need to find the best one in every coming year and move clients accordingly in a timely manner. The odds of that happening still make the unmanaged index look like the better alternative.
Overall market conditions have also posed a problem for active managers. Since hitting highs approaching 20% in the 1980s, intermediate government bond yields have headed down. Their prices, which move in the opposite direction, have been on an upswing. Managers holding any cash or low yielding bonds were penalized and have fallen behind. When prices are falling, cash offers an easy way for them to beat the index, but in this environment it consistently worked against them.
This year was even worse as even bond guru Bill Gross of PIMCO bet against Treasuries on the belief that yields would be on the rise and prices would suffer. Actually the opposite occurred when this summer’s U.S. national debt debate and the European credit crisis sent the world’s investors streaming into the safety of U.S. Treasuries. Managers who followed Mr. Gross’ lead lost ground to the index and remain there today.
Finally the biggest hurdle holding actively managed bond funds back is the persistently low yield. Historically 83% of intermediate Treasury return has come from yield. With rates now at historically low levels and holding, the average Intermediate Government fund’s expense of 0.98% virtually wipes them out. Sure, some funds charge less than that but the fact that this is the average means there’s roughly as many charging more. With further capital gains limited by government bonds’ already high prices, yield will be even more important. Managers who missed some of this summer’s run-up or worse, those who were essentially out of Treasuries like Mr. Gross, will have an extremely difficult time making up lost ground.
As the chart above illustrates, this year’s reason for active bond funds’ poor performance may have been different, but the results were the same. Until U.S. bonds enter a prolonged bear market, investors are better off relying on bond index funds or index ETFs. It’s ironic that equity fund managers are most frequently portrayed as incapable of beating their indexes when bond fund managers are even worse. Sometimes it’s better to remain out of the spotlight.
Explore posts in the same categories: Current Environment, ETFs, Mutual Fund EvaluationTags: benchmark, Current Events, ETFs, Morningstar, mutual funds
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