Score One For Active Investing

Cautious investors take note: investment skill does make a difference in the bond market

The essentials

There is considerable debate over the value of an active investment approach for fixed income funds and, in particular, bonds. Prevailing wisdom is that passive funds perform better than a portfolio manager relying on his or her own skill and research. Fabio Moneta of Smith School of Business at Queen’s University studied the performance of nearly 1,000 U.S. bond mutual funds over a 10-year period, using measures constructed from a novel data set of portfolio weights. He found that active fund managers, on average, generate gross returns of 1 percent per year over the benchmark portfolio. The results provide the first evidence of the value of active management in bond mutual funds.

The value of an active investment approach is a point of contention in the mutual fund world — especially in the bond sector, where some cautious investors question whether the potential returns justify the higher fees charged by active managers.

But investment skill does exist in the bond market and, for certain fixed income funds, the ability to use an active strategy can play an important role in generating returns over and above fees, says Fabio Moneta, an assistant professor of finance at Smith School of Business at Queen’s University.

Active investing refers to a portfolio manager’s use of his or her own skill and research to select undervalues securities, to time the portfolio, and to move the portfolio across different credit qualities, between sectors such as government and corporate, and across the various maturities.

Active managers, says Moneta, ultimately engage in considerable trading activity to generate alpha, or excess return. “Bond fund managers demonstrate investment ability by holding securities that outperform their benchmarks by almost enough to cover their expenses and transaction costs,” says Moneta.

Why the Growth in Active Bond Funds?

In the fixed income space, the success of an active investment approach has been the subject of some debate. In a research report, Vanguard Investments noted that 57 percent of active global bond funds outperformed the unhedged Barclays Global Aggregate Bond Index over a 10-year period (ending in 2012), but that this performance came at an increased relative exposure to risk.

On the other hand, Morningstar’s Active/Passive Barometer — launched early in 2015 — reports that the intermediate-term bond category is a bright spot for active managers, with nearly half of actively-managed funds in this category outperforming equally-weighted passive funds on average over the last 10 years.

Although the active-passive debate is at an early stage for bond mutual funds, Moneta says the evidence to date does not appear to support active management. This is puzzling, he says, given the growth of active bond mutual funds and the success of some fund managers.

One of the problems, he says, is that fixed income funds are only measured against a returns-based index whose composition changes dramatically over time, due to variations in duration and credit quality or simply because bonds mature or are called. This makes it extremely difficult to measure fund performance.

A more accurate measure, he says, is to use portfolio holdings to construct the benchmark, resulting in fund-specific indices, based on their position in relation to, say, credit quality or maturity.

Taking a New Approach

In his research, Moneta chose to move away from the typical returns-based approach to measuring fixed income fund performance. Instead he studied the performance of nearly 1,000 U.S. bond mutual funds over a 10-year period, using measures constructed from a novel data set of portfolio weights.

“Using holdings information to measure fund performance complements what is captured by the returns-based approach, providing a more complete picture of the performance,” says Moneta.

With a benchmark constructed using past holdings, he found that active fund managers, on average, generate gross returns of 1 percent per year over the benchmark portfolio. “These results provide the first evidence of the value of active management in bond mutual funds,” Moneta writes in a research report recently published in the Journal of Empirical Finance.

This research, says Moneta, shows “managers need to be aware that there are different ways to measure performance and there are basically some issues with the measurement of fund performance.”

At the same time, bond investors remain cautious. According to recent reports, spreads between investment-grade corporate bonds and U.S. Treasuries are increasing, a sign of declining confidence in companies and the economy.

Room for Both Active and Passive Approaches

In the fixed income fund sector, there is room for both active and passive approaches to investing, Moneta says. The active approach itself is best suited to managers who invest primarily in high-yield corporate bonds. Essentially, says Moneta, the lower the credit quality, the more alpha the manager will be able to generate, as these securities are often illiquid and traded over the counter, requiring the manager to negotiate price with his or her counterpart.

In the Treasury bond market, however, “passive investing makes a lot of sense, as there’s not too much you can add to the treasury market because securities are efficiently priced, they’re very liquid.”

The downside to an active approach may involve higher fees in comparison to passive funds, and a potential drag on performance as a result. But in an environment in which a bond fund manager has the ability to generate alpha, says Moneta, the difference can be negligible.

With the market nearing the end of its bull run, Moneta notes that there is only one direction interest rates will likely go, meaning managers in the corporate bond space should be seeking a more hands-on approach.

“In the current situation, I think it is especially valuable to be an active fund manager,” he says. “I think you can weather the storm a bit better because you can invest in securities, anticipating that eventually, interest rates are going to go up.”

— Helen Burnett-Nichols

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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