Myth vs Reality in the Hunt for Fixed Income Alpha (Tucker)

Thursday, December 8th, 2011

In the past few decades indexing has increased in popularity among investors. Most of the growth has come in liquid, developed markets such as US equities. The conventional wisdom has been that these markets are too efficient to provide consistent opportunities for active management and the creation of alpha, so a low-cost indexing approach may make more sense.

This same conventional wisdom has led many investors to continue to predominately use active mutual funds in less efficient markets such as fixed income. The theory is that fixed income markets are more opaque, resulting in information asymmetry between investors, and a skilled active manager can use this asymmetry to their advantage to consistently outperform the market.

That’s the theory. But what does the evidence say?

• Year-to-date through the end of September, 95% of active intermediate bond mutual funds have underperformed relative to the Barclays Capital U.S. Aggregate Bond Index, the common benchmark for the Morningstar US intermediate term bond category. Over the past 10 years through the end of September, 68% of active intermediate bond funds have underperformed, according to data from BlackRock and Morningstar.
• For active fund managers who do outperform in any single year, it has been very difficult for them to repeat and outperform again the next year. This graphic illustrates this difficulty. Because investors cannot directly invest in an index, the analysis below compares the active intermediate bond mutual funds to the iShares Barclays Aggregate Bond Fund (AGG), which seeks to track the Barclays Capital U.S. Aggregate Bond Index. Over the last 5 years, only 2% of active intermediate bond mutual funds were able to consistently outperform AGG 3 years in a row:

So what gives? If the fixed income market is less efficient, shouldn’t that make it more fertile ground for alpha generation? The theory is certainly plausible, but it ignores three key points that investors should keep in mind:

1. The market inefficiencies that lead many to assume that active management would be more successful in fixed income are the same forces that make it more difficult to capture alpha. In a less efficient market liquidity is harder to come by, price transparency is lower and transaction costs are higher. This creates a higher hurdle for fund managers to overcome because there is more friction incurred in implementing strategies, and it makes the consistent production of alpha that much more difficult.
2. Even if there is the opportunity to create alpha, there is no guarantee that fund managers will make the right moves to take advantage of it. Every opportunity for alpha creation is also an opportunity for alpha destruction. The creation of alpha is driven not only by opportunity, but also by the combination of opportunity and skill. Active management skill is difficult to create and identify. While many investors understand this idea as it applies to equities, it also applies to less efficient markets such as fixed income.
3. As I explained in my blog last week, the pursuit of alpha involves taking on risk. Many bond fund managers who create alpha do so at the cost of higher return volatility, resulting in less total return per unit of risk than their benchmark. For the fixed income portion of an investor’s portfolio, if safety and stability are the objectives, there can be a conflict between the investor’s goals and the variable performance of the active fund.

There are fund managers who do produce fixed income alpha. But much of that alpha can be eaten up by fees and transaction costs, and those who do produce alpha may have difficulty doing so repeatedly. As in other markets, indexing with ETFs in fixed income offers investors a way to obtain targeted market exposure in a vehicle that has low management fees, low transaction costs, and more liquid access than most other fixed income options.

Footnote 1: Sources: BlackRock^®, Morningstar. Five-year period ending 9/30/11. All figures are net of fees. Active mutual funds are based on Morningstar’s US intermediate term bond category.  Percentages are survivorship-adjusted and reflect the fund universe that existed at the start of the analysis period (e.g., the analysis includes funds that existed at the beginning of the analysis period but are no longer available due to fund mergers or liquidations over the analysis period). Analysis is based on the oldest share class of active open-end mutual funds to avoid double-counting of multiple share classes. Performance could have been positive or negative for both active funds and iShares ETFs during the time period. Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise.

Buying and selling shares of ETFs will result in brokerage commissions. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Past performance is not indicative of future results.

Copyright © iShares

Tags: Active Management, Barclays, Barclays Capital, Blackrock, Bond Fund, Bond Funds, Bond Index, Conventional Wisdom, Fertile Ground, Fixed Income Market, Fixed Income Markets, Footnote, Fund Managers, Index Investing, Indexing, Information Asymmetry, Intermediate Bond, Ishares, Morningstar, Mutual Funds, Period Ended September, Term Bond
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Highlights from Warren Buffett’s Letter to Shareholders 2010

Monday, February 28th, 2011

by Trader Mark, Fund My Mutual Fund

Warren Buffett’s much read annual letter is out and I’ve added some links below for those who are interested.

The full letter in pdf format is here.

1) The NYT Dealbook does an overview in As Berkshire Improves, Buffett Sings Praises of U.S.

2) The Associated Press writes Warren Buffett Remains Optimistic About U.S. Future

Billionaire Warren Buffettt wants Americans to be optimistic about the country’s future but wary about borrowing money and the games public companies play with profit numbers they report.  He said a housing recovery will likely begin within the next year.

3) WSJ Dealbook has quotes and quips from the letter below

Discussing why Berkshire keeps so much cash on hand:
Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed.
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“Money will always flow toward opportunity, and there is an abundance of that in America.”
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On human potential and the nation’s future
Human potential is far from exhausted, and the American system for unleashing that potential–a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War—remains alive and effective.
****

John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.” (I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.)
****

One footnote: When we issued a press release about Todd [Comb's] joining us, a number of commentators pointed out that he was “little-known” and expressed puzzlement that we didn’t seek a “big-name.” I wonder how many of them would have known of Lou in 1979, Ajit in 1985, or, for that matter, Charlie in 1959. Our goal was to find a 2-year-old Secretariat, not a 10-year-old Seabiscuit. (Whoops–that may not be the smartest metaphor for an 80-year-old CEO to use.)
****

On hedge funds:
The hedge-fund world has witnessed some terrible behavior by general partners who have
received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains. Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses. Investors who put money with such managers should be labeled patsies, not partners.
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Berkshire and the housing/mortgage crisis:
Our borrowers get in trouble when they lose their jobs, have health problems, get divorced, etc. The recession has hit them hard. But they want to stay in their homes, and generally they borrowed sensible amounts in relation to their income. In addition, we were keeping the originated mortgages for our own account, which means we were not securitizing or otherwise reselling them. If we were stupid in our lending, we were going to pay the price. That concentrates the mind. If home buyers throughout the country had behaved like our buyers, America would not have had the crisis that it did.
(Emphasis added)
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On home ownership
Home ownership makes sense for most Americans, particularly at today’s lower prices and bargain interest rates. … But a house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender–often protected by a government guarantee–facilitates his fantasy. Our country’s social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford.
****

On the worst of the global financial crisis:
As one investor said in 2009: “This is worse than divorce. I’ve lost half my net worth–and I still have my wife.”

****
In discussing the bazaar that is the coming annual meeting:
Remember: Anyone who says money can’t buy happiness simply hasn’t learned where to shop.

Copyright (c) Trader Mark, Fund My Mutual Fund

Tags: Anomalies, Associated Press, Billionaire, Borrowing Money, Commentators, Dealbook, Finance Departments, Flat Earth Society, Footnote, Frequent Interruptions, Human Potential, John Kenneth Galbraith, Letter To Shareholders, Lifetime University, Nyt, Recessions, Tenacity, University Finance, Warren Buffet, Warren Buffett, Wsj
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Will Google (And MSFT, And HP, And BAC) Be The Biggest Loser From The Irish Bailout?

Sunday, November 21st, 2010

A few days back we asked whether if as part of the now certain Irish austerity package, the imminent rise in the corprate tax rate for offshore companies based in Ireland would result in a crunch in the bottom line for US corporations such as Google. Now that a hike from the prevailing 12.5% rate is inevitable, US companies have launched an offensive to make it clear that only Irish citizens will be subject to the critical austerity measures. The Telegraph reports that “the Irish government has been given a stark warning from some of the biggest American companies in Ireland on the risk of a mass exodus if the country’s low corporation tax rate is raised.” If companies, which are purely circumventing much higher US corporate tax rates, also have to share the austerity burden, they will simply depart from the already insolvent country, leaving it with even less tax revenues, thus accelerating the toxic loop of greater insolvency coupled with even less revenue. And since the IMF is backed primarily by the US, which is end-domicile to the bulk of the corporations in question, it is obvious that MNCs have all the leverage and will most certainly get their wishes, further widening the chasm between the “corporation” and the simple Guinness-drinking, potato chewing peasant. In the brave new world, the pursuit of life, liberty and happiness applies only to (bailed out) banks and corporations. Everyone else has been relegated to footnote status.

More from the Telegraph:

The warning – from executives at Microsoft, Hewlett-Packard (HP), Bank of America Merrill Lynch and Intel – spoke of the “damaging impact” on Ireland’s “ability to win and retain investment” should the country’s corporation tax rate be increased from 12.5pc.

It came as talks between members of the Irish government and the European Union and the International Monetary Fund continued around the clock on a financial aid package of as much as €100bn to shore up the country’s beleaguered banking system.

Although Brian Lenihan, the Irish finance minister, has indicated Ireland’s 12.5pc corporation tax rate – the lowest in the eurozone – will not be raised, a number of factions within the European Union are known to have pushed for it to be increased in return for the bail-out.

Nicholas Sarkozy, the French president, said yesterday that while raising taxes will not be a condition of the bail-out, he expects Ireland to raise its corporation tax rate: “It’s obvious that when confronted with a situation like this, there are two levers to use: spending and revenues. I cannot imagine that our Irish friends, in full sovereignty, [would not use] this because they have a greater margin for manoeuvre than others, their taxes being lower than others.”

Foreign corporations who had found a beneficial tax climate in Dublin (most notably Google) now account for a major portion of the country’s economy.

Foreign investment equates to €110bn – or 70pc – of all exports with US companies alone employing more than 100,000 workers.

Yet if Ireland does not relent, which is unlikely, the bulk of US corporations will simply depart for such recently beligerent partners to the US as China:

While the companies are not threatening to leave at this stage, the statement – signed by senior Irish executives from each of the four companies mentioned – does directly point out that although Ireland’s tax rate may be low in European terms, it is not when compared with locations such as Singapore, India and China.

Yet the biggest loser of all this may be Google, which as was portrayed recently in an extensive analysis by Bloomberg, benefitted massively by a complex (and perfectly legal) Irish-based tax avoidance trick, which adds up to $100/share to the stock price.

An expose in Bloomberg details how courtesy of various, perfectly legal, tax avoidance schemes, Google’s effective tax rate is 2.4%, which has boosted the company’s stock price by a whopping $100/share!

Is Google’s loss in market cap about to make the EU’s contribution to Ireland (whether $80 or $180 billion) seem pale in comparison?

h/t Titan Group ltd

Tags: Austerity, Bailout, Bank Of America, Biggest Loser, Brave New World, China, Footnote, Google, Hewlett Packard Hp, India, Insolvency, International Monetary Fund, Irish Citizens, Irish Government, Life Liberty And Happiness, Mass Exodus, Merrill Lynch, Offshore Companies, Peasant, S Corporation, Tax Revenues, Telegraph Reports
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