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

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.

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