The logical question

In 2000, the consensus view of stock funds was very different from what it is today. At that time, investors favoured pricey funds that were actively managed. Funds carrying expense ratios that were greater than 1 per cent attracted considerably more assets than those with expense ratios of under 0.5 per cent. And while Vanguard’s index-fund business was growing handsomely, the company had not yet assumed the industry lead.

That all changed during the ensuing decade. By 2010, actively managed equity funds were suffering redemptions, passive stock funds enjoyed inflows, and Vanguard was the world’s largest fund provider. Investors had lost confidence that they could identify winning actively managed stock funds before the fact.

However, they retained their faith in active fixed-income management. True, investors were beginning to discover bond index funds, which registered $70 billion of net inflows during 2009. However, actively managed bond funds posted $250 billion of net new sales during that same year. One might think with their greater volatility, and thus greater possibility of excess returns, that equities were better suited for active management. But fund investors believed otherwise.

They now appear to be adjusting that opinion. Over the past 12 months, net sales of bond index funds in the US have exceeded those of actively run fixed-income funds, although that race remains tight. This leads one to wonder: Will active bond funds endure the same fate as their equity-fund cousins? Or are their conditions somehow different?

The land of the giants

Indirectly, Morningstar’s director of manager research Russ Kinnel has addressed that query, in “What’s Behind the Strong Performance of Big Funds?” On the surface, it appears that rather than index, equity investors could have profited by purchasing the industry’s largest funds. Of the 41 actively run US equity funds that currently possess more than $20 billion in assets, 10 carry top-decile returns over the past decade, when compared with other funds in their categories. Meanwhile, none have landed even in the bottom quartile, never mind the bottom decile.

Sadly, that apparent success was a mirage, because - as you may have already noted - Russ was playing his readers. His article’s initial logic was circular. The largest funds became that way, at least in part, because of their strong 10-year returns. When Russ ran the study properly, measuring fund size not by current assets but instead by those of a decade ago, he found that the big funds had only slightly outgained the norm. On average, that group’s 10-year category ranking is a moderate 41.

This advantage disappears entirely after accounting for the effect of expenses. Because their size permits them to offer volume discounts (and also because investors no longer buy expensive funds; this logic is circular as well), the largest stock funds tend to be cheaper than most. After adjusting for that difference, the average 10-year category ranking for the giants lands almost exactly in the middle of the pack, at 49. In contrast, Vanguard Total Stock Market Index’s VTSMX ranking is 24.

Onto bonds

Russ also evaluated fixed-income funds using the same approach. Predictably, the largest funds as assessed by current assets have shone--even more brightly, it turns out, than have the largest stock funds. The 10-year category rankings for the 20 largest active bond funds average a spectacular 21, with only one of those 20 funds (ironically, a Vanguard offering, Vanguard Intermediate-Term Investment-Grade VFIDX) placing in its group’s bottom half. Score one for active management!

But of course, that outcome was once again an illusion, for the same reason as the initial equity-fund results. Once more, Russ revised his study, now assessing how 2010’s biggest funds performed. This time, the actively managed bond funds continued to show well. The average category ranking was just below 30, indicating that the typical industry leader from 2010 subsequently placed in its group’s top third.

Thus, at least as gauged by the showing of the industry’s biggest funds, investors were correct to prefer actively managed bond funds to actively managed equity funds. However, even more than with equity funds, the superiority of the large actively run bond funds owed solely to their relatively low costs. On a pre-expense basis, their average 10-year category ranking was a sluggish 56.

Not good enough

That’s a problem. When rank-and-file investors realise that “star” bond-fund managers haven’t been more successful than their equity-fund counterparts at beating their compatriots - thereby demonstrating the level of skill that is required to beat the benchmarks over time - they will inevitably switch to index funds. This process may take some while, particularly as bond funds are now receiving high inflows, but the outcome looks to be inevitable.

MORE ON THIS TOPIC: Fixed income flows fire up

Not helping matters have been the struggles of the two best-known bond funds, Pimco Total Return PTRRX and DoubleLine Total Return Bond DBLTX. Once-dominant Pimco Total Return has shed three fourths of its shareholders in recent years due to stretch of weak results, accompanied by (unnecessarily) dire headlines. For its part, DoubleLine’s fund was terrific coming out of the gate, but it has lagged 90 per cent of its rivals over the trailing five years. Such patterns are depressingly familiar to those who invest in active equity funds.

There will always be room for small, opportunistic bond funds that can exploit niche opportunities. Unfortunately for active management’s fortunes, though, such funds cannot support the brand. The only way that fixed-income active management can forestall its index-fund competition is by getting strong, well-publicised performance from the industry’s leaders. The biggest bond funds must do better. In recent years, they simply have not been good enough.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.