This study may help investors make a more informed decision between an active bond fund and a lower-cost passive strategy, writes Morningstar's Miriam Sjoblom.

Long-time readers of Morningstar’s research have heard us relentlessly beat the drum for funds that charge low fees. For all our manager research analysts’ combing through historical portfolios, scrutinising performance data, and grilling portfolio managers to formulate views on a fund’s People and Process Pillars, there’s no surer indicator that a fund has an advantage over its peers than a cheap price tag. That’s just simple maths.

Expenses are especially crucial to consider for fixed-income funds, because returns between bond funds tend to be more compressed. And with yields near historic lows across bond sectors in recent years, fees have eaten up an even larger share of the returns that investors pocket.

It’s no wonder, then, that investors have increasingly turned to the expanding menu of low-cost passive exchange-traded funds for their bond exposure.

A new study authored by my European-based manager research colleagues, Mara Dobrescu and Matias Möttölä, starts with the headline conclusion that the typical fixed-income fund is "priced to fail", meaning it can’t keep up with its benchmark after fees. But is a passive approach that minimises costs the right approach for every type of bond fund? If not, where might an active manager stand a better chance of beating the benchmark or a similar passive option?

The duo sought to answer these questions using history as a guide for forming expectations about a fund’s potential to outperform. They examined the historical excess return distributions in 25 Morningstar Categories across Europe, Asia, and Africa (EAA) as well as the United States. Focusing on share classes available to retail investors, they looked at excess returns on a gross and net of fees basis, both compared with the funds’ assigned category index and the closest passive option.

They developed a useful grouping of bond fund categories to help investors make an informed choice between active and passive options, described below.

1. In benchmark-driven categories, costs have a greater impact on net returns than manager skill, making the case for low-cost investments - either active or passive.

This group includes mainly government bond and investment-grade corporate bond categories where the "gravity" of the benchmark has been strong. The median gross return for each category was close to zero and didn’t move much over time, with the study using rolling three-year periods going back to 2002. The dispersion of returns within categories also tended to be narrow.

For funds in the US inflation-protected bond category, for instance, the median gross excess return versus the category benchmark, the Bloomberg Barclays US TIPS Index, was just 5 basis points. This slimmest of margins put the typical fund at a 63-basis-point disadvantage versus the benchmark net of fees.

Funds in the category only managed to beat the index gross of fees by a percentage-point margin 10 per cent of the time. There were some three-year periods in which none of the funds in the category could beat that modest hurdle. In a playing field this competitive, a passive option priced as low as 5 basis points looks compelling.

2. In more-diverse peer groups, a low-cost passive option is often superior to the typical active fund, but there is still room for manager skill to add value, provided fees are reasonable.

Categories that fall into this subset exhibited a reasonably close fit to their index over time, but still had a high dispersion of excess returns around the median. They also demonstrated periods in which the median itself deviated significantly from the index.

On the surface, the results appear identical to the previous group: The typical active fund underperforms the index, or outperforms it very narrowly, even before fees.

Thus, a low-cost passive fund seems like a reasonable option. But because there’s more dispersion between the best and worst active funds in these categories, they appear to provide a more lucrative field for active managers.

For example, the typical fund in the US intermediate-term bond category underperformed its category benchmark, the Bloomberg Barclays US Aggregate Bond Index, by 20 basis points net of fees.

However, funds that landed in the best quintile of the peer group managed to outperform the benchmark net of fees by close to half a percentage point on average – and some did even better. This suggests there’s some value to investing with skilled managers in this cohort.

There is a caveat: many active funds in the category have struggled during periods of credit stress while the benchmark has thrived. So, when choosing an active manager in this peer group, it’s important to weigh the risks of its approach against the potential long-term rewards.

3. In categories where volatility and transaction costs are high, both active and passive funds struggle to achieve the performance of the category benchmark over the long term.

In the US, the emerging-markets bond and emerging-markets local currency categories fall into this third group, alongside their EAA counterparts. The medians of gross excess returns in these categories over the period studied deviated dramatically from their respective benchmark indexes.

For instance, the median of three-year excess returns for emerging-markets bond funds lagged its category index, the JPMorgan EMBI Global Index, by 74 basis points annualised. But that median waggled in a range of more than 5 percentage points, depending on which three-year period you looked at. In this case, the category’s performance versus the closest representative ETF appeared similarly poor.

The case for passive management over active isn’t necessarily clear-cut in emerging-markets bonds, however.

Firstly, the category is not as homogenous as it may appear. It includes funds that invest most of their portfolios in hard currency debt, such as bonds from emerging-markets issuers in US dollars or euros, aligned with the category’s hard currency benchmark.

But as the local currency and corporate bond markets have grown over the years, more of these hard currency funds have held stakes in local currency and corporate debt. The category also includes funds that take a diversified approach, investing more evenly across all three emerging-markets debt sectors.

So far, there’s no accepted standard benchmark for a diversified approach to emerging-markets debt. Given how volatile emerging-markets currencies have been historically, even small currency exposures can have a sizable impact on returns. In 2016, for instance, the local currency JPMorgan GBI-EM Global Diversified Index gained 8.7 per cent, but underlying returns among individual countries were vastly different in some cases, mainly owing to currency fluctuations.

The index’s two largest issuers, Brazil and Mexico, moved in drastically opposite directions that year: Brazil gained 58 per cent, while Mexico lost 17 per cent.

Investors looking for straightforward emerging-markets debt exposure have good reason to simply choose a comparatively cheap ETF, with the fees charged by both active and passive funds in these categories generally higher than those charged elsewhere. But a wide dispersion of returns among the sector’s constituents also presents opportunities for skilled active managers to outperform through country and currency selection, not to mention plenty of patience.

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Miriam Sjoblom is a director on the global manager research team at Morningstar.

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