In an investment world where active managers are under siege by passive competitors, are bond strategies holding their own more than equities? For Michael Mauboussin, the director of research at US alternative asset manager BlueMountain Capital, the answer is yes. That is perhaps unsurprising, given the asset manager’s decision earlier this year to liquidate its $1bn computer-driven investment portfolio and shift its focus back to its roots in credit and fixed income.
On the surface, the headline industry statistics would seem to back this conclusion up. Over the past decade, US active bond managers have received $0.9 trillion in net inflows, versus $1.1 trillion in outflows for equity specialists, according to data from Morningstar Direct. However, could it be that the march of passive investment is simply more advanced for the latter? After all, the first equity exchange traded fund (ETF) was launched in 1993, but the first fixed-income ETF did not arrive on the market until almost a decade later. There may be some truth in this because, while flows into active bond funds were positive for 20 of the past 26 years, three of the six years of outflows occurred since 2012.
Nevertheless, Mr Mauboussin argues that active bond funds have the edge over their equity counterparts for one main reason – their ability to outperform passive strategies to a far greater extent. Over the past three years, almost 70 per cent of intermediate active mutual bond funds outperformed their passive peers, according to Morningstar data, compared with around 30 per cent of large-cap equity funds.
The reason for that, Mr Mauboussin argues, is that there is greater opportunity for active bond fund managers to prove their worth. As the absolute skill of equity managers has improved, the relative skill gap between the best and worst performing active managers has narrowed, something that has not occurred to the same extent for bond managers. That is not because the skill of those managers has not also improved, but because of the greater difficulty in mimicking bond indices, which can enable active managers to outperform passive peers.
Bond markets have more securities, are more costly to trade and have greater turnover than equities. For instance, the Bloomberg Barclays US Aggregate Bond index has more than 10,300 securities, with US treasuries and mortgage-backed securities making up around two-thirds of the index and corporate bonds another 25 per cent. The maturity and issuance of new securities means there is the need for frequent re-balancing for a manager tracking the index, Mr Mauboussin points out, which can be challenging due to the increased cost of liquidity since the financial crisis. Pricing securities in real time can also be difficult.
In comparison, the S&P 500 has just 505 underlying securities and turnover is relatively infrequent, averaging around 4 per cent of the index’s market capitalisation annually over the past six decades.
The motivations of certain bondholders can also make it difficult to assess how hard it is to outperform a benchmark. For instance, some institutions may be forced to sell an investment-grade bond if it is downgraded to high-yield due to regulations constraining the types of securities they may hold. In turn, that can lead to a lower price for the security than may be justified by the broader investment case.
But for retail investors, the benefits of investment outperformance must be weighed up against the additional fees charged by active managers. After all, active average expense ratios remain 40 basis points higher than passive ones. In judging the benefit of active management, Mr Mauboussin points to the model created by economic professors Jonathan Berk and Richard Green, which calculates economic return by calculating a manager’s return on invested capital minus its weighted average cost of capital, multiplied by assets under management.
By applying this calculation to US bond funds between 1978 and 2018, Mr Mauboussin concludes that $390bn in gross profit was extracted from $35 trillion in assets under management, equivalent to 1.1 per cent of assets under management, exceeding the fees charged during the period. Meanwhile, for active equity funds, gross profits roughly equalled fees charged.
Looking for Easy Games in Bonds is authored by Michael J. Mauboussin, director of research at BlueMountain Capital Investment, and can be downloaded here.
