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Not All Active Funds Consistently Underperform

By Ben Carlson, A Wealth of Common Sense

There was a mind-blowing stat flying around last week that showed less than 10% of all U.S. stock funds are currently beating the S&P 500 in 2014. Over longer time frames, the fact that most index funds beat the majority of actively managed funds is a given at this point, but indexing always looks even better during a strong bull market.

The semi-annual SPIVA Scorecard report that Standard & Poors puts out shows how difficult it can be to beat the market – through June 30, just 14% of active stock funds outperformed over 3 years while 26% were able to outperform over 5 years.

But there is an outlier in this report in a different asset class. Take a look at the bond fund outperformers:

SPIVA-bonds

The highlighted section shows that a much smaller number of bond funds in the intermediate-term category underperformed the benchmark. Over three years almost 70% of active funds outperformed while the number of outperformers over five years was over 60%.

Talk to any asset allocator and they will most likely tell you that intermediate-term bonds (most define intermediate-term as 3-10 years in maturity) should be your core holding in the fixed income asset class. This is the sweet spot where you get similar performance to long-term bonds, but with less volatility and more yield and total returns than short-term bonds. It also happens to be where the bond kings, such as Bill Gross and Jeff Gundlach have made a name for themselves.

Through November 30, the performance numbers for this category are even better. My friend Jake (@econompic) ran the latest numbers for me to see how intermediate-term bond funds as a group have performed against the Vanguard Total Bond Market Fund. He also took things a step further and broke out the performance by the size of the fund as well:

SPIVA-bonds-II

The outperformance is impressive over every period, but notice how the outperformance is even more pronounced as fund size increases.

So why is it that it’s so difficult to beat the market in other asset classes, but the majority of intermediate bond funds outperform? These results turn plenty of assumed rules of thumb completely on their head. There’s never just one reason for anything that happens in the markets, but here are some of my thoughts on this apparent chink in the armor of the index fund complex:

Size can be the enemy of outperformance in the stock market, but it doesn’t appear to matter as much with regards to bonds. Not many investors realize this, but the bond market is actually larger than the stock market. Even though it’s larger in size, the bond market is more illiquid than the stock market, so being a larger firm can be a benefit when buying across a number of different funds or bond issues as economies of scale are present.

The Barclays Aggregate Bond Index is widely cited and used to benchmark core bond fund holdings. The index is heavily invested in government bonds, which make up 42% of the holdings. Mortgage bonds (31%), corporates (26%) and municipals (1%) round out the bond types that make up the index weights. There’s no free lunch when investing, but simply altering the structure of the holdings to underweight government bonds and overweight mortgage or corporate bonds has been a fairly easy way to earn extra yield and total returns. Tilting the duration of the fund has been another option to earn outsized gains.

Even Vanguard’s John Bogle has stated in the past that he thinks total bond funds hold too many government bonds. There’s a good possibility that the easy money has been made in bonds in a falling interest rate environment, but the basic risk-reward relationship between treasuries and corporate bonds should hold – meaning treasuries should do better during periods of market and economic stress and corporates should do better when things calm down.

Going all the way back to 1926, corporate bonds have outperformed 10 year treasuries by roughly one percent per year. While one percent may not sound like a lot, it’s an enormous number in bond land where the returns tend to cluster much closer together between the winners and losers than the stock market. For example, in the SPIVA scorecard the annual outperformance over 1, 3 and 5 years for intermediate funds was only 0.69%, 0.12% and 0.15%, respectively.

The past is never prologue when sorting through the winners and the losers in the markets, but this data does show that it’s possible for active funds to consistently beat the market. Now all you have to do is go out and pick the future winners.

Source:
SPIVA U.S. Mid Year 2014 Scorecard