The majority of UK, global and diversified bond funds have underperformed their benchmark over five and 10 year periods, according to research by Vanguard.
While passive studies normally tend to focus on equities, the group’s white paper revealed that most actively managed bond portfolios have either underperformed or closed over the medium and long-term and, more often than not, funds that do outperform are unable to do so on a consistent basis.
“The evidence shows that, on average, actively managed bond funds have struggled to deliver the market-beating returns investors should expect, given that they often pay a premium for active strategies,” a recent white paper said.
“When we adjust the figures to account for funds that were closed or merged, the distributions clearly show that the bulk of funds have not been able to outperform their benchmark, illustrating the fact that, after charges, the majority of active bond managers struggle to create value for their investors.”
Fixed interest has come under increasing pressure in recent months, with record low yields and the threat of rising interest rates serving as significant headwinds to investors. Vanguard says the diversification benefits of bonds still make them crucial for the vast majority of investors however, as examined in an article earlier this month.
Passive equity funds have become increasingly popular with investors and advisers and recent years, but the vast majority still go for an actively managed fund when choosing their bond exposure.
However, Vanguard’s research suggests that the case for index investing is just as strong for bonds as it is for equities.
In the table below, the distribution of returns from actively managed funds in a range of bond sectors is shown over five and 10 years.
Performance is measured against the benchmark stated in each individual fund’s prospectus.
The percentage of underperforming actively managed funds over 5yrs
Source: Vanguard
The blue sections show ‘surviving’ funds whilst the gold sections show ‘surviving’ and ‘dead’ funds, suggesting more than half of funds across the five sectors underperform.
The numbers over 10 years are particularly telling, with more than 75 per cent of global bond funds, UK diversified bond funds, UK government bond funds, European diversified bond funds and US diversified bond funds falling short of the benchmark outlined in their prospectus.
Vanguard says that the efficiency of the bond markets makes it very difficult for fund managers to underperform, made harder by the erosional impact of charges.
“The distribution of returns [in bond funds] broadly follows a bell curve, reflecting the zero-sum game characteristics of all investment markets,” the report said.
“The performance of a benchmark index is, by definition, the weighted average of the performance of all the investments that make up the market in question. As a result, for every pound invested that outperforms the index, there must be another pound that underperforms.”
The report adds that the impact of charges in actively managed funds shifts the majority of them below the benchmark, further boosting the case for passive investment in bond funds.
This, the white paper argues, makes a strong case for a passive bond fund.
“Passive funds can benefit from some distinct advantages inherent in indexing: lower costs, broad diversification and minimal cash drag,” said the paper.
“Primarily because of their low-cost structure, well-managed index investments can perform positively relative to higher cost investments.”
Passives serve very well as a base of portfolios, according to Chris Spear (pictured), managing director of Spear financial, who says he is recommending them more and more frequently for his clients.“In my experience [passives] tend to be better in strongly rising markets and actives in more volatile markets, although this is not always true,” he said.
“Over the longer term, the average active manager tends to underperform.”
“There can be some drag on performance in active funds due to the higher costs. There is a bit of a price war from some of the more notable active fund houses at the moment, but passives are still undoubtedly cheaper.”
Juliet Schooling-Latter, head of research at Chelsea Financial Services, says investing in government bonds particularly suits a passive model.
“I think it is most appropriate with gilt funds as active managers have always struggled to outperform,” she said.
In spite of Vanguard’s findings, the group acknowledges that there is an elite group of active managers with a proven track record of outperformance. While the odds are heavily stacked in passives’ favour, the white paper says there are ways of scoping out the best of the best.
“Finding a talented active manager with a proven philosophy, discipline and process can increase the chances of success,” it said. “Yet, identifying such a manager is a resource-intensive process that requires some up front and ongoing due diligence.”
“A good active manager should have a proven long-term investment philosophy and the processes and discipline to stick to it even when returns are flagging – as they sometimes will. Investors, too, need to stick to the active funds they’ve chosen through the inevitable periods of underperformance.”
“Another crucial factor is, of course, cost. Data suggests that low-cost funds tend to outperform more expensive funds. Active funds are no exception and cost is the one characteristic investors know in advance.”
“While there is no guarantee, sticking to these principles increases investors’ chances of picking an outperforming fund,” the paper finished.
This article was written in collaboration with and is sponsored by Vanguard Asset Management.