Bond Fund Performance

“Even the intelligent investor is likely to need considerable will power to keep from following the crowd.” – Benjamin Graham

I’ve spent the last couple of weeks going over the different aspects of investing in the bond market. Earlier this week I covered investing in bond funds, but I didn’t spend too much time addressing the performance of actively managed bond funds versus bond index funds.

By now we’ve all seen the performance data that shows how actively managed stock mutual funds have underperformed index funds over numerous time frames. But I haven’t seen much information that covers the same performance data when it comes to bond funds.

Luckily, the blogger at Your Wealth Effect recently presented some historical performance data for intermediate bond funds (which is probably where most bond investments are made). Take a look at these numbers he provided:

Here are five findings of after comparing bond fund returns across the Morningstar Intermediate-Term Bond category. Data as of April 30, 2013:

• 22.3% or 413 of the 1,153 intermediate term bond funds Morningstar tracked for the one year April 2012 – April 2013 outperformed their index.
• 24.7% or 426 of the 994 intermediate term bond funds Morningstar tracked for the 3 years April 2010 – April 2013 outperformed their index.
• 34.7% or 391 of the 868 intermediate term bond funds Morningstar tracked for the 5 years April 2008 – April 2013 outperformed their index.
• 14.9% or 130 intermediate term bond funds outperformed their index over two different time frames (example 1 Year and 3 Year, or 1 Year and 5 Year, or 3 Year and 5 Year)
• 25.5% or 221 intermediate term bond funds outperformed their index over all three (1, 3 and 5 Year) time frames.
• This last point surprised me the most. I actually expected more funds would outperform over two time frames rather than all three time frames. 

Before the Index crowd runs out and declares their team the victor, be aware of the wide mix of bond investing styles Morningstar places in the Intermediate Term Bond category. Here are just a few:

• Funds that invest primarily in mortgage bonds such as DoubleLine Total Return
• Funds that invest in corporate and government bonds such as PIMCO Total Return or Vanguard Total Bond Index
• Funds that invest primarily in corporate bonds
• Funds that invest primarily in preferred stocks
• Funds that invest using leverage or derivatives and as well as funds that have no leverage or derivatives
• Funds that invest only in investment grade bonds and as well as funds that have exposure to both investment grade and high yield bonds
• Funds that have exposure to international bonds and as well as funds that have no exposure to international bonds

These numbers are obviously surprising when you look at the actual percentages of bond funds that underperformed the simple intermediate bond index.

The caveat listed in his post about the fact that all different types of bond funds are lumped in here is worth noting. The index used is very basic while many of the funds invest in different strategies (mortgage bonds, preferred stocks, high yield, etc.).

And while you would like to have an apples-to-apples comparison, what these numbers really tell you is how simple low-cost investment strategies can often outperform more complex ones. Obviously, mean reversion in the markets will lead to these other strategies having their day in the sun eventually, but the simple index has proven itself to be a nice option in the bond space historically.

Style drift could be another factor that helps explains these differences. Style drift is what happens when a portfolio manager goes outside of their stated fund objective to look for investment opportunities.

Larry Swedroe pointed out in his column this week that 352 mutual funds classified by Morningstar as bond funds actually held stocks in their portfolios. I’m sure most of this has to do with yield chasing in preferred stocks, but this is a potential risk that I’m sure not too many investors are aware of.

Another factor to consider is how important costs are for bond funds. We’ve looked at how important costs can be in determining stock mutual fund performance, but I think these bond performance numbers show that they are even more important when dealing with more stable fixed income investments.

This is simply because the distribution of returns in bonds isn’t as wide as it is for stocks. That means that it will be much harder to outperform when investing in bonds and costs are a huge drag on performance.

Bill Gross has consistently outperformed about 90% of all other bond funds over the long-term and his PIMCO Total Return Fund has only beat the index by about 1.5% a year. This is an amazing track record but it goes to show you that the level of outperformance is fairly narrow in bond funds.

The challenging interest rate and inflation environment that we currently face should make things interesting going forward to see if the bond index outperformance will continue or if active managers will have their day and earn their fees.