Big and Bigger Lies About Bond Fund Managers

A broker uses his phone in front of the main display at the Stock Exchange in Madrid, Wednesday, May 16, 2012. Spain's Prime
A broker uses his phone in front of the main display at the Stock Exchange in Madrid, Wednesday, May 16, 2012. Spain's Prime Minister warned that the country faced the real danger of being locked out of international markets as investors continued to fret about the future of the euro. At one stage, the difference between the interest rates demanded by investors for Spanish and German 10-year bonds shot past the 500 basis point level, prompting Mariano Rajoy's warning over the country's ability to continue funding itself. (AP Photo/Daniel Ochoa de Olza)

In times of economic uncertainty, investors tend to flee to the perceived safety of bonds. Let's ignore the fact that bouncing from stocks to bonds is a form of market timing. As an investment strategy, market timing has a dismal record. Unfortunately, many investors want the returns of stocks, with the reduced risk of bonds. Those that are looking just for a safe haven invest in "risk free" bonds, like Treasury Bills.

Most often, investors looking for higher returns from their bond holdings invest in actively managed bond funds (where the fund manager attempts to beat a designated benchmark, like the Barclays Capital Aggregate Bond Index). They could invest in lower management fee bond index funds of comparable risk, but they believe an active bond manager has the investment skill likely to increase returns over the benchmark index, while taking no more risk. They are paying more for the services of the active fund manager and expect to be rewarded.

The big lie is that actively managed bond funds are likely to outperform index funds of comparable risk. The bigger lie is that actively managed bond fund managers have demonstrable investment skill, permitting them to beat their benchmark index, net of fees.

The big lie is easy to demonstrate. Standard & Poors publishes a biannual analysis of the performance of index and actively managed stock and bond funds. Its report for the year-end 2011 found that, in most bond fund categories, benchmark indexes outperformed the majority of active bond managers. Some of its findings were startling. For the period from December, 2006 to December, 2011, 93.62 percent of actively managed bond funds underperformed their benchmark index.

The bigger lie is more complicated. According to a comprehensive study in 2009, by Marlena I. Lee of Dimensional Fund Advisors, the universe of bond fund managers is dominated by those who underperform their benchmark. The relatively few exceptions are impossible to identify in advance.

Ms. Lee found that investors paid higher fees to actively managed bond funds, expecting to receive enhanced returns. Her analysis demonstrated the opposite effect. Aggregate underperformance in 2008 cost investors about $1.4 billion. She concludes that past "winners" are often unable to replicate their stellar performance.

Here's the clincher demonstrating the bigger lie: Most bond fund managers in her study lacked sufficient skill to cover their costs.

The takeaway is clear:

  • Don't try to time the market by bouncing in and out of stocks and bonds.
  • Don't pay a premium to actively managed bond fund managers. They are likely to underperform their benchmark indexes.
  • Stick to a globally diversified portfolio of stock and bond index funds, in an asset allocation appropriate for you.

Investing is simple once you understand the big and bigger lies perpetuated by the securities industry.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book is The Smartest Money Book You'll Ever Read. The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.