Active Bond Managers Fare No Better

(MoneyWatch)  A few months ago, I had a post discussing how actively managed bond funds have a hard time outperforming their indexes. Now, there's additional evidence on the inability of bond fund managers to add value and increase returns.

Marlena Lee of Dimensional Fund Advisors studied the performance of 2,353 bond mutual funds covering the period 1991-2008. She found that:

• Collectively, investors in active bond funds underperform by about 90 basis points (or 0.9 percent) per year. This means bond fund investors lost about $1.4 billion in 2008 in the chase for outperformance.
• Bond fund underperformance is mostly driven by fees.
• This underperformance was true across all categories of funds (government, corporate, high-yield).
• There was no evidence of winner persistence in net returns beyond the randomly expected. We can't separate skill from luck because past performance isn't predictive of future performance, while costs are a good predictor of future performance.

Lee's results are consistent with the findings of similar studies. For example, a Journal of Business study showed that the average actively managed bond fund underperforms its benchmark index by 0.85 percent per year. Another study found that only 128 (16 percent) out of 800 fixed-income funds beat their relevant benchmark over the 10-year period covered.

We also have evidence from Standard & Poor's. Here is a breakdown of the percent of active funds that failed to outperform their benchmark for the five-year period July 2004-June 2009, as reported in the latest S&P Indices Versus Active Funds Scorecard.

• Long-term government -- 98 percent
• Intermediate government -- 78 percent
• Short-term government -- 81 percent
• Long-term investment grade -- 92 percent
• Intermediate investment grade -- 80 percent
• Short-term investment grade -- 97 percent
• National municipal -- 94 percent
• California municipal -- 100 percent

The winning strategy, be it in equities or fixed income, is to invest in index or other passively managed funds (or build a ladder of individual securities) and give up the hope of outperforming the market. If you do that, you are virtually guaranteed to outperform the vast majority of investors, both institutional and individual. Seriously, costs matter.