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Passive Management Works for Bonds, Too

I've had a number of posts on how active management has a hard time outperforming the market when it comes to stocks. A recent article from The Wall Street Journal showed the same is true for bonds as well.

The paper quoted a Standard & Poor's study showing that fixed income index returns beat actively managed fund returns in all 13 fixed-income categories studied over one year and three years. The same was true for 11 of the 13 categories over five years.

In some cases, the gaps were wide. For example, the average annualized asset-weighted returns for investment-grade long-term bond funds were 3 percent versus 5.7 percent for the Barclays Capital U.S. Long Government/Credit Index over five years.

These findings should not surprise anyone. The simple mathematics of active management show that active and passive investors earn the same returns in aggregate, but active investors have greater costs and, therefore, earn lower net returns.

John Bogle of Vanguard studied the performance of bond funds. He wrote in his book Bogle on Mutual Funds that "although past absolute returns of bond funds are a flawed predictor of future returns, there is a fairly easy way to predict future relative returns." Bogle found "the superior funds could have been systematically identified based solely on their lower expense ratios."

There's also a study by Morningstar that demonstrates both the importance of costs and the fallacy of using past performance of actively managed bond funds to predict future performance. Morningstar tested funds with strong performance and high costs against funds with poor performance and low costs. In its December 2004 issue of Morningstar FundInvestor, it found that "Sure enough, those with low costs outperformed in the following period."

Why did these studies conclude that bond fund managers charge Georgia O'Keeffe prices and deliver paint-by-numbers results? The efficient market hypothesis provides the answer: The market's efficiency prevents active managers from persistently exploiting any mispricing. And as difficult as it is for active managers to add value when it comes to equity investing, it's much harder for them to add value in fixed-income investing.

First, with U.S. Treasury debt, all bonds of the same maturity will provide the same return. Thus, there's no ability to add value via security selection. If we restrict holdings to the highest investment grades, there's an extremely limited ability to add value via security selection because credit risk is low. That leaves interest rate forecasting as the only way an active manager might add value in any significant way. And there's no evidence of any persistent ability to forecast interest rates.

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