Budding bond kings self-sabotage with their fees

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Earlier this year Alphaville wrote about the latest SPIVA scorecard that tots up the performance of active mutual fund managers. Surprise! 2022 was yet another year where a majority couldn’t beat their benchmarks.

S&P Dow Jones Indices has just released the institutional investor version of this regular snapshot, and it pretty much shows the same as the mutual fund report. Last year was one of the better ones for active managers, but the long-run picture of underperformance is unchanged (though institutional accounts do a bit better).

However, the really interesting bit is this chart showing clearly the before-and-after-fee performance of both equity and bond funds of both stripes, retail and institutional.

The share of underperforming equity mutual funds and institutional accounts shrinks if you exclude the fees they charge, but the broad conclusion remains the same: the large majority of stockpickers underperform in the long run.

However, things look radically different for fixed income investors, and especially for bond mutual funds. A majority of them do beat the market even in the long run, but most of the alpha they produce is gobbled up by fees.

On one hand this is unsurprising. Bond markets are less efficient, and portfolio managers can buy lots of stuff that never even make it into the main indices. The potential for eking out market-beating gains is therefore much greater (simply loading up on credit would have done nicely over the past 20-30 years).

And it’s a well-known that fees tend to gobble up alpha even where it can be found, which is why the headline findings tend to show that bond funds also underperform in the longer run, albeit less dramatically than equity funds.

But the extent of the pre-post-fee results is far starker than Alphaville previously suspected. Almost two-thirds of all bond mutual funds, and over half of institutional accounts, managed to beat their benchmarks before fees! But after fees — in an asset class where the scope for gains is more limited than in equities — turns that on its head.

Or as S&P Dow Jones Indices puts it:

In some fund categories, the typical range of securities selected by active managers have similar returns, while in other fund categories, the range of returns is wider. For example, the universe of short-dated U.S. Treasury bills normally has a tighter range of returns than the universe of all international equities. Intuitively, one would expect management fees to have a greater impact in categories like the former, because one then expects most active funds to perform similarly before the subtraction of fees, and the level of fees subtracted will hence prove more influential — especially in determining relative rankings or outperformance rates.

Investment fund fees have been sloping downwards across the board for much of the past two decades, as asset managers desperately try to blunt the flow of money into cheap passive funds.

US bond funds actually on average cost less than equity funds, according to the Investment Company Institute’s latest factbook.

But the conclusion Alphaville draws from the chart at the top is that bond funds still charge way too much, and if they’re serious about their fiduciary duties to investors they should keep cutting fees until it bleeds.

Further reading:
— Super passive goes ballistic; active is atrocious
— Why bond funds may be riskier than they seem