The Characteristics Of Winning Bond Funds – ValueWalk Premium

The Characteristics Of Winning Bond Funds

This article originally appeared on ETF.COM here.

The U.S. bond market is one of the largest in the world, with managers controlling more than $2 trillion in assets. Given its size, an important question is identifying active bond fund managers that add value.

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Markus Natter, Martin Rohleder, Dominik Schulte and Marco Wilkens contribute to the literature on the performance of actively managed bond funds with their study, Bond Mutual Funds and Complex Investments, which was published in the October 2017 issue of the Journal of Asset Management.

Methodology

Using a database of nearly 1,000 bond funds, and covering the period 1999 through 2014, the authors analyzed the effects that complex instruments such as derivatives, restricted securities, short selling, leverage and security lending have on the performance and risk characteristics of bond mutual funds.

How the use of complex investments impacts returns is especially important because the authors write that more than 49% of bond funds use derivatives of some kind, compared to only 36% of equity funds.

The difference is even more dramatic for futures, with almost 47% of bond funds using them compared to just 23% of equity funds. In addition, 36% of bond funds use leverage of some kind, 15% through short selling, compared to only 7% of equity funds.

It’s not hard to understand why active bond fund managers would turn to complex instruments – they have to find some way to overcome the burden of their average 0.83% average expense ratio (versus about 0.05-0.25% for the typical passively managed fund). But to what degree are they successful?

Following is a summary of the authors’ findings:

  • Overall, complex investment permissions and engagement do not have a significant impact on performance. Specifically, leverage instruments, borrowing, margin purchases and short selling do not lead to any differences in performance.
  • While the average gross alpha of the bond funds studied was 0.39% per year, net-of-fee alphas were -0.41% per year.
  • Bond funds employ interest rate futures (IRFs) to raise their average portfolio duration and thus increase their exposure to changes in interest rates. In other words, they employ IRFs to speculate on changes in interest rates. However, IRFs negatively affect fund performance, leading to risk-adjusted underperformance on the part of IRF users (relative to nonusers) by an economically meaningful 54 basis points per year. Returns were adjusted for exposure to term, default, optionality (such as in mortgage-related securities) and equity (such as in convertible bonds) risks. The results are statistically significant at the 1% confidence level.

Read the full article here by Larry Swedroe, Advisor Perspectives

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