Most investors and advisors who have come to use and appreciate ETFs would agree that the case for ETFs relative to actively-managed mutual funds in the equity arena is firmly established, crystal-clear and completely unambiguous. But what about in the fixed income domain?
Relative to their equity counterparts, can fixed income ETFs boast of advantages nearly so compelling in the areas of holdings transparency, breadth of systematic coverage of asset classes, consistency of coverage (i.e., lack of style drift and related concentration migration risks), low cost, tax efficiency and trading flexibility (for risk management purposes)? And are active fixed income mutual fund managers nearly so incapable of consistently outperforming their generic, passive index benchmarks? The answers, really not surprisingly, are Yes, Yes, Yes, Yes, Yes, Yes, Yes and a very, very big (huge) YES!
“Oh, but there are such important inefficiencies and a lack of price discovery in bond markets that active management and security selection surely must add alpha,” according to the familiar refrain from active fixed-income managers and their legions of marketing and sales specialists.
But is that active managers’ holy grail known as alpha delivered in the real world? How about if we just cut to the chase and take a look at the world’s largest actively-managed fixed income mutual fund and its corresponding index benchmark?
Let’s look at the world’s largest actively managed bond mutual fund – PIMCO’s Total Return Bond Fund. with roughly $120 billion in assets across its slate of share classes. The fund earned a 5-Star Morningstar rank overall as well as for 3, 5 and 10 year performance in the intermediate-term bond category. That 5-Star ranking implies that the fund was in the top 10% within a group of peers falling under the Intermediate-Term Bond Fund classification. And let’s look also at two ETFs covering the Barclays Aggregate Bond Index – the index identified as Total Return Bond Fund’s “benchmark”.
Overall, it looks like the world’s largest actively managed bond fund, representing the top ranking 10% of such funds, is basically neck-and-neck with ETFs based on the fund’s passive benchmark index … Morningstar one-year (2008) data show that the PIMCO fund beat the two ETFs on a pre-tax basis by 65-92 basis points but underperformed on an after-tax basis by 51-72 basis points. On a 5-year basis, PTRAX beat AGG on a pre-tax basis and by 92 basis points on an after-tax-basis. And, again, that’s part of the top 10% of the Intermediate-Term Bond fund class. So, going forward, how likely is the Total Return Bond Fund to eek out a long-term positive performance spread to its passive index counterparts? Whether an investor in the Total Return Bond Fund or another of the 900+ actively managed mutual funds in the space, looking and hoping to fall into that “superior” 10% group, you simply have to ask your self, “Do I feel lucky today?”
