Active Equity Fund Managers Stuck in the Rough, While Active Bond Managers Tend to Stay on the Fairway

Since the launch of the State Street Global Advisors S&P 500 exchange-traded fund (SPY) in 1993, passive, index-replication portfolio construction has been widely adopted and represents the common investing experience of John and Jane Q. Public. Passive equity index investing has been a boon to investors small and large, enabling the ownership of thousands of individual issues at a low cost[1], through a single trade.[2] In the quarterly publication S&P Indices Versus Active (SPIVA) Scorecard, S&P Dow Jones Indices monitors the performance of actively managed mutual funds and ETFs relative to their stated benchmarks.[3] Across 17 domestic equity management styles, from large-cap to multi-cap blended fund, 63.43% of actively managed funds underperformed their benchmarks in 2017. Over 10 years, on an annualized basis, an average of 86.65% of actively managed equity funds underperformed their benchmarks through 2017. Thus, individual investors have embraced passive indexing, and with good reason.[4]

The narrative is different for active bond managers. A supermajority of actively managed investment-grade intermediate bond funds, benchmarked against the Barclays US Government/Credit Intermediate Index, bested their bogey last year. Specifically, 68.63% of the investment-grade intermediate bond funds monitored by the SPIVA Scorecard generated returns superior to their benchmark. On a 10-year annualized basis, 48.94% hit a birdie. Drawing from Morningstar historical statistics, research compiled by PIMCO tells a similar story: “The percentage of active bond funds and ETFs outperforming their median passive peers over the past 1, 3, 5, and 7 years all exceeded 50%; more than half outperformed their median passive peers over the past 10 years.”[5]

Perhaps “bond-picking” is the new “stock-picking”? With the Fed winding down QE and pushing short-term rates upward, can active bond managers #MakeBondsAttractiveAgain?

Over the last year, core inflation has remained muted – under 2% – while the 2-year Treasury note has broken out from 1.35% to 2.34% during the same time period – meaning that the real rate of interest has increased while inflation has held steady. For Baby Boomers looking at retirement and adding new money to their fixed-income allocation, this is welcome news. Millennials taking on a mortgage to finance their starter home may look at signing on to another year’s lease instead.

A survey of literature on active bond management reveals a consensus around certain factors that researchers believe may contribute to index-beating returns:

1. (*) The bond market comprises thousands of different issues with varying maturities, which seldom trade. A bond deal to finance the construction of a new high school may have multiple tranches, maturing over 20 years. This single project generates a dozen new marketable securities. There are thousands of school districts in the United States, as compared to 500 companies in the S&P 500. As time marches on, a 10-year bond turns into a 5-year bond, and a 5-year bond matures. Wash, rinse, repeat. This inherent dynamism in the bond market, paired with infrequent trading across the thousands of different issues, can lead to asset mispricing, price negotiations, and opportunities for alpha. Bond indexes and the passive ETFs that track them are constantly refreshed with new securities. As PIMCO states: “The market is an ever-evolving set of assets that need to be traded actively for replication purposes. This is more acute with securities that have finite lives and regularly return capital.”[6]
2. (*) Unconstrained, actively managed bond strategies can allow the manager flexibility to capitalize on market dislocations, increase or reduce weightings among sectors, and move up and down the yield curve to capture relative value. As the 2017 tax bill moved through Congress, there were provisions in both the House and Senate versions that would eliminate a municipal refinancing technique known as pre-refunding. The House bill went further and called for an end to private activity bonds, which allow private organizations such as nonprofit hospitals, colleges, and charter schools to access tax-free financing. The uncertainty caused issuers to rush deals to market before the rules were changed. Supply flooded the market, pushing up rates. Cumberland extended durations across our taxable and tax-free portfolios. Our traders were able to purchase municipal bonds at or near par with a 4% tax-free coupon, while similarly dated Treasuries were yielding 2.70%.  
3. (*) Bond managers who deploy their strategy across a composite of separately managed accounts are less vulnerable to forced selling during times of panic. Mutual funds and ETFs typically resort to selling their higher-quality assets that are more liquid, in order to quickly meet redemptions. Conversely, separate account managers are not beholden to the emotions of thousands of shareholders. With each separate account comprising individual bonds, the manager can sell less-volatile, shorter-dated paper to fund the purchase of issues unwillingly unloaded by mutual funds and ETFs at fire-sale prices. Managers of open-ended mutual funds and ETFs are subservient to one price, that of the net asset value (NAV).

The idiosyncrasies of the largest market in the world – the sovereign and corporate debt markets – continuously generate new opportunities for the active manager. At Cumberland Advisors we actively manage both municipal bond and taxable bond strategies, both guided by a total-return objective and limited to credits with an A rating or better. For individuals and organizations seeking a long-term buy-hold-rebalance approach, Cumberland Advisors manages a strategy, dubbed Active Taxable Bonds/Passive Equity, that joins passive equity exposure with active bond management.

[1] “The average ETF carries an expense ratio of 0.44%, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest. The average traditional index fund costs 0.74%, according to Morningstar Investment Research.” http://guides.wsj.com/personal-finance/investing/how-to-choose-an-exchange-traded-fund-etf/

[2] The Schwab® S&P 500 Index Fund (SWPPX) is available to investors at a net expense ratio of 3 basis points (.03%). https://www.schwab.wallst.com/schwab/Prospect/research/mutualfunds/summary.asp?symbol=SWPPX

[3] S&P Indices Versus Active Scorecard. “The SPIVA Scorecard is a robust, widely-referenced research piece conducted and published by S&P DJI that compares actively managed funds against their appropriate benchmarks on a semiannual basis. We offer scorecards reporting on actively managed funds in the following countries and regions: Australia, Canada, Europe, India, Japan, Latin America, South Africa, and the U.S.”  https://us.spindices.com/search/?ContentType=SPIVA&_ga=2.244572805.1865916684.1522156867-1827973429.1522156867

[4] We note that indexes do not include expenses associated with the acquisition and disposition of securities, personnel costs, compliance, legal, shareholder administration, etc.

[5] https://www.pimco.com/en-us/insights/viewpoints/quantitative-research-and-analytics/bonds-are-different-active-versus-passive-management-in-12-points/ pg. 3

[6] https://www.pimco.com/en-us/insights/viewpoints/quantitative-research-and-analytics/bonds-are-different-active-versus-passive-management-in-12-points/ pg. 8