Morningstar Magazine - August/September 2018 - 36

Spotlight: Fixed Income

be rational to pay without eroding the odds of
outperforming an index or a passive option
too much. Fees may differ widely depending on
the share class an investor has access to.
To give a sense of the effect fees may have, we
calculate two comparisons using net returns.
We screen out institutional share classes and use
the oldest of the remaining share classes.
displays how funds' net excess return
medians moved against the category indexes
through time, with the vertical line at zero.
Net excess returns for the median period were
negative for all 25 categories analyzed in
the rolling three-year periods. This is not entirely
surprising, but it powerfully demonstrates
the extent to which fees weigh on funds' success.
Even in categories where funds may be able
to add value on a gross basis, the median fund
failed to beat the benchmark after fees.
EXHIBIT 5

If the median fund does not cut it, how about
funds that do better than the average? In
E X H I B I T 4 , we observed that gross excess returns
for top-quintile funds were high enough to
allow positive excess returns. E X H I BI T 6 shows
comparisons of top-quintile funds on a net
basis against both the category index and the most
relevant or longest-running comparable ETF.
This exhibit covers the rolling three-year periods
since December 2012, the earliest common
date of the ETFs we have looked at.
There were only eight categories in which funds
at the 20th percentile outperformed the
benchmark index in the average three-year period,
and only one, GBP government bond, where
the outperformance was greater than 1 percentage
point annualized. In the categories where we
observe a narrow range of outcomes, the
median net excess return of the best quintile came
very close to zero. In other words, funds
that landed in the top quintile of their peer group
were just able to match the performance of
the category index.
Returns against passive offerings are, however,
more encouraging: In 16 categories, active funds
in the top quintile outperformed the most relevant
ETF on a net-of-fee return basis. For example,
in EAA fund EUR high yield, while even the best

36

Morningstar August/September 2018

active managers in this category lagged
the category index, investors would not have been
better off buying an ETF. The stringent liquidity
criteria applied by passive funds, as well as
the inherent transaction costs of this less-liquid
market, typically led the ETFs to miss
an even greater proportion of the index's returns.
Thus, despite underperforming the benchmark
index, funds in the top quintile of the EUR
high-yield bond peer group outperformed
a representative ETF, iShares EUR High Yield Corp
Bond ETF, by more than 1% in the average
three-year rolling period from December 2012
to 0ctober 2017.
Active funds in the USD high-yield category
performed equally well against a representative
ETF. High-yield ETFs typically filter out
the smaller bonds in the universe for liquidity
reasons, and active managers have numerous
opportunities to add value by investing
in smaller, less-liquid bonds that offer higher
compensation for that illiquidity. Strong
fundamental research can also pay off if active
managers are able to exploit informational
inefficiencies in this market.

of any three-year period were close to zero and
did not move much during the 154 rolling
periods we looked at. Excess three-year rolling
returns moved the least within these nine
categories through time. This means that investors
should have an easier time setting expectations
for fund excess returns and alphas.
In four of the categories (EAA fund EUR diversified
bond, EUR government bond, GBP government
bond and USD diversified bond), the typical active
fund consistently underperformed the category
index even before accounting for fees. There
was also little dispersion between the best and the
worst active funds. This makes a strong case for
low-cost investments. It makes sense for investors
in these categories to focus on passive funds and
the small number of active funds that charge
fees lower than those of comparative passive funds.

We can broadly sort the 25 categories we have
studied into three groups based on the dispersion
of medians, maximum and minimum
values, and interquartile ranges for category
median excess returns.

In the other categories (EAA EUR corporate bond,
USD government bond, US fund inflationprotected bond, US fund long government, and
US fund short government), the typical active
fund outperformed the category index gross
of fees, but only by a very narrow margin (5 to 17
basis points in the median period). Median fees in
these categories range from 42 to 85 basis points
per year, implying that most funds are structurally
priced to fail. These categories make a strong
case for low-cost passive options, though they
might provide slightly greater opportunities than
the previous group for cheap active funds.

Group 1: Benchmark-Driven Categories

Group 2: Categories With Moderate Stability

EAA Fund EUR Corporate Bond

EAA Fund Global Bond

EAA Fund EUR Diversified Bond

US Fund High-Yield Bond

EAA Fund EUR Government Bond

US Fund Intermediate-Term Bond

EAA Fund USD Diversified Bond

US Fund Long-Term Bond

EAA Fund USD Government Bond

US Fund Short-Term Bond

EAA Fund GBP Government Bond

EAA Fund USD Corporate Bond

US Fund Inflation-Protected Bond

EAA Fund USD High-Yield Bond

US Fund Short Government

EAA Fund GBP Corporate Bond

US Fund Long Government

US Fund Corporate Bond

These are categories where the "gravity" of
the benchmark is strong: The median gross returns

Some categories fall in a middle ground. In these
categories, the median of the distribution

Results by Categories



Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018

Contents
Morningstar Magazine - August/September 2018 - Cover1
Morningstar Magazine - August/September 2018 - Cover2
Morningstar Magazine - August/September 2018 - 1
Morningstar Magazine - August/September 2018 - 2
Morningstar Magazine - August/September 2018 - Contents
Morningstar Magazine - August/September 2018 - 4
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