A recent Wall Street Journal article, “New Fund Stars Ride Junk Bonds to the Top”, profiles several bond funds which have drawn in large sums of investor assets since the financial crisis, in part, by delivering higher than expected returns from safe fixed income investments. Many of the funds’ managers are being branded as superstars for their apparent ability to deliver high yields from low-yielding segments of the market.
So how good are these managers? Do they really have a secret sauce or are they simply gaming the system? Let’s take a look.
Most bond funds are benchmarked against the Barclays US Aggregate Bond Index (Aggregate) which according to Barclays is a “broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market”. Outperform that index over several years and you can be a bond fund manager superstar. Is it difficult to do that?
First, let’s review the Aggregate index components by type and by rating. As of March 2014 they were as follows:
Source: Barclays US Aggregate Index Factsheet – March 2014
Close to 72% of the index components are Aaa rated, the highest rating available. In addition, the entire benchmark index is composed of investment grade bonds.
One of the funds profiled in the WSJ article, DoubleLine Total Return allocates 29%1 of the portfolio to below investment grade and unrated bonds. Despite having close to a third of the portfolio in junk bonds, the fund is benchmarked to the Aggregate, an all investment grade index, both by mutual fund rating firm Morningstar and DoubleLine itself. Since the fund’s inception (4/6/10), the institutional share class has outperformed the Aggregate by 13.8%. Impressive.
According to the article, Total Return fund manager, Jeffrey Gundlach asks rhetorically, “Who wants an index fund that yields 2%”? He states further that investors “want exposure to these high-yield and distressed securities and they’ve become comfortable with what we’re doing.”
Really? I doubt it.
Let’s run an experiment. Suppose we create our own mutual fund called Beat The Agg fund (BTAG). We invest 71% of the assets in the Vanguard Total Bond Market ETF (BND) and 29% in the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and we rebalance back to those targets monthly. Let’s see how BTAG compares to the Aggregate over the last five years.
Portfolio constructed based on 71% Vanguard Total Bond Market ETF (BND) and 29% iShares iBoxx $ High Yield Corporate Bond ETF (HYG). Rebalanced Monthly. June 3, 2009 – June 2, 2014.
Over the past five years, BTAG beat its “benchmark” by almost 10%. I think we’ve found another superstar.
Of course, taking more risk means taking more risk. So how would things look here when the market is falling apart. Luckily, we have data from the recent financial crisis to see how additional risk can manifest itself during turbulent periods. Following is a chart comparing BTAG to the Aggregate during the last bear market.
The S&P 500 peaked on October 9, 2007 and bottomed on March 9, 2009
During the turbulence of the financial crisis, BTAG underperformed the Aggregate by 13%. Even more importantly, the underperformance came at a time when safe fixed income investments are expected to provide ballast to offset the volatility in the equity portion of the portfolio.
Actively managed bond fund managers want investors to believe they are delivering better returns than the benchmark without taking additional risk. Success in establishing that belief can make them famous and wealthy. In reality, they are delivering exposure to riskier segments of the bond market for a high fee. There’s nothing super about that.
1 29.3% of the fund is rated below investment grade or not rated as of April 30, 2014 (from DoubleLine website)