Attention Bond Fund Investors: Are You Getting What You Pay For?

(June 2012) “You get what you pay for!”  Does this expression hold true for bond mutual fund fees? Do higher fees really lead to better investment performance?

As a category, mutual funds that are actively managed have higher fees than passively managed mutual funds. Actively managed funds involve a portfolio manager making investment decisions with the goal of beating a market index. On other other hand, a passively managed mutual fund tries to track a market index by mirroring the holdings in the index.  According to Morningstar, the average actively managed bond mutual fund has an average annual expense ratio  of 1.01%.  They also show that the average annual expense ratio for passively managed bond mutual funds is only 0.37%.  (for a full explanation of the different typs of mutual fund fees go here)

 

After fees (excluding sales load which are avoidable), which has a better performance: Actively or Passively Managed Funds (all funds, including stock funds)?

Answer: There is no clear winner.

Over 5 and 10 year periods, actively managed funds slightly outperform passively managed funds. However, over the last three years, passively managed funds have done almost 2.0% better than actively managed funds.

Time Frame
Last (as of May 31st, 2012)
Actively Managed Mutual Funds Performance Passively Managed
Mutual Fund Performance
Difference
3 Years 11.07% 12.82% 1.75%
5 Years 0.55% - 0.56% 1.11%
10 Years 5.28% 4.87% 0.41%

When you drill down into bond funds the differences are even smaller, although, actively managed bond fund do slightly outperform passively managed bond mutual funds over 3 and 10 year time horizons. Over a 10 year time horizon, the performance difference is a a microscopic 0.03%. In other words,  again we have tie. The numbers below are for taxable bond funds, which exclude municipal bond funds but include Treasury bond funds.

Time Frame
Last (as of May 31st, 2012)
Actively Managed Taxable Bond Fund Performance Passively Managed
Taxable Bond Fund Performance
Difference
3 Years 8.65% 8.00% 0.65%
5 Years 5.57% 6.84% 1.37%
10 Years 5.55% 5.52% 0.03%

The average performance of actively and passively managed funds are essentially equal. However, investors don’t invest in the average fund. They try to find one that has consistently outperformed the market and its peers. One fund that consistently beat it peers was the Legg Mason Capital Management Value Trust managed by Bill Miller. Between 1991 – 2005, the fund beat the S&P 500, However, the next three years the fund underperformed the S&P. Picking a good actively traded mutual fund is as tricky as picking a bond or stock.

 

A Note of Caution

The above analysis looks at the average performance of all funds.  When you drill down further however you will find that the majority of actively managed funds do not beat their index.  The performance numbers are still in line with passively managed funds because of a few top performing funds which bring the average return for all actively managed funds up.  The bottom line is that 70% of actively managed Intermediate Government Bond Funds and 89% of actively managed Intermediate Corporate Bond Funds failed to outperform their indexes.

For more on bond mutual funds visit the bond funds section of Learn Bonds.

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