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To follow up on a recent post by Steve Abramowitz:
A Morningstar article published 3/11/25 addressed this subject looking at performance over the past 10 years.
It found that less than one out of every four active funds topped the average of their passive rivals over the 10-year period ended December 2024.
Long-term success rates were highest among bond and real estate funds.
The prospective payoff for choosing a winning fund versus the penalty for picking a loser.
In the case of US large-cap funds, the distributions skew heavily negative.
The opposite tends to be true of fixed-income and real estate categories, where long-term success rates have generally been higher and excess returns among surviving active managers have skewed positive over the past decade.
Finally Morningstar found that funds in the cheapest quintile succeeded more often than funds in the priciest one (28% success rate versus 17%) over the 10 years through 2024.
Morningstar has reported innumerable times that lower cost funds almost always outperform higher cost ones. With so many funds in so many investment categories available, why would anyone pick the high cost fund?
As Jack Bogle was fond of saying, “you get what you don’t pay for”.
David, a great informative follow-up.
But I’m perplexed about one finding in both reports. Active bond funds did relatively well. Why should this be since bonds are less variable than stocks and so managers presumably have less wiggle room to outperform? This seems counterintuitive to me because active bond funds’ higher expenses should then be the deciding factor in determining (and inhibiting) their performance. Hence, why not an advantage in favor of passive funds?
Maybe it’s that style drift phenomenon again. Might some managers have “cheated” by sometimes going out on the yield curve as interest rates came down (so raising bond prices) over the last 10 or so years? Will someone please help me with this, so I can get some peace!
Steve, I have a vague memory of a HD writer writing of the possible advantage of an active bond fund over an index. I’ve searched but can’t turn it up, and I won’t name the writer in case my memory is just imagination. Perhaps a nimbler brain can assist.
Whenever you see these “success rates” for active managers, it’s important to consider the impact of “style drift,” also known as “cheating.” Style drift was a bad strategy for large-cap managers over the past decade, because large caps fared so well. Meanwhile, buying some larger companies would have been a plus for small-cap managers when their results are compared to a small-cap index.
The opportunities for style drift are especially large for bond managers. Bond market indexes contain just a fraction of the bonds in any one market sector. Thus, managers can potentially goose returns by holding bonds that are lower quality or longer maturity than those included in the index.
Don’t active mutual funds cheat when they practice “window dressing?”
Yes. But while it makes the fund manager look good in quarterly reports and potentially in the eyes of fund directors, it hurts performance because of the unnecessary transaction costs.
I trying to understand why active one funds apparently do so well in both reports. Since bond fund are less variable than stock funds, you would think that bond funds’ higher would
(Cont’d) higher expenses would detract from rather than improve their performance. Since bond managers have less wiggle room than stock managers, I don’t see what else besides expenses can explain the relative underperformance of passive funds. But the results are in the wrong direction. Interest rates have come down in the last 10 years, boosting bond prices. Could style drift toward bonds further out on the yield curve overcome passive funds’ cost advantage and account for the counterintuitive findings?
Definitely something to be aware of when making comparisons, but not necessarily a bad thing. For example, we have a bond fund that generally invests in what the index does, but can go up to 20% in non-investment grade, and can also deviate from the index in its allocation to credit types within investment grade and in terms of duration. Part of the reason we own it is because it has this flexibility. So when they do this, it’s not cheating to me, it’s what they’re paid for. But absolutely, their superior returns over the last many years don’t make them necessarily “better” than the index, and it’s important to know that these returns came with more risk.
I know you and other smart folk like Bill Bernstein recommend sticking with short term bond indexes and saving risk for the stock side of things. While we have those, I like also having this active management (with guardrails) on the bond side in money we shouldn’t need soon.