The Great Index Apocalypse Comes for Bond Managers

Academics have understood for decades that stockpickers are unlikely to beat their benchmark indexes after fees, but investors’ reaction was delayed. They kept handing equity managers money. From 1993 to 2007, actively managed stock mutual funds boasted net inflows every year except one, according to Morningstar Inc.’s earliest available numbers.

There were three notable reasons why investors stuck with stockpickers as long as they did. First, the best-known index funds merely tracked the broad market—so investors who wanted exposure to specific styles of stockpicking, such as focusing on hard-luck “” companies or smaller firms, were drawn to active funds. Second, the mutual fund industry persuaded many investors that stockpickers would better protect their money during downturns than index funds. Third, and perhaps most consequentially, the industry promoted star managers such as Peter Lynch and Jeffrey Vinik of Fidelity Magellan, Bill Miller of Legg Mason Value Trust, and John Neff of Vanguard Windsor. The message was unmistakable: Successful investing came down to hiring hotshot managers.

Then the 2008 financial crisis seemed to change everything. Stockpickers, including some of the brightest lights, suffered as badly as index funds or worse. The stage was set for a revolution, and investors revolted. They’ve pulled $1.5 trillion from actively managed stock funds since 2008 through July while putting $2.7 trillion in index funds. For the first time ever, there’s more money invested in U.S. stock index funds than actively managed ones, after accounting for estimated fund flows in August.

Meanwhile, active bond managers have continued to prosper. Investors have put roughly $160 billion more into actively managed bond funds than into bond index funds since 2008. As of July, active bond managers oversaw $2.2 trillion more than bond index funds did. It’s not as if active bond managers stand a better chance of beating their benchmarks than stockpickers. S&P Dow Jones Indices tracks the performance of active managers in its biannual Spiva U.S. Scorecard, and the results are never flattering. The most recent report shows yet again that the overwhelming majority of bond managers failed to keep up with their benchmarks over periods of five years or longer.

So why are investors clinging to active bond managers even as they dump stockpickers? The reasons are not unlike those that once kept them in active stock funds. The industry has persuaded people they need an active manager to navigate bond markets, many of which are less liquid and more opaque than stock markets—and less well-understood by ordinary investors. And star managers still burn brightly in the bond world.

Those selling points will soon evaporate, however. And it may not take a crash in the bond market. Look more closely at what happened to active stock managers, and you’ll see it wasn’t just the miserable experience of 2008 that drew investors away from them. A burgeoning industry of exchange-traded funds began to offer investors a wide variety of low-cost index portfolios that approximate popular styles of active management. (I use some of these funds in my own asset-management business.) You have a lot more choice than an S&P 500 fund. You can buy just the stocks on the S&P. Or the ones with high dividends. Or an index fund that’s tilted to stocks with a variety of characteristics that a stockpicker might favor, such as momentum in recent price gains or high-quality earnings.

This allows investors to compare a manager to an index fund that has a similar investing style. Then they can discern how much of the manager’s outperformance is attributable to skill and how much to simply being in the right style at the right time. In that light, even the great star managers of the past might look a little more earthbound. Lynch’s fondness for buying high-growth companies at a reasonable price, for example, was a winning formula in the 1980s. But what if there had been an index fund for that?

Bond markets are becoming increasingly automated and liquid. That’s paving the way for more specialized bond index funds, such as those investing in lower-quality or more esoteric bonds than the ones reflected in broad market benchmarks.

It’s telling that some of the best-known and successful bond managers have eclectic styles—it’s hard to stand out if you’re mainly investing in Treasuries and high-quality bonds like everyone else. Consider Dan Fuss of Loomis Sayles Bond Fund. The fund easily outpaced the return of its benchmark index, the Bloomberg Barclays US Government/Credit Index, from its inception in 1991 through August. But Fuss’s benchmark is a poor proxy for his strategy. He has a penchant for junk bonds and occasionally stocks, which are riskier than most bonds. Fuss acknowledges as much—he says existing benchmarks don’t capture what the fund aims to do.

Jeffrey Gundlach’s DoubleLine Total Return Bond Fund has also beaten its benchmark, the broad-market Bloomberg Barclays U.S. Aggregate Bond Index, by a wide margin since inception in 2010. But that, too, is only part of the story. Gundlach has long specialized in mortgage-related bonds. He tends to invest substantial amounts in non-agency mortgage-backed securities, collateralized mortgage obligations, commercial MBS, and other securitized debt.

Right now, it’s not easy to find a single index fund you could compare either manager to. But the more fine-grained passive bond funds get, the more investors will be able to scrutinize managers’ performance and take their money elsewhere if managers don’t measure up. Some skillful bond managers will still beat the indexes. It’s just going to get a lot tougher, and investors will be watching the exit sign more closely.
 
Nir Kaissar, a columnist for Bloomberg Opinion, is founder of asset management firm Unison Advisors.

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