Bill Gross Is Right That It’s Tougher to Outperform
(Bloomberg Opinion) -- Bill Gross, the former bond king, may be officially retired, but he had one final warning for those still managing money: You’ll never outperform the way he did in his heyday at Pacific Investment Management Co.
To be clear, this isn’t his ego talking. In a conversation with Bloomberg News’s Erik Schatzker, Gross said that markets have changed, becoming so much more efficient that virtually no wagers are surefire ways to get ahead and generate so-called alpha. Here are a few ways he said he outperformed both his benchmark and his peers over the years, without necessarily any “brilliance” on his part:
Gross says he used to pounce when banks introduced new credit products because they inevitably were poorly understood and traded at discounts to intrinsic value. The first few years of mortgage bonds in the 1970s are an example.
“Investors basically wouldn’t touch them,” he said. “Our accounting department, they didn’t know how to segregate the principal and the interest, and there were complaints aplenty. I said, ‘Come on, get over it!’ because these things were so cheap. We got in early.”
Similarly, Pimco was a big buyer of Treasury futures in the 1980s. Clients heard “futures” and asked, “Is this like soybeans? Are you trading corn?” Gross recalled. As a result, the spreads between the cash and futures markets were unusually wide and created a “sort of riskless arbitrage.”
Gross said those opportunities are gone now, for a few reasons. First, the era of easy money from global central banks has suppressed interest rates, yield spreads and volatility, making any dislocations few and far between. Banks had already pushed the envelope on derivatives and other structured products, and in a post-crisis world have little incentive to innovate much further. And the rise in high-speed quantitative strategies has made riskless arbitrage largely a thing of the past — though the data-crunching computers do occasionally suffer from the same weaknesses as humans.
All of this makes sense intutively (no one assumes futures are limited to agricultural commodities anymore). But is it true that alpha is getting harder to come by?
A report from Morningstar Inc. suggests the answer is yes. In its semiannual “Active/Passive Barometer” released last month, the research firm found that “actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons.” In 2018 specifically, their success rate fell relative to 2017 in 16 of 20 asset classes. Overall, just 35 percent of active managers outperformed.
In the fixed-income market, a mere 29 percent of corporate-bond and high-yield funds were deemed successful in 2018, dropping off from their 2017 success rate by more than just about any other asset class. Their 10-year track records show they beat a composite of passive funds more than 50 percent of the time. Morningstar noted that “active bond funds have been buoyed by bets on riskier corporate bonds, which had performed well in recent years but faltered in 2018.”
Indeed, some of the top managers of “unconstrained funds” like the one Gross ran at Janus Henderson Group Plc simply loaded up on riskier debt and coasted to lofty returns as yield spreads tightened. Mike Swell, who co-manages the Goldman Sachs Strategic Income Fund, once told me that “a lot of people have gotten rich being lazy long in credit.” His fund didn’t, instead taking bets on differentials in currencies and interest rates. It trailed most peers for years. This year, it’s beating 79 percent of them, Bloomberg data show.
At the same time, such wild swings in performance don’t exactly inspire confidence among investors. Gross knows this firsthand, given the massive withdrawals from his unconstrained fund last year. He told Schatzker that he “became a risk taker, but not necessarily measured,” when he shifted away from a total-return strategy.
But if active bond managers just add more higher-yielding debt than their benchmarks, that doesn’t feel sustainable either. The sharp underperformance in 2018 proves that. Last year’s sell-off wasn’t even that large by historical standards: The yield spread on an index of high-yield bonds reached a peak of 531 basis points on Dec. 27. By comparison, the spread reached 839 basis points in February 2016, 876 basis points in October 2011 and 1,971 basis points in December 2008.
That’s not to say passive funds fare much better in times of market stress. But in general, they’re expected to hold more liquid, benchmark securities that could hold up better. And, more important, they have much smaller management costs. The narrative has shifted so far in favor of low-fee products as investors learn how much a few extra basis points can cost in the long run. I’ve written before about the grim outlook for active managers because of this trend, which Moody’s Investors Service said is like the migration to mobile phones from landlines.
Interestingly, Morningstar’s report found that the cheapest 20 percent of active funds succeeded about twice as often as the most expensive 20 percent over the past 10 years, showing both the benefit of lower fees and that more cost-efficient funds survived the decade. “Cost matters. Fees are the one of the best predictors of future fund performance,” the authors of the report said.
Active managers will hate to hear it, but in a market devoid of alpha-generating opportunities, the easiest, most risk-free way to juice returns is probably continuing to chip away at fees.
For those interested in the methodology, this is from Morningstar: "Our `benchmark' for measuring success is different than others'.We measure active managers’ success relative to investable passive alternatives in the same Morningstar Category. ... We believe that this is a better benchmark because it reflects the performance of actual investable options and not an index."
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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