There Is Nothing Quite Like the Assurance of Failure

Should any of us own a managed bond mutual fund? Should any of us everown a managed bond fund?

These rude questions came to mind as I read the most recent SPIVA report— that’s the regular report from Standard and Poor’s that examines the performance of managed funds against their chosen benchmarks.  The most recent report, covering the period to the end of last year, shows that managers of intermediate term government bond funds failed to beat their target index by a mind boggling 93.62 percent over the last five years.  They also failed 89.8 percent of the time in the five years from 2002 through 2006.

Management failure: If it’s anything, it’s consistent

We’ve learned to expect that about 70 percent of equity fund managers will fail to beat their index benchmark. We’ve also learned to expect that bond fund managers are likely to do slightly worse.

But really, how can they stay in business with a 90 plus percent fail rate?

To be fair, there were some categories where managed bond funds did better. The best was the category “general short (term) funds” where only 60.54 percent of managers failed to beat their index over the last five years. But that was the bestin the last five-year period. So in the best performing category, the majority of managed bond mutual funds still failed to beat their index.

Searching for the exceptions that prove the rule

Was there any light, anywhere? Yes. Of the 9 categories considered over two five-year time periods, a slender majority of emerging markets debt fund managers beat their benchmark from 2002 through 2006, the previous 5-year period. So it can be done. There is an exception to the rule.

So tell me:Can you name another area in life where we voluntarily pay a premium for a virtual guarantee of failure?That’s what we do when we buy managed bond mutual funds.

Measuring how much of your money goes to managers

Now consider the portion of the return on your money that goes to the managers who are so adept at failure. Morningstar calls the largest category of bond funds general funds, with intermediate maturities. There are about 1,263 of them, of which 219 sell through front-end load commissions that average 4.12 percent and annual expense ratios that average 0.93 percent. At the end of March these same funds were providing an average yield of 2.36 percent. In other words, your commission cost exceeded your yield for nearly two years. After that, the managers got 39 percent of the yield on your money through fund expenses.

Another 219 of these funds had deferred sales loads. These are expenses that are recovered through high 12(b)-1 charges. The average 0.91 percent 12(b)-1 fee took the average expense ratio up to 1.62 percent. The current average yield on these funds was 1.65 percent. Here, annual expenses are about equal to annual yield, 1.65 percent versus 1.62 percent. This means the managers get the income while the investor gets 100 percent of the risk.

The remaining funds— no load funds that had neither front-end nor deferred sales commissions— had a lower average expense ratio, 0.74 percent, and a higher yield, 2.41 percent, than the funds available through the traditional brokerage sales channels. Even so, the management expenses absorbed 31 percent of the income.

What happens when you opt for a fixed income index fund? Things get better for you. You still have the risk of buying bonds at historically low yields. But without the burden of sales and management expenses, you get a better deal for income.

How much better? Lots. Averaging all 87-index funds in the category, the expense ratio was 0.33 percent and the yield was 2.44 percent. The cost of investing was only 13.5 percent of income. Invest with the larger and better-known bond index mutual funds or exchange traded funds and expenses could be as little as 5 percent of interest income.

If you choose low-cost index funds, your chance of failure is much smaller

In spite of these realities (which you won’t be told by your friendly salesperson because they are not encouraged to examine the statistics) millions of savers and investors still depend on commissioned sales people because they are afraid to make decisions for themselves.

Well, don’t be.

With a virtual guarantee of failure to beat an index from heavily marketed managers, we have no reason not to  “go for it” and select a fixed income index fund.  Chances are about 9 out of 10 that you will do better.

On the web:

SPIVA Report downloads here: https://us.spindices.com/search/?ContentType=SPIVA