Bond Funds: You Get What You Don't Pay For

Innumerable studies have shown that it’s well-nigh impossible to beat the averages consistently investing in equity funds. But what about bonds? Bonds, after all, have more structure – perhaps there are ways an expert fund manager could exploit that structure and gain an edge over other investors. Is it possible to predict how well a bond fund will perform relative to other funds?

In a recent article, “Predicting Bond Fund Returns,” in the Winter 2011 issue of the Journal of Investing, finance professors Dale L. Domian of York University and William Reichenstein of Baylor University pose that question. They study specifically whether the funds’ expense ratios or their previous five-year returns could have helped predict their returns over the five-year periods 1995-1999, 2000-2004, and 2005-2009.

Bond returns vary considerably, as a more-or-less predictable function of two risk measures – their durations and their quality ratings. To prevent the wide variation caused by these factors from swamping other discernible effects, Domian and Reichenstein studied separately groups of bond funds that fall into each of the Morningstar style categories.

This was not an isolated study, but rather the latest in a line of research stretching back more than a decade. Reichenstein previously studied this issue in 1999, 2002 and 2004 for both taxable and tax-exempt bond funds, collaborating both with Domian and with others. In each case, the researchers found that fund expense ratios were a good predictor of subsequent performance – the higher the expense ratio, the worse the performance.

In fact, the results failed to rule out the efficient market null hypothesis – that performance was lower by exactly the amount of the fees. This result, if perhaps counterintuitive, will not be unfamiliar to those who are knowledgeable about research on equity returns. A long string of studies, dating back to Nobelist William F. Sharpe’s paper on mutual fund performance in 1966, through an article by Mark Carhart in 1997, to recent studies by Morningstar, have shown that expense ratios are the best predictors of equity fund performance.

Domian and Reichenstein conclude from their research that for bonds too, there is “a one-to-one negative relationship between expense ratios and net returns.” The clear implication is that advisors should look first at the expense ratio of the fund and place primary importance on that variable. Those hoping that bonds can be an exception to the law of averages will have to keep searching.

The Morningstar categories

The Morningstar categories were created, in part, as a means to separate a decision that is in principle the responsibility of the investor – the risk posture – from decisions that are the responsibility of the investment managers. The recent conventional wisdom has been that an investor, or the investor’s advisor, should choose the “style” categories and the allocation to each of them, while the manager of each style should either attempt to match the average performance for that style category at a low fee or outdo it for a higher fee.

In the Morningstar mutual fund classifications, equity and fixed income funds are each divided into nine styles. Each of the two asset classes is divided into three partitions on two axes depending on the securities it holds. In the case of equities, the axes are large-small capitalization and value-growth. In the case of fixed income, the axes are long-short duration and low-high credit quality.

Hence, the “Morningstar Style Box” for fixed income has nine cubbyholes, for various permutations of short, intermediate, or long duration combined with low, medium, or high credit quality.