New research documents the abject failure of the vast majority of municipal bond funds to outperform a passive benchmark.
Academic research, as presented in my book co-authored with Andrew Berkin, The Incredible Shrinking Alpha, and supported by the annual SPIVA scorecards, shows that for both common stock and taxable bond investors, a passive strategy of merely tracking a benchmark index generally outperforms active strategies after accounting for portfolio management fees. Joshua Gurwitz, David Smith and Gerhard Van de Venter contribute to the literature on the performance of active management with their study, “Municipal Bond Mutual Fund Performance and Active Share,” published in the June 2021 issue of The Journal of Investing.
Gurwitz, Smith and Van de Venter evaluated the performance of actively managed U.S. open-end municipal bond mutual funds between 1999 and April 2020 using both benchmark-adjusted returns (such as the Bloomberg Barclays Municipal Bond Total Return Index) and a four-factor pricing model. The four factors were: (1) the return on the Bloomberg Barclays Municipal Bond Total Return Index less the return on the one-month T-bill, (2) the excess return of each open-ended mutual fund’s (OEMF’s) benchmark less the return on the one-month T-bill, (3) the yield spread between 10-year and three-month constant maturity Treasury securities (term spread), and (4) the difference in average yield between Aaa and Baa corporate bonds (credit spread). The corporate bond spread was used in place of the municipal bond spread for data availability reasons.
The authors began by noting that more than 99% of the $815 billion in assets held in U.S. municipal bond mutual funds at year-end 2019 were actively managed – most municipal bond portfolio managers selected individual securities issued by state and local governments; made geographical, quality or duration bets; or timed movements into and out of cash in an attempt to outperform benchmark indexes. Their final dataset contained 512 U.S. municipal bond OEMFs of which 199 “national” funds were classified as high-yield, short-term, intermediate-term and long-term classifications. Geography was the dominant feature in the remainder of the funds, focused on a single-state issuer.
For their analysis of each OEMF’s active weight, an annualized passive investing expense ratio of 0.07% was used – the expense ratio for the lowest-cost municipal bond exchange-traded fund (ETF), the iShares National Muni Bond ETF (MUB), which passively tracks the return of the S&P National AMT-Free Municipal Bond Index and has an expense ratio of just 0.07%. At the time of the study, the index contained about 11,900 investment-grade municipal securities of issuers across the U.S. Following is a summary of their findings:
- The average monthly return net of each OEMF’s self-designated performance benchmark was -0.07%, or -0.84% per annum.
- During the sample period, only 8% of funds generated returns that beat their benchmark indexes, and 29% produced positive excess returns (alpha) based on the four-factor pricing model.
- Managers specializing in single-state issues did not manifest unique knowledge or insight. In fact, their performance was among the worst.
- Active share for the aggregate sample was only 25%; 75% of the holdings could have been duplicated with an expense ratio of just 0.07% by using MUB. Given that the passive share could be obtained for just 0.07%, and the average OEMF had an expense ratio of 0.76%, that implies an active expense ratio exceeding 3% and annualized active alpha of -3.3%.
- The average monthly active alpha ranged from -0.61% for high-yield funds to ‑0.23% for short-term national funds.
Their findings led Gurwitz, Smith and Van de Venter to conclude: “The evidence overall suggests that active management of municipal bond portfolios is not a value-enhancing activity.”
Given their findings, that is an understatement. Assuming $815 billion in assets and an underperformance of 0.84% against their benchmark, that produces an annual destruction of value of about $7 billion a year. Poor performance doesn’t come cheaply. You pay dearly for it – with the active expense ratio exceeding 3%, those are hedge-fund-like fees!
The findings of Gurwitz, Smith and Van de Venter demonstrate that just as active management in stocks and taxable bonds is a loser’s game (one that’s possible to win, but the odds of doing so are so poor, you shouldn’t play), the same is true in the municipal bond market. Given their findings, one can only wonder why 99% of assets in municipal bond funds are still actively managed. Apparently, investors have been unaware of just how poorly active funds have fared. You no longer have that excuse.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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