The active/passive decision in global bond funds

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Executive summary. This paper extends the evaluation of active versus passive management to global bond funds. Previous Vanguard research has shown that only a minority of active U.S.

stock funds, non-U.S. stock funds, and U.S. bond funds outperformed common market indexes over the ten years ended December 31, 2012 (Philips, Kinniry, and Schlanger, 2013). However, the past shortcomings of active management have been less apparent, on average, within the active global bond fund universe. Some investors may believe that managers for these funds possess superior skill or that the size and diversity of the world’s largest asset class give talented managers more opportunities to allocate capital among mispriced securities.

Ultimately, our analysis concludes that most of the historical

outperformance in active global bond funds has been the result of risk

1

that managers have assumed beyond that of the benchmark.

We demonstrate that once excess risk is taken into account, the

Vanguard research November 2013

1 Risk can take various forms, including currency risk, interest rate risk, and credit risk. However, for the purposes of this paper, we measure risk in terms of the volatility of returns; therefore, the term volatility may be used interchangeably with risk.

The active/passive decision in global bond funds

Authors

Christopher B. Philips, CFA Todd Schlanger, CFA Brian R. Wimmer, CFA

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relative performance of global bond funds is less favourable. In addition, we show that global bond index funds—and in particular, hedged global bond index funds—provide an attractive alternative to achieve the exposure of the asset class.

As the accessibility and liquidity of the global bond market have improved over the past decade, the case for investing in global bonds to enhance a portfolio’s diversification has strengthened. Strong cash flows into global bond funds have ensued. According to Morningstar, over the three years ended December 31, 2012, investors contributed nearly $60 billion in net capital to global bond funds and exchange-traded bond funds. That’s roughly the same amount of assets that short- and intermediate-term U.S.

government and municipal bond funds and bond ETFs attracted combined.2 Furthermore, during that time, actively managed global bond funds in particular garnered more than 96% of the nearly

$60 billion. This stands in contrast to the recent preference for low-cost index funds in most other asset classes.3

Greater average risk exposure in active global bond funds

Figure 1 displays the intersection of risk and return relative to the unhedged Barclays Global Aggregate Bond Index for a sample of 275 managed global bond funds we analyzed over the ten years ended

December 31, 2012. When measuring returns alone, 57% of these global bond funds (see Figure 1a) outperformed the index during that period. With 57%

of active global bond funds outperforming the market indexes, the funds can seem appealing, considering that in most other fixed income and equity market segments, far fewer than 50% of funds outperformed over the same period.4

Since both experience and research have shown us that long-term outperformance is rare in most markets, it’s important to understand how active global bond funds have achieved such atypical results.

This naturally led us to the question of risk versus the benchmark. Excess risk (or in some cases, less risk) relative to a fund’s benchmark arises when an active manager purposefully purchases bonds whose combined characteristics differ from those of the benchmark.

It is widely known that all active bond fund managers aim to use their expertise to deliver superior performance. Less well known, however, is that active global bond funds, on average, have increased the risk of their portfolios in search of

Notes on risk: All investing is subject to risk, including the possible loss of the money you invest.

Investments in bonds are subject to interest rate, credit, and inflation risk. Investments in bonds issued by foreign companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets. Diversification does not ensure a profit or protect against a loss.

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Figure 1. Most active global bond funds exhibited greater volatility than the unhedged Barclays Global Aggregate Bond Index

Notes: Annualized returns and volatilities calculated for ten-year period ended December 31, 2012. Funds with at least 36 months of continuous history at any point during the analysis period are shown. Funds are compared with unhedged Barclays Global Aggregate Bond Index for entire period they have existed.

Sources: Vanguard calculations, based on data from Thomson Reuters Datastream and Morningstar, Inc.

–6 –4 –2 0 2 4 6%

49%

8%

16% 27%

57

% of funds had a higher return than the benchmark

–15 –10 –5 0 5 10 15%

Lower Greater

Volatility relative to unhedged benchmark

LowerGreaterReturn relative to unhedged benchmark

–6 –4 –2 0 2 4 6%

49%

8%

16% 27%

–15 –10 –5 0 5 10 15%

Lower Greater

Volatility relative to unhedged benchmark

LowerGreaterReturn relative to unhedged benchmark

76

% of funds exhibited greater risk than the benchmark a. Fund performance versus unhedged benchmark

b. Fund volatility versus unhedged benchmark

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these higher returns. For example, we found that 76% of the funds in our sample exhibited greater risk than the benchmark over time (see Figure 1b, on page 3).

Risk can take various forms, including currency risk, interest rate risk, and credit risk. Although it is difficult to precisely measure the impact of each of these risks and their total volatility contribution within each fund, we used returns-based style analysis5 to develop a better understanding of how fund exposures differ from the benchmark.

Figure 2 displays the relative exposures (over- or underweight positions) for the average active global bond fund in our study universe relative to the unhedged Barclays Global Aggregate Bond Index during the ten years ended December 31, 2012.

Notably, the average exposures in active global bond funds (relative to their benchmark) favour

logic behind this is clear: Because investors need to be compensated for bearing increased risk, they will demand extra yield—that is, the risk premium. And when confronted with the challenge of outperformance, active managers are likely to invest in securities that have these risk premiums associated with them (as shown in Figure 2). For example, the exposure to emerging-market bonds (one of the highest-returning segments of the global fixed income universe in recent years6 and historically only marginally represented in the global bond index) has been sizable, while corporate and securitized bonds have also been overweighted, but to a lesser extent. Conversely, active global bond funds’ exposure to U.S. government bonds, whether U.S. Treasury securities or other government-related issues—all of which have lower risk premiums than higher-risk securities such as those in emerging markets—has been significantly lower than that of the index.7

Figure 2. Estimated active global bond fund exposures relative to the Barclays Global Aggregate Bond Index

Note: Relative exposures were estimated by comparing sector exposures identified by returns-based style analysis with sector exposures of unhedged Barclays Global Aggregate Bond Index for ten-year period ended December 31, 2012.

Sources: Vanguard calculations, using data from Morningstar, Inc., and Barclays.

–15 –5 0 5 15%

10

–10

More risk Less risk

Emerging market

10

%

Corporate

5

%

Securitized

3

%

U.S. government-related

–8

%

U.S. Treasuries

–10

%

Exposure relative to unhedged benchmark

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There is nothing inherently wrong with applying strategic tilts in an actively managed portfolio, but investors should keep in mind that high-quality government bonds have proven to be strong diversifiers to equity market risk in times of market stress, such as during both the global financial crisis of 2008–2009 and the U.S. Treasury downgrade in August 2011 (Kinniry, Schlanger, and Philips, 2012).

Accordingly, investors should be aware that reducing exposure to government bonds in favour of other securities with a higher expected risk premium may dilute the diversification potential of a portfolio during future periods of market turmoil.

Incorporating risk into performance analysis To appropriately measure performance, it’s important to adjust for the additional risk that has accompanied deviations from the benchmark. That allows us to determine whether any excess returns are the result of deft manager decisions or simply a willingness to accept greater risk through the beta exposures identified through the style analysis.

To analyze the risk-adjusted performance of global bond funds, we first calculated the return- to-risk ratio for each fund and for the benchmark over the ten years ended December 31, 2012.

We then compared the two to see whether the funds generated more or less return per unit of risk than the benchmark. Figure 3 displays the results, in order from lowest relative risk-adjusted performance to highest relative risk-adjusted performance. A negative number means a fund produced less return per unit of risk than the benchmark, while a positive number means a fund produced more return per unit of risk than the benchmark. The results show that less than half (41%) of active global bond funds outperformed on a risk-adjusted basis—notably fewer than the 57% that outperformed purely from a return perspective.8

8 We also performed this analysis over numerous other time periods ranging from one to 15 years, and the same relationship held; once we adjusted global bond fund returns for risk, a smaller proportion outperformed.

Figure 3. A minority of active global bond funds produced more return per unit of risk than the unhedged benchmark

Notes: Risk and return were calculated and compared with those of unhedged Barclays Global Aggregate Bond Index for all funds with at least 36 months of continuous history during ten-year period ended December 31, 2012. The return-to-risk ratio for the benchmark during this period was 0.98.

Sources: Vanguard calculations, using data from Morningstar, Inc., and Barclays.

Return per unit of risk relative to unhedged index –1.50

0 1.50

0.75

–0.75

Weaker relative risk-adjusted performance

59 %

Stronger relative risk-adjusted performance

41 %

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The impact of currency

To this point in our analysis, all of our fund-

performance measures have been calculated relative to the unhedged Barclays Global Aggregate Bond Index, since most active global bond funds do not fully hedge their currency exposure. However, foreign currencies can represent a sizable source of volatility for global bond funds (Philips et al., 2012). Therefore, it is worthwhile to analyze risk-adjusted performance relative to the hedged Barclays Global Aggregate Bond Index as well. Figure 4 displays the return per unit of risk generated by active global bond funds relative to the hedged benchmark. For long- term investors primarily concerned with maximizing risk-adjusted performance, the record of active global bond fund managers has been disappointing (as the figure shows, only 4% of managers produced stronger relative risk-adjusted returns). For more on the benefits of hedging currency exposure, see Philips et al. (2012).

Conclusion

On the surface, using actively managed strategies looks attractive in the global bond sphere, as a majority (57%) of active global bond funds outperformed the unhedged Barclays Global Aggregate Bond Index over the ten years ended December 31, 2012.

However, our analysis shows that the returns of active global bond funds have clearly benefited from an increased relative exposure to risk. Utilizing risk-adjusted returns is, therefore, a more relevant method of evaluating the performance of active global bond funds.

We reiterate the finding of this analysis that once risk is taken into consideration, a minority of active global bond funds outperformed a global bond benchmark. Accounting for risk reduces the number of outperformers to 41%. Adjusting for foreign exchange movements, the number of outperformers is further reduced to just 4%. Therefore, if the primary objective of an investor is to maximize risk- adjusted performance within the global bond asset Figure 4. Even fewer active global bond funds produced more return per unit of risk than the

hedged benchmark

Notes: Risk and return were calculated and compared with those of hedged Barclays Global Aggregate Bond Index for all funds with at least 36 months of continuous history during ten-year period ended December 31, 2012. The return-to-risk ratio for the benchmark during this period was 1.75.

Sources: Vanguard calculations, using data from Morningstar, Inc., and Barclays.

Return per unit of risk relative to hedged Barclays Global Aggregate Bond Index –1.50

0 1.50

0.75

–0.75

Stronger relative risk-adjusted performance

4 % 96 %

Weaker relative risk-adjusted performance

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References

Bosse, Paul M., Brian R. Wimmer, Christopher B.

Philips, and Joanne Yoon, 2013. Active Bond Fund Excess Returns: Is It Alpha . . . or Beta? Valley Forge, Pa.: The Vanguard Group.

Kinniry Jr., Francis M., Todd Schlanger, and Christopher B. Philips, 2012. Recent Stock Market Volatility: Extraordinary or ‘Ordinary’? Valley Forge, Pa.: The Vanguard Group.

Kinniry Jr., Francis M., Donald G. Bennyhoff, and Yan Zilbering, 2013. Costs Matter: Are Fund Investors Voting With Their Feet? Valley Forge, Pa.:

The Vanguard Group.

Philips, Christopher B., Joseph Davis, Andrew J.

Patterson, and Charles J. Thomas, 2012. Global Fixed Income: Considerations for U.S. Investors.

Valley Forge, Pa.: The Vanguard Group.

Philips, Christopher B., Francis M. Kinniry Jr., and Todd Schlanger, 2013. The Case for Index-Fund Investing. Valley Forge, Pa.: The Vanguard Group.

Sharpe, William F., 1992. Asset Allocation:

Management Style and Performance Measurement.

Journal of Portfolio Management 18: 7–19.

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