Investors likely already know that low cost index funds tend to greatly outperform high fee actively managed funds (to the tune of 1.5% or more annually). That comes as no surprise. However, what was surprising to us is that in fixed income, the tables are greatly turned. While passive funds do have a slight edge over active ones on average (0.18% per year), in many cases high fee actively managed fixed income funds outperform passive ones. This holds true over long time periods, including ten-year horizons.
FINSUM: This is an interesting finding and one that makes intuitive sense. The bond market is vast, hard to access, and full of intricacies. That kind of environment lends itself to specialism in a way that large cap equities does not, and the performance metrics show it.
ETFs are a product that has been growing at breakneck speed. AUM in the product is approaching $4 tn, which is astonishing given that it has really only taken a decade to get there, but still quite a bit smaller than the $16 tn in mutual funds. Experts say that the ETF market is going to increasingly resemble the mutual fund market as offerings diversify into smart beta, thematic ETFs, customizable ETFs, and fixed income. The last area—fixed income—is where creative indexing makes the most sense, as doing so can account for the common weighting issues that are much riskier in bonds than in equities (you don’t want your largest holding to be the issuer with the most debt).
FINSUM: The logic for fixed income ETFs is very strong, especially given how illiquid and restrictive buying bonds directly is. However, smart beta and other active ETFs (which are more expensive) don’t really have a big leg up on experienced mutual funds.
It has been well-documented lately that active managers rarely outperform the market on a routine basis. Essentially, studies have shown that they are expensive and generally unproductive. However, new research shows that there are a subset of funds which are even worse—so-called “closet” trackers. These are funds which advertise themselves as “active” investors, but in reality try to track indexes very closely. Despite the odd mixture, the situation makes sense from their angle. If they advertise themselves as “active” but then track indexes, they are able to charge the high fees of active managers, but do not take the same risks. This means they will almost never fall to the bottom quartile of fund performance, and are therefore less likely to lose their investors. On average, “closet” trackers charge 143 bp in fees per year, very close to truly active funds, which charge 155 bp. Passive funds charge just 61 bp on average. “Closet” trackers have the lowest average returns of any group of funds studied.
FINSUM: This article is a real warning shot for anyone placing capital. Top fees and consistently mediocre returns are the business model of these funds, and one would be wise to give them a wide berth.