Gross Dominance in Jeopardy as Indexing Revolution Engulfs Bonds
Stock pickers in the U.S. have suffered half a trillion dollars in withdrawals since they started losing ground to index-tracking funds five years ago. Now, active bond-fund managers are beginning to feel the heat.
Passive funds won 39 percent of all new money garnered by bond strategies this year, up from 22 percent two years earlier, according to data compiled by Morningstar Inc. (MORN) in Chicago. Assets in exchange-traded funds that track bond markets more than quadrupled since the beginning of 2008 to $168.3 billion, data from the Investment Company Institute show.
Investors are paying closer attention to the value added by active managers as yields hover near record lows and top long- term performers such as Bill Gross and Dan Fuss are trailing markets this year. Eight out of 10 bond-fund managers have underperformed the U.S. market in the past 20 years, compared with 72 percent of stock-fund managers, according to research compiled by Vanguard Group Inc., the firm best known for its low-cost index funds. BlackRock Inc., the world’s largest asset manager, and Legg Mason Inc. said their clients are shifting bond investments increasingly to passive products.
“We’re moving to the second phase of the index revolution,” Peter Fisher, head of fixed-income at BlackRock, said in an interview. “The world is a frightening, uncertain place and investors want to make their portfolios much simpler so they can sleep at night.”
Shielded From Competition
Bond funds have largely been shielded from passive, low- cost competitors because investors had few incentives to scrutinize fees as the 30-year rally in Treasuries lifted returns. Active bond mutual funds garnered $537 billion in deposits between 2008 and 2010 as investors rushed to the perceived safety of bonds, according to Morningstar. This year, active bond funds attracted $52.1 billion in estimated net deposits through September.
Bond markets are also harder to track because of the number of securities in many bond indexes. The Barclays Capital U.S. Aggregate Index has more than 7,500 securities, 15 times the number in the U.S. benchmark stock index, which contains the 500 largest U.S. companies.
Active U.S. stock pickers such as Fidelity Investments’ Harry Lange and Legg Mason (LM)’s Bill Miller, who at their peak collectively managed $4.2 trillion, have suffered $537 billion in withdrawals industrywide since redemptions started in 2006. Miller, whose main fund ended a 15-year record streak outperforming the Standard & Poor’s 500 Index that year, has seen assets tumble from a peak of $21 billion in 2007 to $2.5 billion. Miller on Nov. 17 said he would step down as manager of the fund in 2012 after a 30-year career running it.
‘Active Is Better’
For most bond investors, active managers such as Gross and Fuss, who are unconstrained in their ability to invest in the sectors they deem attractive, are still able to add more value over long periods of time than “plain vanilla” funds that don’t have the same flexibility, said Geoff Bobroff, an independent fund consultant based in East Greenwich, Rhode Island. Deposits into bond index funds may be more driven by institutions rather than individual investors, he said.
“In a less volatile environment, active management in fixed-income is better and the primary reason for that is that they are more nimble and not constrained by their benchmarks,” Bobroff said in an interview. “Indexation in bonds is very different from equities as you’re seeing more institutional investors wanting to mix and match ETFs in their bond portfolios whereas on the equity side you see more retail investors.”
Pimco’s Total Return strategies have driven deposits since the 2008 credit crisis, as investors flocked to top-performing bond managers. Gross’s Total Return open-end strategies drew $15.4 billion in 2008, $51.2 billion in 2009, and $23 billion in 2010, according to estimates by Morningstar. This year that Pimco strategy has had $2.9 billion in redemptions, according to Morningstar.
“Pimco Total Return has been a large driver of all bond fund flows,” Timothy Strauts, an ETF analyst at Morningstar, said in an interview. “The poor performance of that fund may have something to do with it, but also as yields have fallen, lower fees become more and more important.”
Gross, who runs the $244 billion Pimco Total Return Fund, has advanced 1.9 percent this year through Nov. 25 at less than one-third the pace of the benchmark, in part because of his avoidance early this year of U.S. Treasuries. The $18.8 billion Loomis Sayles Bond Fund (LSBDX), co-managed by Fuss and Kathleen Gaffney, rose 0.8 percent, according to data compiled by Bloomberg. The Loomis Sayles fund holds no Treasuries.
Gross earlier this year announced plans to open his first actively managed ETF, the Pimco Total Return Exchange-Traded Fund, as Newport Beach, California-based Pimco seeks to expand in the fastest-growing segment of the industry. The new ETF would charge annual fees of 0.55 percent, the firm said in a July filing. The institutional share class of Gross’s mutual fund, available in some retirement accounts, carries an annual expense ratio of 0.46 percent, while the firm’s most widely used retail share classes charge fees ranging from 0.75 percent to 0.85 percent.
Industrywide, the number of bond ETFs has grown from just six in 2006 to more than 160, according to data from Washington- based ICI, including those that invest in government bonds, emerging markets, high-yield bonds and other specific categories.
“Bond index funds have been the unsung heroes in the index wars,” Dan Wiener, chairman of Adviser Investments in Newton, Massachusetts, said in an interview. “The worry for active managers should be whether their cost structure is too high and whether they are adding value.”
The average intermediate-term bond fund has returned about 4.7 percent this year through Nov. 25, according to Morningstar. That compares with the 6.8 percent advance in Barclays Capital U.S. Aggregate bond market index in the same period.
Many of the bond-fund managers were hurt this year as the sovereign-debt crisis in Europe combined with concerns that the U.S. economy is slowing sent investors to the safety of government-backed securities.
“I think you’re going to see a huge movement into indexation of bonds, much lower fees,” BlackRock (BLK)’s Chief Executive Officer Laurence D. Fink said during a Oct. 19 conference call with investors and analysts. “If you don’t believe interest rates have that much further to go down over the next few years, you’re only earning a few hundred basis points of return.”
‘Moving to Passive’
Legg Mason’s CEO Mark Fetting also noted that clients increasingly shifted to passive bond products. Legg Mason, based in Baltimore, manages active stock and bond funds. In an Oct. 27 call with investors and analysts, Fetting said he noted a “couple of clients moving to passive.”
“Although, if we get into a more sustained, less volatile environment, I think clients will appreciate the value that comes from active strategies,” Fetting said.
New York-based BlackRock, the world’s biggest provider of ETFs, and Vanguard Group, the Valley Forge, Pennsylvania-based firm best known for its index funds, are among firms that stand to benefit from a shift in investor preferences.
BlackRock’s iShares ETFs drew $15.8 billion into fixed- income products this year through Sept. 30, even as investors pulled $3.3 billion from active bond funds at the firm, according to a quarterly filing.
The top-selling bond fund this year is the $46.6 billion Vanguard Total Bond Market II Index Fund, which tracks the U.S. bond market. The fund has taken in $4.8 billion in investor money this year through Oct. 31, data from Morningstar show.
Overall, index funds and ETFs have attracted $34.5 billion of the $88.4 billion that all U.S. fixed-income funds have gathered so far this year, according to Morningstar.
“We’re in the very early stages of index domination in the bond world,” Francis Kinniry, a principal in Vanguard’s investment-strategy group, said in an interview. “It’s very difficult for active bond managers to add value over time as it’s less about security selection and more about big decisions on sectors and interest rates.”
Over the past 10 years, 71 percent of active bond funds have performed worse than the U.S. fixed-income market, Kinniry said, citing numbers compiled by Vanguard using data from Morningstar and Barclays Capital. Over the past 15 years, 85 percent have trailed the benchmark, he said.
On the stock side, 62 percent of active managers lagged behind the U.S. stock market over the past 10 years, according to Vanguard using data from Morningstar and Dow Jones Inc. Over the past 15 years, 67 percent of the active U.S. managers performed worse than the market, the data show.
The $10.7 billion Vanguard Intermediate-Term Bond Index (VBIIX) fund, which tracks an index rather than trying to beat it, has topped 99 percent of intermediate-term bond funds this year, according to data from Morningstar. The fund, which has an expense ratio of 22 basis points, has returned 9.2 percent, trouncing the returns earned by Gross and Fuss this year. Over the past five years, the fund has advanced at an annual rate of 7.5 percent, in line with Gross’s fund.
Gross and Fuss have beaten indexes over a longer period. Over the past 10 years, the Vanguard fund has advanced 6.58 percent annually, according to Morningstar, behind Gross’s return of 6.64 percent. Fuss’s 10-year record is even better, rising at an average annual rate of 9.84 percent over the past decade.
Only two intermediate-term funds have beaten the Vanguard index fund this year. One is an actively managed bond fund run by Jeffrey Gundlach, the $1.2 billion DoubleLine Core Fixed- Income fund, which has advanced 10.3 percent this year. The other is the $328 million BlackRock Bond Allocation Target Shares, which has advanced 13 percent this year.
BlackRock’s Fisher said the move to bond indexing reflects a shift in the way investors, both retail and institutional, are allocating money. Investors understand that asset-allocation, the process of dividing money between stocks and bonds or between sectors such as high-yield and government bonds, accounts for anywhere from 60 percent to 80 percent of their returns, he said. With ETFs, investors are able to build their own portfolios, according to Fisher.
As bond-market returns are falling, investors are also paying a lot of attention to fees, Morningstar’s Strauts said in an interview. The average fee charged by a fixed-income ETF is 0.31 percent, compared with the 0.4 percent average fee for index mutual funds and the 1.05 percent fee for active bond funds, he said.
“In an environment when yields are so low, the fees can result in a sizable difference for investors,” Strauts said.
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