|Bond Funds: Treadmill to Oblivion?|
Remarks by John C. Bogle, Founder and Senior Chairman The Vanguard Group of Investment Companies
Before the Fixed Income Analysts Society, Inc.
New York, NY
March 18, 1998
The rise and decline of the bond fund empire is one of the most captivating, yet untold, chapters in the annals of the mutual fund industry. I tell it today simply because it presents a picture of complacency and overreaching by so many operators and managers of fixed income funds, but a picture that might well serve as a lesson that the mutual fund principles of diversification and managementas valid today as they have ever beensimply cannot provide adequate returns to investors when they are offset by more-than-compensating cost encumbrances.
Your memories do not have to be particularly long to recall that, as recently as 1993, bond fundsthen with assets of $760 billionwere the largest component of the mutual fund industry. Indeed, at their peak of importance, reached in 1986, bond fund assets of $260 billion were 60 percent larger than the $160 billion invested in equity funds.
Since then, of course, we have seen a powerful resumption of the long post-1982 bull markets. In the booming stock market, equity fund investors have enjoyed record returns (16 percent per year). While a very good bond market also brought generous returns to bond fund investors (8.5 percent), they paled by comparison with stocks. Partlybut only partlyas a result, bond fund assets of $800 billion today are an equally pale reflection of the $2.4 trillion in equity fundssome 60 percent smaller. Turnabout, I suppose, is fair play.
But I would submit to you that the relative performance of the stock and bond markets was only one of two major causal factors in the huge decline in the relative importance of the once-dominant bond fund component of the industry. The other factor is equally basic: as a group, bond funds have failed to meet the legitimate needs of investors in terms of providing adequate relative returns. And if this still-important component of the burgeoning mutual fund industry doesn't make important structural changes to serve investors, the third chapter of its history, following the rise and decline, will be the complete fall of the bond fund empire.
The first chart below shows the relative growth of these two components of this burgeoning industry, while the second chart illustrates the remarkable rise and equally remarkable decline in the importance of bond funds relative to equity funds. Unless we change our ways and give bond fund shareholders a fair shake, the final outcome will surely echo Gibbon's landmark history, The Decline and Fall of the Roman Empire. Bond funds will be on a treadmill to oblivion.
Bond Fund vs. Equity Fund Assets and Relative Assets
"Misery Loves Company"
I am not quite alone in my concern about the dubious investment utility of today's bond funds. For I am joined by no less a proven investment professional than Peter Lynch, heretofore best known, as it were, for sharing my conviction about the merit of stock index funds ("most investors would be better off in an index fund," he said). In the case of bond funds, he says in his 1993 book, Beating the Street, "their purpose in life eludes me." And well it should. For, as he adds:
"Bond funds (have been) consistently outperformed by individual bonds, sometimes by as much as 2 percent a year . . . (doing) worse relative to the bonds the longer the funds were held. The benefits of expert management were exceeded by the expenses that were extracted from the funds to support the experts."
He added that, "since one U.S. Treasury bond or Ginnie Mae certificate is the same as the next, there is little a manager of one of these funds can do to distinguish himself from competitors." This reasoning led to what Mr. Lynch described as "Peter's Principle #5: There's no point in paying Yo-Yo Ma to Play the Radio."
Bless Peter Lynch for the simple investment truism that he has revealed: in highly efficient market segments comprised of commodity-like securities (long-term treasury bonds, for example), it is extremely difficult for even the most brilliant and successful money manager to garner a significant margin of advantagebefore the deduction of costs. It follows, then, that it is virtually impossible for him to avoid providing returns to the shareholders of the funds he managesafter the deduction of coststhat fall well short of market returns.
The record is clear on this point. Over the past five years, for example, the return of an average corporate bond fund has lagged the return of the corporate bond market by an average of 1.5 percent per yeara 1.3 percentage point shortfall for the no-load funds, and a 1.8 percentage point shortfall for the much larger group charging sales loads, either through front-end loads or the noxious annual hidden loads known as 12b-1 fees that are incorporated into fund expense ratios to help the funds' managers to sell more shares. The same pattern is equally apparent in the government bond and municipal bond arenas, as this table shows:
*For each market index groupcorporate, government, and municipalthe return is an average of the appropriate Lehman Bros. short, intermediate, and long-term indexes. The returns of corporate, government, and municipal funds reflect a similarly weighted average of short, intermediate, and long-term funds.
Facing the situation that this differential cost structure exemplifies, Mr. Lynch presents the sales charge issue in this way: "another mystifying aspect of bond fund mania (and, I would emphasize, mania it was when he wrote his book in 1993) is why so many people are willing to pay a . . . sales charge, a.k.a. load, to get into [bond] funds." He is not really mystified, however, for that question quickly leads him to the "Yo-Yo Ma principle" he has articulated. Once again, he and I agree. Yet fully three of every five bond funds get awayapparently without challengewith charging a load. Indeed, anomalous as it may seem, three-quarters of the assets of all bond funds are owned by shareholders who have paid a sales load as the ticket of admission to a game that, as a general rule, is not worth playing.
A Flagrant Example
Let me single out just one flagrant example of the impact of costs on returns in the most efficient of all bond markets: short-term government bonds. The funds in this category carry an annual cost handicap of 1.01 percentas, well, low as 0.68 percent for the average no-load fund and 1.73 percent for the average load fund. Just imagine it. Just to make the point clear: in the case of the average no-load fund, costs would consume 13% of the current yield on the U.S. Treasury 2 ½ year note; in the case of the average load fund, 32%. That penalty could fairly be described as confiscatory.
You are all bond market professionals, and so I ask you, what are the chances that you or one of your fellow professional investors could select a portfolio that would add fully 50% to the return of a short-term Treasury portfolio in order to earn his keep? That is the truly awesome challenge of raising a net fund return of 3.6 percent (5.31.7) by 1.8 percentage points to the 5.4 percent return required to add just 10 basis points of value? If you were to argue that there was a 1 in 1000 chance (which I doubt), my next question would be: what chance would an investor have of identifying that manager in advance? It just doesn't seem like a bet worth making. Yet investors have placed $25 billion in short-term government bond funds.
And it gets worse. Some funds, anxious to provide market yields, make a practice of purchasing Treasury notes at a premium, and publish a yieldand actually pay a dividendthat fails to amortize that premium. (In fairness, they are required to also report an "SEC yield" that is net of amortized premiums.) Result: higher income now, a guaranteed capital loss later. This horrible example resulted in shareholders of one fundonce with more than $1 billion in assetsexperiencing a decline in net asset value from $10.19 per share in 1991 to $8.62 as 1998 began, a capital loss of 15% for a "safe" investment in U.S. government-guaranteed short-term paper.
Now, I've given you these negative examples of what is happening in the bond fund arena simply to set the stage for a comprehensive examination of the role of costsexpense ratios and sales chargesin shaping returns. All bond funds are not created equal. Bond index funds differ from actively managed funds. Low-cost funds differ from high-cost funds. Managers have different skill levels. In all, some bond funds give investors the inalienable right to overpay; some (admittedly a much smaller number) give investors the equally inalienable right to a fair shake. The principal conclusion of my research may be obvious: costs matter.
How Much Do Costs Matter?
But it's worth determining just how much costs matter. So let's examine the extent to which costs are the determinant of returns in the fixed income fund arena. I'm going to try to present my case in an orderly, lawyer-like manner, using four large and diverse segments of the industry, in which bond fund policies are based on clearly defined maturities, and bond fund portfolios are oriented to high-quality issues. As it happens, these are the largest four segments of the bond fund industry: long-term municipal bonds, short-term U.S. government bonds, intermediate-term government bonds (including GNMAs), and intermediate-term general (largely investment-grade corporate) bonds. In all, 448 fundsabout 70 percent of all bond funds in the Morningstar listcomprise these four segments, so we surely have a representative sample.
The results were consistent and uniform. In three of these four segments, the low-cost quartile outpaced the high-cost quartile, by an amount very closely equivalent to the difference in expense ratios. (That is, each quartile had about the same gross return, and costs accounted for substantially all of the difference among funds.) In the fourth case, returns in the low-cost quartile ran only slightly above returns in the high-cost quartile, but the high-cost funds held portfolios that were significantly riskier in every respect.
Long-Term Municipal Bonds
First, I'll consider high-quality long-term municipal bonds. Let's begin with a look at the entire set of funds in the group, using five-year returns as reported by Morningstar Mutual Funds. There are 92 funds in this group, and this scatter diagram presents for each the annual rates of return on the vertical axis and the annual expense ratio on the horizontal axis. I've also shown the assumed results of an index fund (though it would be difficult to replicate the municipal bond index) for purposes of illustration.
To simplify the analysis, let's divide the funds into four quartiles, ranging from the highest cost to the lowest cost funds, and see what conclusions emerge. This table shows the results:
The direct relationship between low cost and high returns shown in the first two columns could hardly be more obvious. Expenses in the high-cost quartile were 0.80 percent more than in the low quartile, and returns 0.91 percent less. Equally obvious is the fact that, high-cost or low-cost fund, the gross returns earned by the funds are remarkably similarabout 7.70 percent. While the gross returns of the lowest cost managers were just a touch better, the lion's share of their advantage lay in the fact that their managers consumed the smallest percentage of the returns available in the long-term tax-exempt bond marketjust 7 percent, versus 18 percent for the high-cost managers. Clearly the expenses of the low-cost hypothetical index fund consumed but a tiny (3%) fraction of return, and its performance can hardly be considered wanting.
How about the possibility that differences in volatility, in quality, or in duration played a role. Alas, there is very little difference in risk. This table presents the facts:
As you can see, the slight differences in duration and volatility that exist favor the actively managed low-cost funds, with each group having about the same portfolio quality. But the index fund achieved its competitive pre-cost return with a significantly lower duration (and thus less risk) and substantially higher quality (100% AAA versus 60% for the managers). These differences reinforce the clear conclusion: the winning group of long-term municipal bond funds are those with the lowest costs.
Short-Term Government Bond Funds
For our second example, we'll move all the way down the maturity spectrum to short-term funds, using U.S. government bond funds as the example. There are 100 funds in this category, and our opening diagram presents returns and costs for the entire group:
Note that the lowest cost funds provided a gross return of 5.93 percent, or, after a 0.42 percent expense ratio, a net yield of 5.51 percent. The high-cost funds earned a bit more (6.15 percent) but, after a heavy 1.62 percent expense hit, delivered but 4.53 percent to investorsalmost a full percentage point less. Here again, we see a direct relationship between low cost and high return. The question comes down to a simple one: which would you rather have, a manager who picks short-term government bonds for you and takes 27 percent of what he earns, or one who picks the same bonds and takes 7% of the return for his efforts? Or, looked at from your own vantage point as an investor, would you rather earn 93% of the market return or 73 percent? That should not be a hard question to answer.
As it turns out, return is not the only issue here. For while we might expect that "other things are equal" in such a generic asset class as short-term government bonds, let's at least examine the possibility of inequalities:
Well, we've learned something worth knowing: the low-cost fund group not only delivers the highest returns, but it assumes the lowest risks, measured both by duration and price volatility. The index fund is about average for the full list. (Credit quality is similar throughout, as you would expect.) The slight lowering of risk as cost declines helps to explain why each point of reduction in cost accounts for slightly less than a full point of higher return. In any event, to state the obvious, the low-cost short-term corporate bond funds let you eat your cake and have it too. They provided the highest returns, hand-in-hand with the lowest risks. It is truly a winning combination.
Intermediate-Term Government and GNMA Funds
Now let's move from long and short maturities to intermediates. Perhaps the best test of our thesis is the relationship between costs and returns among intermediate-term and GNMA funds. (Both have demonstrated very similar returns over time, and Morningstarproperly, I thinkincludes them in a single 169-fund category). You must be getting used to this pattern of cost and return by now, but I'll show it again anyway. Here's the chart:
We seem to be in a bit of a rut here. Quartile by quartile, we see substantially similar gross returns, but a large gap in net returns caused, substantially all of which is engendered by cost. If there are differences in risk, they are quickly resolved in favor of the lowest cost funds once again, as this now-familiar chart shows:
**25 of the 35 funds in the quartile are 100% in governments; the 10 outliers bring the average to 90%.
While durations of the managed funds are about the same, the low-cost intermediate-term government fund group, as it turns out, carries volatility risk about 20% less than its higher cost peers. The index fund duration is some 20% lower. Portfolio composition is fairly uniform. So, with duration, volatility, and portfolio quality all in the same ballpark, cost carries the day, dollar for dollar.
Intermediate-Term Corporate Bond Funds
I'll burden you with one more example only because, while it sends the same message, it sends it in a different language. But it illuminates the point I am hammering home. In the intermediate-term corporate bond fund category, net returns are fairly constant irrespective of costs, though the lower-cost funds still tend to deliver slightly higher returns to investors. The index fund proves to be a singularly excellent performer, in part because of its low costs, but also because it is one of the fabled shoemakers who sticks to his last, faithful to its definition by holding 100% investment-grade corporate bonds.
This same pattern becomes especially clear when we examine the four cost quartiles. The low-cost group provided a market return advantage of 0.16 percent (7.31 percent versus 7.15 percent) over the high-cost group, although its cost advantage was a much more substantial 0.74 percent (0.55 percent versus 1.29 percent).
How have these high-cost managers been able to offset most of their large-cost handicap? Did they do so because their high fees somehow endowed them with greater management skills? Or did they simply assume larger risks? This next table gives that question a clear and unequivocal answer:
As the table makes clear, with
each higher level of costwithout a single exceptionhigher
risk was assumed by the managers. It seems as though they were determined
to provide competitive returns, but, given their higher costs, they
had no recourse but to assume higher risks. This apparent relationship,
as far as I know, has remained undisclosed. But it is there. There
in the form of higher duration. There in the form of higher price
volatility. And there in the form of lower portfolio quality. (The
difference between the low-cost portfolios83 percent in governments
and A-rated corporates and 8 percent in below-BBB bondsand
the high-cost portfoliosless than half as much in governments
and investment grades and more than twice as much in below-BBBsis
material.) So the same direct dollar-for-dollar trade-off we've seen
earlier between return and cost has been supplanted in part by a reverse
trade-off between risk and cost. In the corporate bond fund segment
of the mutual fund industry, that eternal trade-off is at its most
This chart makes it obvious that the reduction in final value engendered by cost rises from "only" 20 percent after one decade to a truly confiscatory 35 percent after four decades. Ignorance of this cumulative cost may be intellectual bliss, but it is financial devastation.
The fact is that lots of defenses exist to avoid the fee overreaching that is suggested by the return-risk-cost trade off. But none of them seem to be working.
I want to be clear that low-cost bond fund options do exist today. But there are not very many. Only 36 of the 716 bond
funds in the Morningstar 5-year data base have expense ratios below 0.50%,
which I think of as the upper limit of a fair cost. Universally, these 36
funds rank in the high range of returns among the top-quartile performers.
Why aren't there more low-cost options, and when will investors demand them
and advisers supply them? Why aren't there more bond index funds? The grand
total, as far as I can tell, is nineastonishing in the light of the
data I've presented earlier. That paucity is appalling in commodity-type market
segments where fund cost is a critical determinant of returns to shareholders,
and where an index fund can be run for 20 basis points or less. Why, in short,
are the fees and loads of most bond funds so exorbitant?
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