Are active bond funds using the wrong benchmark to measure performance?
Bond funds are back in fashion.
After years in which investors were forced to accept exceptionally low yields, today’s higher-rate environment has made fixed income considerably more interesting. Yields are more compelling, income is once again a meaningful part of total return, and active bond managers have more opportunities to differentiate themselves.
The performance numbers are reinforcing that enthusiasm. Over the past year, roughly 75% of fixed-income funds outperformed the Bloomberg U.S. Aggregate Bond Index (the Agg), compared with only about 40% of U.S. stock funds beating the S&P 500 over the same period.
For investors and advisors, however, there is an important qualification hiding inside those numbers.
A fund can outperform the Agg without taking less risk. It can outperform because it owns securities that the Agg does not own, takes more credit exposure, assumes greater interest-rate sensitivity or moves into entirely different asset classes. In other words, “beating the benchmark” can sometimes say more about the risks a manager is taking than about the manager’s skill.
That distinction deserves renewed attention as investors allocate more capital to active fixed income.
The Benchmark Problem
The Bloomberg U.S. Aggregate Bond Index is an important benchmark, but it was never designed to represent every possible bond strategy.
The Agg consists entirely of investment-grade bonds. Roughly half its market value is in Treasury securities, another quarter is backed by U.S. government agencies, and much of the balance is high-quality corporate debt. Most of its securities mature within 10 years.
That makes the Agg a reasonable reference point for a broad, investment-grade U.S. bond portfolio.
It becomes considerably less useful when the portfolio being evaluated has a fundamentally different risk profile.
Morningstar tracks 2,726 fixed-income mutual funds and ETFs, and 1,229 of them use the Agg as their primary benchmark. Yet among those funds are 131 that invest primarily in high-yield bonds.
The Agg contains no high-yield debt.
There are also 62 nontraditional bond funds using the Agg as their benchmark. These strategies may invest in instruments ranging from stock-index options and real estate to business-development companies—none of which are represented in the Agg.
The same issue appears elsewhere. Forty-three bank-loan funds, 24 municipal-bond funds and four emerging-market funds also compare their performance with the Agg, despite the fact that the index contains none of these securities.
That creates a basic analytical problem: a fund can beat the Agg by taking risks that the benchmark does not measure.
For advisors, that is not a minor technicality. It goes directly to how performance should be explained to clients.
Outperformance Can Be a Risk Story
The temptation with active fixed income is to look at the return spread first.
If an active bond fund has produced substantially more than the Agg, it is natural to conclude that the manager has added value. Sometimes that will be true. But the first question should be: What produced the excess return?
There are several possibilities.
A manager may have made better security selections within a comparable risk universe. That is the classic case for active management.
But the manager may also have owned lower-rated bonds, extended duration, concentrated the portfolio, increased exposure to illiquid securities or moved into asset classes offering higher yields. Each decision can increase expected return—but each introduces a different source of potential loss.
Credit risk is particularly important.
A Treasury-heavy investment-grade index does not carry the same default and spread risk as a portfolio heavily invested in high-yield corporate bonds. During periods of economic expansion and stable credit markets, that additional risk can look like skill. Investors collect higher coupons and may benefit from narrowing credit spreads.
The reverse can happen when economic conditions deteriorate.
Credit spreads can widen rapidly, lower-quality securities can fall sharply and liquidity can disappear precisely when investors want to sell. A strategy that looked consistently superior during benign conditions can suddenly produce materially larger losses.
The same principle applies to interest-rate risk.
A fund that holds longer-duration bonds may outperform when yields fall because its securities have greater price sensitivity to changes in rates. But that same duration can become a liability when yields rise.
The result is an uncomfortable but important observation: historical outperformance does not tell an advisor whether the client was compensated for skill or compensated for taking additional risk.
Often, it is some combination of both.
The New Rate Environment Changes the Conversation
This matters more today because the fixed-income landscape is fundamentally different from the ultra-low-rate environment that dominated much of the previous decade.
Higher yields give investors more income and provide active managers with a larger opportunity set. But they also make the consequences of positioning more visible.
When yields were extremely low, investors were already confronting a difficult trade-off: accept limited income from high-quality bonds or move further out on the risk spectrum.
Today, investors can obtain considerably more income without necessarily abandoning high-quality fixed income. That changes the hurdle rate for taking additional risk.
An advisor should therefore ask whether the incremental yield offered by a riskier strategy is sufficient compensation for its incremental credit, liquidity and duration exposure.
That is a more useful question than simply asking whether the fund has beaten the Agg.
The higher-rate environment also creates a potential behavioral problem. Investors who have recently discovered that bond funds can once again generate attractive returns may extrapolate recent performance too aggressively.
A fund that delivered impressive trailing returns may have benefited from conditions that will not persist. Clients may not realize that the attractive return came partly from risks they did not explicitly intend to take.
What Advisors Should Examine
The answer is not to abandon active bond funds.
Instead, advisors should make the due-diligence process more granular.
Start with the benchmark. Before discussing whether a manager has outperformed, determine whether the benchmark actually resembles the portfolio. If a high-yield fund is being compared with an investment-grade index, the performance comparison requires considerable qualification.
Then decompose the return. Advisors should examine how much of the excess performance came from duration, credit quality, sector allocation, security selection and other exposures.
This can change the investment story substantially.
Suppose a fund has beaten the Agg by several percentage points. If much of the difference came from owning lower-quality credit, the appropriate comparison may be another high-yield or multisector strategy rather than the Agg. The question then becomes whether the manager added value relative to peers taking similar risks.
Look beyond yield. A higher distribution yield is not necessarily a higher-quality income stream. Advisors should examine credit ratings, maturity structure, duration, issuer concentration, sector exposure and liquidity.
Stress-test the portfolio. What happens if Treasury yields rise another percentage point? What happens if credit spreads widen substantially? What happens if both occur at the same time?
The answers can reveal risks that a trailing-return chart conceals.
The Client Conversation Needs to Change
There is also a communication opportunity here.
Clients often understand equity risk intuitively. They know that stocks can fall sharply. Bond funds are frequently perceived as the more conservative side of the portfolio, even though the risk profiles of individual bond strategies can vary enormously.
Advisors can make the distinction tangible by describing fixed income along several dimensions rather than treating “bonds” as one asset class.
A short-duration Treasury fund, a municipal-bond portfolio, a bank-loan fund and a high-yield multisector strategy may all sit under the broad fixed-income umbrella. Their potential income, volatility, liquidity and response to economic shocks can be very different.
That framing helps clients understand why two bond funds can produce dramatically different outcomes even when both are marketed as fixed income.
It also makes performance discussions more honest.
Instead of saying, “This fund beat the Agg,” the advisor can say, “This fund produced a higher return, partly because it took more credit and duration risk than the benchmark.”
That is a much more useful statement.
The Real Question Is Risk-Adjusted Value
The renewed interest in bonds is constructive for portfolios. Higher yields can improve income generation, diversification and the prospective role of fixed income in a traditional asset allocation.
But active management should not be evaluated through benchmark performance alone.
The Agg remains a useful reference point for the investment-grade U.S. bond market. It becomes misleading when treated as a universal measuring stick for strategies that deliberately operate outside that universe.
For wealth advisors, the central issue is therefore not whether active bond funds are beating the Agg. It is why they are beating it, and whether clients understand the risks required to produce that excess return.
In the current environment, that distinction is particularly important. A portfolio that generated impressive returns by reaching for credit, extending duration or moving into less liquid securities may look brilliant in a rear-view mirror.
The advisor’s job is to look through the rear-view mirror.
The most useful fixed-income analysis starts with the risks a client owns today, the risks they are being paid to accept, and the risks they may discover only when markets turn.
