Are bond fund managers smarter than equity fund managers?

By now, most investors know that active fund managers struggle to beat the market.

That's the main reason for the surge in popularity of cheap "passive" funds (those which aim to track the market using mechanical methods, rather than beat it using expensive managers).

However, while this is true of funds that invest in equities, it's not the case for every active fund.

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If you're investing in a bond fund, it seems, the choice is far less clear cut.

Why do bond fund managers beat their benchmarks?

Looking for Easy Games in Bonds, a new paper from Michael Mauboussin of Blue Mountain Investment Research, looks at why bond fund managers seem to be better at beating their underlying market than equity fund managers.

The evidence looks pretty compelling. Mauboussin takes Morningstar research and looks at the percentage of active funds in the US that beat the passive alternatives.

For US stocks, going back over both three years and ten years, the numbers are clear. Regardless of whether you go for value, growth or both, very few US equity funds investing in big companies manage to beat a passive option. Over ten years, it's fewer than 10%.

Given those odds, if you are investing in big US companies, then unless you have a very compelling reason to go for a specific active fund, then you should go down the passive route.

But it's a very different picture for bonds. Mauboussin pulls out the "intermediate-term", "corporate" and "high-yield" categories. Over ten years, more than half of the active funds in every category manage to beat their benchmark. And over three years, it's a similar story only "high-yield" disappoints, and even there, more than a third of funds beat the passive option.

So what's the secret? Are bond fund managers smarter than equity fund managers? That's not quite Mauboussin's conclusion (although they're smart enough to choose an easier market in which to outperform, so maybe they are).

Instead, the key advantage that bond fund managers have is that their benchmarks are less demanding in two key ways: ;they are harder for passive funds to track, and they are easier to beat in relatively straightforward ways.

Bond benchmarks are easier to beat

Firstly, bond indices are much more complicated than equity indices. The S&P 500 has about 500 stocks. That's quite straightforward to replicate, which means in turn that any tracking error (the gap between an index and the performance of any index fund that claims to track it) will be small.

That's not the case for bond indices. One of the main ones the Bloomberg Barclays US Aggregate Bond Index contains more than 10,300 securities. As a result, tracker funds only hold a representative sample of the underlying bonds. Mauboussin notes that the leading exchange-traded funds (ETFs) in the sector might hold anything from 25% to 75% of the underlying index.

That means there is more room for tracking error. And that's before you consider the fact that the component parts of the underlying index change more frequently than those of the S&P 500.

Secondly, as John Rekenthaler of Morningstar points out, bond benchmarks are more forgiving than equity benchmarks. If you are a US equity manager, then one way to "game" your benchmark could be to squeeze as many small caps into your funds as you can and keep your weighting to large caps as low as possible.

Over time given that small caps are meant to outperform in the long run this should give you an advantage over the benchmark. However, it's a risky option. For one thing, you can only emphasise small caps so far before you get reclassified and measured against a small-cap benchmark. For another, large caps sometimes end up winning for a long period of time as they had recently.

The Barclays US Aggregate Bond index on the other hand, has more than half of its assets in the safest bonds of all US Treasuries and other government-backed bonds. So as a bond fund manager, you need only have less than half of your money in these "safe" assets to be in with a good shot of beating the benchmark.

There are other elements emphasised by Mauboussin bond markets are less liquid, more idiosyncratic, and arguably less efficient than equity markets, due to the presence of lots of players who buy or sell for reasons unrelated to price (central banks doing quantitative easing, for example). However, the "easy-going" benchmark argument is sufficient for this discussion.

The lesson for investors: don't buy anything you don't understand

The big question of course is: what does this mean for investors?

My first point would be that bonds in general look expensive right now, so this is to an extent, academic. It's true that bonds might stay expensive, but as Will Denyer and Tan Kai Xian of Gavekal point out, if that's the case, then the underlying conditions (low interest rates, dovish central banks) should be good for equities too.

But putting that aside, I think this is yet another illustration of one of the most important points for investors to remember don't buy anything unless you understand what you're buying.

When it comes to buying index funds, that means understanding three things. One, how well does the financial instrument track the underlying index? Two, what does the underlying index actually contain? Three, is that really what you want exposure to?

For example, say you want to buy US stocks. An S&P 500 tracker is the obvious option and it's easy to understand. The big tracker funds do a good job of tracking the index; the index itself is widely used and is a good way to track US stocks; and if you are looking for exposure to a diverse range of the biggest stocks in the US, then the S&P 500 is a decent way to do it. ;

But say you fancy buying Chinese stocks. There are many different trackers, they all track different indices, and they have wildly varying outcomes. (I wrote about this earlier in the year here). So you can't just opt for any old tracker you need to have a better understanding of what you really want to get exposure to.

The same goes for bond funds. Before you start worrying about passive or active or whatever, think about what you want to invest in first. Only then should you narrow down the range of options open to you.

If you can get a passive fund that will give you the desired exposure, that's great it'll be cheaper. But you may find that an active fund as with certain emerging equity markets, for example is the only available option that gives you the exposure you want.

It's the usual story. Don't get distracted by labels, or arguments about humans versus machines. Just decide what you want to buy, then find the cheapest way to buy it.

Speaking of cheap investments, you can get your first six issues of MoneyWeek magazine free if you subscribe now. See what I did there?