On the Money with Dynamic Funds

PARTICIPANTS

Professor Martijn Cremers
Dean of Notre Dame’s Mendoza College of Business

Lloyd Perruzza
Head of National Accounts, Dynamic Funds

Mark Brisley: You're listening to On the Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders.

Lloyd Perruzza: I'm your host, Lloyd Perruzza, Head of National Accounts, VP Managed Assets & Fixed Income Strategy for Dynamic Funds.

Today’s podcast is strictly about helping all investors better understand the world of fixed income, which has gone from being that boring “out of sight; out of mind” part of many portfolios before 2022, to a stomach-churning rollercoaster ride since.

This has left many investors examining the role that bonds and bond funds play in their portfolios.

What’s more, this podcast is extremely special because we were able to secure an exclusive audience with one of the world’s foremost minds in finance.

Professor Martijn Cremers Dean of Notre Dame’s Mendoza College of Business and acclaimed researcher in the field of money management.

In our podcasts, I am usually quick to summarize our guest’s bio, but in this case, it is well worth our time and my sincere pleasure to explain why this is such a thrill for us to have the good professor join us today.

If you are anything like me, and find the world of asset management genuinely fascinating, the work of Professors Cremers has been foundational to investing around the world.

In much the same way as Professor David Swensen of Yale changed the world of pension & endowment management OR Nobel prize winners Harry Markowitz & William Sharpe changed the way we look at building portfolios.

Professor Cremers & his peers have been pivotal in providing all investors everywhere THE key foundational research to judge the merits AND the success of their investment management systems.

If you pay anyone anywhere a fee to manage any money for you, Professor Cremers work is something you must get to know it is that important.

From his 2009 groundbreaking research paper on active share which helped investors everywhere for the first time to finally judge the legitimacy & efficacy of their investment disciplines to his latest 2023 draft paper on bond investing the opportunities to improve your investing prowess from his teachings are many!

In fact, his new paper is exactly the reason I contacted him and it will be the basis of our conversation today.

With that welcome Professors Cremers, a genuine honour to have you join us.

Martijn Cremers: Thank you, Lloyd. Thank you for having me.

Lloyd: As I noted, Professor, it was your newest paper, "Passive Bond Fund Management is an oxymoron." It was the catalyst for this podcast. On the assumption that many of our listeners aren't likely nor eager to spend their weekends reading PhD papers on bond management, why do you feel understanding this research is important to investors today?

Martijn: The key problem that our paper focuses on is how can you, as a non-professional investor, best invest in bonds. Through passive bond funds or through actively managed bond funds? This very basic question is important to all investors as exposure to bonds in your overall portfolio is critical and really that is a central decision to make. The key choice is between passive funds that track a benchmark at typically low costs.

Versus an actively managed fund that tries to select individual securities to outperform that benchmark and do so if that's possible at a lower risk. Then secondarily, if you decide to invest in an actively managed fund, what to pay attention to when choosing among actively managed bond funds?

Lloyd: Why don't we start by helping investors first understand how a passive bond index is typically created, and the hurdles commensurate with replicating them? I think that'd be a good place to get going here.

Martijn: Yes. Passive bond funds, they aim to provide investors with returns that closely track a particular benchmark index. That can be, for example, the overall bond market or a particular segment of the overall bond market. For example, bond issued or sold by the government or bond sold by corporations. The most commonly followed bond benchmark for US bonds is called the Bloomberg US Aggregate Index. This contains bonds across all segments of the US bond market and provides a very comprehensive exposure to US bonds.

The two main challenges of bond benchmarks are first, there's so many different securities to consider. The US government, Canadian government, large corporations, they issue or sell many, many different bonds with different maturities. For example, the most common stock benchmark is the S&P 500, containing, of course, about 500 US stocks. The most common bond benchmark that I just mentioned, the Bloomberg US Aggregate benchmark, it contains over 12,000 different bond securities. Many of these 12,000 bonds are not very liquid. They're hard or costly to trade.

Passive bond funds have an enormous challenge. They try to do two things. First, closely track their benchmark. Second, do so at a low cost. That's really difficult to do if tracking the benchmark involves, well, 12,000 securities, many of which are relatively expensive to trade.

Lloyd: How do passive bond funds overcome these challenges? What does that mean for performance?

Martijn: The main way that passive bond funds overcome this challenge, that the benchmarks that they try to track have so many different securities. That many of these are expensive to trade. The main way that they overcome this is that their actual investments deviate substantially from their benchmarks. Yes, they try to track these. In practice, they don't try to track these too closely. It's just simply too difficult. They tend to invest in many fewer securities than their benchmarks and typically focus on the more liquid bonds.

That is very different than passive stock funds. Passive stock funds deviate generally very little in their investments from their benchmarks. The typical passive bond fund is so different, that as we document in our study, over half the portfolio of a typical passive bond fund is actually different from their benchmark. It's just not actually passively managed. That's why we say in the title of our paper that passive bond management is really an oxymoron. Passive bond funds are not actually passively managed because, on average, they deviate so much from their benchmarks.

They also tend to trade a lot, both to deal with investors putting money in and out, and also to try to track their benchmarks with many fewer securities than that are in the benchmark. To track while you're not actually investing in exactly the same way makes them trade a lot, and that leads to underperformance. In our study, we find that, on average, passive bond funds only perform their benchmarks by about 26 basis points a year.

Lloyd: Now, I'm curious to understand some of your other findings. Specifically, your research noted the lack of positive skewness in bond returns reduces the advantages of holding a broad market index. That brings to mind two quick things here. First, can you please explain the concept of positive skewness in a way that someone who isn't a bond expert can digest? Second, how does this manifest to hurt passive and closet bond index products?

Martijn: This is a very technical question. Let me start at the high level and go more into the technical aspects of it. First, security returns, bonds and stocks are risky. Namely, they can be higher or lower than you may expect. Skewness is a measure of how symmetric these returns are on average, or how much they differ from the expectation on either side. If securities have the same likelihood to have returns that are higher or lower than the expected return, then the skewness would be low.

Positive skewness means that the returns tend to be more likely to be higher than lower than the expected return. That's the case for stocks. Stocks tend to have fairly large positive skewness on average. The typical portfolio of stocks will have a positive skewness, and that is because the return on stocks has basically unlimited upside potential, but it can never go below negative 100%. That unlimited upside, together with a limited downside, creates an asymmetry. That asymmetry, in this case positive asymmetry, is called positive skewness.

This asymmetry is much less for bonds. Bonds, on average, tend not to have large positive skewness. The reason is that for bonds, the upside is more limited. For any bond you have, the best you can do is that you receive all the cash flows that the bond promises you. I abstract away here from follow-up bonds or bonds with option features. Bonds still, you still have the downside. The issuer, the entity that sold the bond, could go into fault or bankruptcy, and you could lose much of your investment.

As a result, bonds tend to not have this large positive skewness that stock bonds have. How does this then matter for investing in bond funds? If you are dealing with an investment class where some securities could vastly outperform others, but it's hard to predict which securities those are. That's generally the case for stocks. Then there is a benefit to holding lots of different securities. You don't want to miss out on those few securities that may do incredibly well. If the market is driven by a smaller number of securities that are going to outperform vastly, you don't want to miss out.

You want to own lots of different securities to make it more likely that the big winners are in your portfolio. That argument doesn't really hold for bond funds. In the bond markets as a whole, it's not the case that there are a few securities that are going to be the big winners that are going to dominate your portfolio. By investing in bonds, it's less important to own lots of them in the hope that you owned a few bonds that are going to do incredibly well because bond returns are much more symmetrical.

Bond markets are not dominated by a few securities that outperform the rest, like stock markets. In other words, passive bond funds own a large number of bonds securities, but they don't really benefit much from that. Instead, owning lots of bonds and having to trade often tends to harm the performance of passive bond funds, because many of these securities that they own, as we discussed, are expensive to trade.

Lloyd: Your seminal research on active share inequities helped the world understand the inherent shortfalls with closet indexing. Given how ubiquitous closet indexing is in bond funds, I would be curious to hear your thoughts on closet indexing and bond investing.

Martijn: Closet indexing relies on our measure of active share that we introduced in our 2009 paper that you mentioned in your introduction. Let me first talk about active share and then about closet indexing. Active share is a measure of how different the holdings of a fund are relative to the holdings of the fund's benchmark. Active share is a percentage. It measures the percentage of the portfolio weights, the holdings in the fund, the percentage of portfolio weights that is different from the benchmark.

If the fund holds very similar securities as the benchmark, then the active share will be low or close to 0%. If the fund has almost no overlap in holdings with the benchmark, it is deviating in holdings very, very much from the benchmark, the active share is going to be high or close to 100%. Again, active share is the proportion of holdings in the fund that is different from or not overlapping with the holdings in the benchmark.

Then closet indexing is the phenomenon of actively managed funds having substantially low active share, or having holdings that are quite similar that overlap a lot with the benchmark. These are funds that charge fees that are much higher than the typically low fees of passive funds, but still have substantial overlap with those passive products or have a low active share. Because the holdings are so similar to the holdings of the benchmark, but the fees are much higher, they tend to underperform due to the higher costs.

Closet indexing has become fairly common among actively managed stock funds, but as we document in our paper, is much. much less common among actively managed bond funds. Therefore the problem of buying actively managed funds that is actually pretty similar to a passive fund that you can buy at a much lower fee is less of a problem for bond funds.

Lloyd: Now, sticking in this narrative, I'm curious in your work on fixed income active share, you notice some material differences compared to equity active share, specifically around understanding issuers versus their individual credit issuance. Can we kindly walk through each of these concepts?

Martijn: Yes. This is another question that I think is fairly technical. Please bear with me as I walk through this. For equity funds, we calculated active share at the individual security level. For bonds, the challenge is that you have many issuers that sell lots of different bonds, versus the US government or large corporations like IBM. When you have the situation that many issuers sell many different bonds, you can calculate active share at two different levels. You could go to the level of the individual security, or you can think about grouping together all securities from the same issuer.

You can compare the holdings of the funds to the benchmark at the level of individual securities. Alternatively, you could combine all the different bond securities from the same issuer together, and compare then the holdings of the funds to the benchmark at the issuer level. You could calculate active share at the issuer level, and then you don't really care whether or not the funds has the exact same particular issues from that issuer, but just whether or not the overall exposure to that particular issuer is the same or not from the overall exposure to that issuer in the benchmark.

Our conclusion from that is that it is more helpful to focus on the issuer level than the issue level. It's more important to focus on active share at the issuer level than focusing on differences in which particular securities issues the bond manager bought among the many different securities that each issuer may have issued.

Lloyd: That tends to be a concept that I don't know that is readily understood by a lot of people who buy bonds or bond funds, generally speaking, to create portfolios, so thank you for that. I'd be curious to also get your take on how you would respond to the challenge that many actively managed funds do not have a good track record.

Martijn: This is a key challenge, and it's a well-known result among stock funds. Many actively managed funds do not have a good track record. This really applies primarily to equity fund managers. As we document in our paper, this is much less of a challenge for bond fund managers. Recall that earlier I talked about the typical passive bond fund underperforming. The option is that we find that the typical or the majority of actively managed bond funds outperforms those passive benchmarks that you can invest in. Further, you can use active share to understand better what the active bond fund is doing.

With the active share measure, you can differentiate among actively managed bond funds. Differentiate active funds that deviate substantially from their passive benchmarks and have a high active share. Versus active bond funds that have a lot of overlap with the benchmark or their passive benchmark that they're tracking and have a low active share. In our earlier work, we found that the poor average track records of actively managed equity funds as a group was really due to those with low active shares, not those with high active shares.

The group of low active share equity managers had substantial underperformance while the group of high active share stock funds performed okay. In this new study, we find the same for bond funds. The underperformance of active bond funds tends to be driven by funds with a low active share. Among the funds with high active share, like bond funds with a high active share, their performance tends to be strong.

Lloyd: I'm really glad you hit on a lot of that dynamic. We use the term legitimately active management, something we take a great deal of pride in at our firm. We actually have been using your active share measure here for a number of years. When we find that in a lot of the groupings that we get put in being dropped in, whether it's an equity or a bond fund, seeing the amount of closet indexing that tends to skew the quartile rankings is a point of great frustration, I think for many true active managers.

I'm glad you were able to touch on that. I'd also be curious to shift us back because we're really focusing on the bond narrative today. When evaluating bond funds, what other material epiphanies did you surface? What else could our audience use when they look at bond funds and assessing bond funds from your perspective?

Martijn: Let me first briefly recap and then answer this question of what else do I think is a key lesson from our new study. To recap, the first key lesson from our study is that passive bond funds do not have a strong record, and that's related to them not actually being very passive. They are substantially different than the benchmark that they're trying to track. That actively managed bond funds typically do better than the passive bond funds. The second lesson then is that it is helpful to distinguish among actively managed bond funds.

Separating closet index funds with low active share from high active share bond funds. Closet index funds with low active share tend to underperform. While in our study, we find that bond funds with high active shares on average have really good performance. Then a key third lesson is that funds with high active shares that also have good track records, so they performed well in the past. They are more likely to continue their past outperformance in the future. That's, of course, one of the key questions for investors.

Investors look at a fund, they see great performance in the past, they want to know what is the likelihood that that great performance will continue in the future. The key result that we have is that if you see a good, strong performance in the past, and if that fund also has a high active share, then we find that it's more likely that that fund will continue their outperformance in the future. That is what we call positive performance persistence. It's the combination of strong past performance and high active share that tends to predict strong future performance or positive performance persistence.

Lloyd: I know that our dynamic portfolio managers are going to be thrilled to hear this podcast, as this aligns very much with the thinking of the entire management team here. Which I think really brings us to our last question and to pivot back towards the advisor community and investor community as they're putting together portfolios. Could you really give us your real reasons for an investor to consider owning a bond fund in the first place? When they're thinking about constructing their portfolios, how do you look at that?

Martijn: A very important reason for investors to own bond funds is diversification or risk management. The key idea is that combining stocks and bonds in your overall portfolio lowers the risk of your overall portfolio without substantial loss of upside. That makes it especially important that bond funds manage their risk exposures well, and protect their downside. If risk management is a key reason to invest in bond funds, then the bond fund manager needs to specialize in risk management.

The good news then for investors in actively managed bond funds is that we find in our study that active bond managers on average are very skilled in risk management, especially those with the high active shares. In particular, we document that bond fund managers with high active share provides the strongest downside protection or best at managing downside risk.

On top of, as a group, having the strongest returns. That makes them very attractive, I believe, for investors combining a stronger likelihood of outperformance together with strong risk management skills, they have a better downside protection in particular.

Lloyd: I have to say this is a genuine pleasure. That was most appreciated Professor Cremers and our sincere thanks to you and to all of our listeners for their time. Thanks again for joining us.

Martijn: Thank you, Lloyd. Thank you for having me.

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