Posted by on Apr 15, 2013 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  April 12, 2013 5:29 p.m. ET

Bond managers are suddenly looking superhuman.

Investors have handed nearly three-quarters of their new fixed-income investments to bond pickers over the past year, as $230 billion has poured into actively managed bond funds, while just $63 billion has gone into bond index funds.

Why are the same investors who have turned their backs on stock pickers showering money on bond pickers?

Past performance, of course. Last year, 79% of intermediate-term bond funds — which hold a mix of government and corporate bonds maturing in five to 10 years — beat the comparable bond index, according to S&P Dow Jones Indices.

Over the past 12 months, investment-research firm Morningstar estimates, intermediate bond funds have surpassed the indexes against which they measure themselves by an average of 1.8 percentage points; long-term government bond funds have beaten their chosen benchmarks by 2.5 points.

Since bond managers have long struggled just to break even with the averages, such market-pounding performance seems close to miraculous. But investors need to realize that the laws of financial physics haven’t been suspended. All these funds are run by active bond pickers. If history is any guide, they won’t outperform the averages forever.

The hot bond funds have nothing to do with the index funds, including exchange-traded funds, that for years have been taking the investment world by storm. Index funds don’t even try to buy the best-performing securities and avoid the worst; instead, they simply drive fees to rock-bottom by holding all the investments in a market index.

In stocks, ETFs have prevailed. But in the bond market, ETFs have been at a disadvantage — at least temporarily. Unlike an ETF, a fund run by an active manager needn’t be a carbon copy of the market; it can take more risk, and that is exactly what many bond pickers are doing. For now, that has pushed their returns past those of the ETFs.

Consider “duration,” a measure of a fund’s sensitivity to interest-rate changes based on which bonds it holds. To get a rough sense of how much the price of a bond fund would fall if interest rates rise, multiply the rate change by the fund’s duration.

If interest rates were to go up by two percentage points, for instance, the net asset value of a fund with a duration of five years would fall approximately 10%. The higher the duration, the more vulnerable the fund is to a spike in rates.

Since the first half of 2009, the average duration of actively run intermediate bond funds has lengthened from 4.4 to 4.8 years, Morningstar estimates.

Over the same period, the duration of the comparable Barclays U.S. Intermediate Government/Credit Bond index barely budged, from 3.8 to 3.9 years. The ETFs that track it and similar indexes also stood pat, since their job is to match whatever the benchmark does.

As a result, active bond funds are taking more interest-rate risk than they were four years ago—buying longer-term bonds that provide higher yield now but will lose more money when rates finally rise. ETFs, on the other hand, are taking almost the identical level of risk as before.

That isn’t all. Over the same period, Morningstar reckons, the quality at intermediate bond funds has slipped from an average credit rating of single-A, or excellent, to triple-B, or one notch above the lowest investment-grade rating — even as the credit quality of the indexes has stayed constant.

As a whole, then, active bond-fund managers are taking extra risks that haven’t blown up — yet.

The real test for actively run funds, says Matthew Tucker, head of fixed-income strategy at iShares, the largest manager of ETFs, is “whether they can reposition risk in front of market events,” not just in response to them.

A handful of bond pickers — Daniel Fuss of the Loomis Sayles funds, Bill Gross at Pimco and Jeffrey Gundlach of the DoubleLine funds foremost among them — have racked up impressive long-term track records. But the vast majority of active bond funds have fared poorly in bear markets — as in 2008, when active intermediate funds lost an average of 4.8% even as the iShares Intermediate Government/Credit Bond ETF gained 6.0%.

Bond funds still have a place, since they diversify the risks of stocks. But before you buy any active bond fund with fabulous performance over the past year, check how it has performed over the past five and 10 years. See how it did in 2008; the best test of whether a manager can avoid the next disaster is whether he avoided the last one.

Chances are, you will quickly see you are better off with an index fund or ETF that doesn’t pump up returns today with risks that will hurt you tomorrow.

Source: The Wall Street Journal,