Morningstar’s Christopher Traulsen warns of bond fund fees wrecking performance

Christopher Traulsen, director of fund research Europe and Asia at Morningstar, says that investors in bond funds need to beware fees that can destroy returns.

Any investor with experience will know about fund fees and their pernicious effect on returns. But given current low yields in the bond market, it’s especially important that fixed-income investors keep the impact of fees front of mind.

Even in the best of times, the impact of fees on fixed income funds is especially high given the relative difficulty in beating fixed-interest benchmarks and the relatively compact spread of returns in fixed-interest sectors. These factors loom all the larger when yields are compressed.

Bond Fund Review: Methodology

To get a sense of the fee impact on fixed-interest funds in the UK in recent years, I recently reviewed the Morningstar GBP Bond categories. The following categories were included in my research: GBP Diversified Bond, GBP Corporate Bond, GBP Flexible Bond, GBP High Yield Bond, and GBP Inflation-Linked Bond. I left in all classes of each fund. Returns were grossed-up to pre-tax levels to allow for accurate comparison between gross/net classes of onshore and offshore funds. Classes were slotted into performance quintiles versus each fund’s assigned Morningstar category over three and five-year periods (all ending at 31 August 2012), with average total expense ratios (TERs) run for each cohort.

Bond Fund Review: Results

The results are clear: lower fees result in better performance. The chart below clearly shows the relationship between bond fund performance and TER.

For the fixed-income universe as a whole, the average TER for each performance quintile increases in linear fashion. The best performing quintile of bond funds over the past three years displayed an average TER of 0.67%, compared to the worst-performing quintile, which had an average TER of 1.05%*. Whilst the inclusion of all classes meant the top quintile included many institutional share classes, it is nevertheless illustrative of the dramatic impact of fund fees on relative performance.

Strikingly, the relationship also holds across the individual categories, although the middle can get fuzzier, particularly for more volatile categories such as GBP High-Yield Bond and GBP Flexible Bond. (The number of inflation-linked classes with five-years of history is relatively small, so the data is slightly noisier for that period and category although the difference between the top and bottom quintiles remains quite clear.)

Lessons for Investors

The unavoidable implication is that investors would be extremely remiss not to focus on costs as a key criterion when selecting a fixed-interest fund. It should by no means be the sole criterion, but investors must keep in mind that the higher the fees, the harder it will be for a manager to outperform. Some managers can be worth paying up for, but these are few and far between. Further, managers come and go whilst fee levels tend to be stable so investors electing to pay up for a given manager are relying on an inherently unstable element to compensate for a structural deficit, which is usually unwise. This data also suggest that passive funds, where available, should be considered providing they are low cost. (Though, then again, not all passive funds are low-cost either!)

*Performance quintiles were determined for each fund relative to its specific Morningstar category peers. Whole-of-universe data was aggregated using the category-specific quintiles.

For further views on fees destroying returns from bond funds, see the video below.

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