To win in poker or markets, look for easy games, advises skill-versus-luck guru Michael Mauboussin. Be the best player at the table and take advantage of less-skilled participants.
For investors, bond markets are the easier game, according to his new paper. In it, he considered why actively managed bond funds have outperformed passive strategies and, as a result, haven’t been hit as hard as active stock pickers by low-cost index funds. U.S. active bond managers reaped $900 billion in net inflows over the last decade, even as their equity counterparts lost $1.1 trillion.
In the paper, he dug into the sources of alpha — risk-adjusted excess returns — for bond fund managers. Active managers, for example, can access the so-called new issue premium.
“Active managers can buy these bonds at a slight discount and get a couple points in excess return right there,” Mauboussin said in an interview with Institutional Investor. “In general, IBM has one stock, but bonds have tons of different issues. So logistically, it’s harder to track any fixed income market because there are just more securities coming and going.” Mauboussin described the “game” of tracking the most popular bond index, the Bloomberg Barclays U.S. Aggregate, as more difficult than equities, given the roughly 10,300 securities, liquidity challenges associated with frequent rebalancing, and a lack of pricing transparency.
Much of bond fund managers’ outperformance against their benchmarks can be attributed to factors such as duration, corporate credit risk, and emerging markets risk, according to the report, called “Looking for Easy Games in Bonds.” Mauboussin directs research at BlueMountain Capital Management, and has published a number of books.
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Previously, Mauboussin researched the effect on alpha of competition from increasingly skilled equities investors. When the number of highly skilled players entering a game increases — whether in baseball or stock and bond markets — the difference between the best player and the worst narrows.
“If you’re a skillful player, you want wide dispersion. Then there are a lot of weak players you can benefit from,” Mauboussin told II. In emerging markets or high-yield bonds, for example, the dispersion is large.
“For instance, the difference between the 75th and 25th percentile managers, measured over three years, is roughly 5 times larger for emerging market debt than for long-term government debt,” he wrote Mauboussin. “Equity funds are more volatile but the difference in dispersion between the high- and low-dispersion asset classes is only two times.”
From 1973 to 2018, the three-year average standard deviation — the difference between the average and extreme performers — of the alpha of U.S. large-capitalization equity mutual funds steadily declined, according to the paper. The exception: a brief time during the run-up in technology and dot-com stocks in the late 1990s.
The story is different in bonds. Between 1978 and 2018, the standard deviation for bond funds has bounced around, with no clear trend, said Mauboussin. “While bond managers have certainly become more skillful over time, the relative skill gap between the best and worst performers has not narrowed as it has for equity managers,” he wrote in the report.