Morningstar Magazine - August/September 2018 - 37

moved around somewhat through time. We also
see more heterogeneity within these groups than
we do in the more stable government and
corporate-bond categories.

Mostly, these deviations were on the downside,
driving down the median gross excess
return into negative territory for five of these
seven categories.

For these categories, such as EAA fund USD
corporate bond and GBP corporate bond,
results appear identical on the surface. The typical
active fund underperformed the index or
outperformed it only very narrowly, even before
fees. Thus, a low-cost passive fund seems
like a reasonable option for investors looking to
invest in these universes. But there is a greater
dispersion between the best and the worst
active funds, and returns of funds in the top
quintile of their peer group were encouraging. For
example, a fund sitting in the 20th percentile
of the GBP corporate bond category outperformed
its category index by more than 1.5% before fees
in the typical period covered by our study.

In several of our high-yield and emerging-markets
debt categories, passive funds fell short of
the performance of market indexes, but so did
most active managers. In areas where the
benchmark index has little value as a guideline,
investors should ultimately pit active and passive
funds against each other to determine their
relative merits. Within the global high-yield
universe (EAA EUR high yield bond, EAA global
high yield bond, US fund high yield bond)
we find that active managers outperformed their
passive counterparts in the median rolling
three-year period after fees, suggesting that
investors are typically better off choosing
an active fund, even if it's just an average one.
Furthermore, the outperformance achieved
by active fund funds that landed in their
category's top quartile was very large (more than
1 percentage point per year, net of fees)
against a comparable ETF, illustrating the high
returns achievable by correctly identifying
manager skill.

Thus, these categories provide a more lucrative
field for active managers. However, one factor
to consider is the persistence of outperformance.
Even some of the best active funds in a given
three-year period can drop out of their category's
top quartile in the following three-year period,
and fund mortality also reduces the odds of finding
a consistent outperformer. Therefore, while
there is some evidence that manager skill adds
value in these categories, selecting active
funds that are likely to outperform their indexes
consistently remains a daunting task.
Group 3: Categories With Unstable Medians

EAA Fund EUR High-Yield Bond
EAA Fund Global Emerging-Markets Bond
EAA Fund Global Emerging-Markets Bond-
Local Currency
EAA Fund Global Emerging-Markets Corporate Bond
EAA Fund Global High-Yield Bond
US Fund Emerging-Markets Bond-Local Currency
US Fund Emerging-Markets Bond

On the other hand, within the emerging-markets
bond universe, the picture is bleaker. We find that
most active funds end up squandering their
theoretical gross-of-fees advantage over ETFs by
charging excessive costs. The median active
managers in the EAA global emerging-markets
bond, EAA global emerging-markets bond
local currency, US fund emerging-markets bond,
and US fund emerging-markets bond local
currency categories lagged their passive
counterparts by a significant margin, net of fees,
over the three-year rolling periods included
in our study. More strikingly, even funds in the top
quartile of these categories underperformed
their comparable ETFs after accounting for fees,
suggesting that passive funds remain a
compelling option here.

3 In benchmark-driven categories, costs have on
balance a greater impact on net return than
does manager skill, making the case for low-cost
investments (be they active or passive).
3 In more-diverse peer groups, a low-cost passive
option is often superior to the typical active
fund, but there is still room for manager skill to
add value, provided that fees are reasonable.
3 In universes where volatility and transaction costs
are high, both active and passive funds
struggle to achieve the performance of the
benchmark index over the long term.

These conclusions bear a significant caveat,
though. In volatile universes that are prone
to market dislocations, the "median" active fund
and the "median three-year period" are not
necessarily a good reflection of investors' actual
experience. Dispersion between the best
and worst active funds is very large, and some
funds exhibit active bets and biases that will cause
their performance to deviate massively from
that of the average fund. Similarly, in some market
conditions, active managers may do better
as a group, only to fall behind the ETF in the
following period.
While such short-term movements are hard to
predict, and manager skill can be difficult
to identify, ultimately fees remain a key factor of
differentiation between active funds and
a key predictor of future long-term performance.
Thus, as a general rule, even in categories
that appear to be more lucrative for active
managers, investors should not turn a blind eye
to costs. K
Mara Dobrescu, CFA, is an associate director, fixed-income
strategies, with Morningstar Research Services.
James Li is a senior quantitative analyst with Morningstar.

Costs Matter

Finally, we've identified a group of categories
in which the median fund's returns deviated
dramatically from the benchmark index over
time, sometimes by more than 5 percentage points.

are in a better position to decide how much they
are willing to pay for funds in a specific
category without impairing their chances to beat
the benchmark. We can summarize our key
findings as follows:

Historical returns data provides useful insights on
the ability of active fixed-income funds to
add value against their benchmarks gross of fees.
With the help of these estimates, investors

Matias Möttölä, CFA, is an associate director,
multiasset and alternatives strategies, with Morningstar
Research Services.

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