Morningstar Magazine - August/September 2018 - 40

Spotlight: Fixed Income

EXHIBIT 5

Alpha Persistence Funds with higher alphas in the past were more likely to survive
and have positive alphas in the future.

have positive alphas. But that information is only
useful if it is predictive of future performance.

Five-Year Lookback and Hold From May 2008

Several studies, including one by Morningstar,²
suggest that there is credence to the
warning that past performance is not indicative
of future results. Each fund's returns come
from a combination of luck, skill (or lack thereof),
and risk. Risk-taking often pays off, but not
always, and it is difficult to predict when the tide
will turn. Focusing on alpha from the regression
analysis largely strips out the returns from
risk, leaving returns from luck and skill, which are
more difficult to disentangle. Luck is fleeting,
while the returns from skill should be more likely
to persist, at least in theory. The key question
is whether managers with higher alphas in one
period tend to do better in the next.

Does Manager Skill Persist?

Past Alpha
Quartile

Success Rate

Median Alpha
of Surviving Funds

Survivorship Rate

Success Rate
Conditional on Survival

Median Fee
2008

69.70

0.07

92.42

75.41

0.57

60.00

0.08

73.85

81.25

0.66

49.23

0.03

75.38

65.31

0.66

28.79

0.00

56.06

51.35

0.85

Success Rate

Median Alpha
of Surviving Funds

Survivorship Rate

Success Rate
Conditional on Survival

Median Fee
2013

43.10

-0.01

94.83

45.45

0.60

31.03

-0.01

81.03

38.30

0.68

22.81

-0.02

94.74

24.07

0.56

22.41

-0.03

74.14

30.23

0.70

Five-Year Lookback and Hold From May 2013
Past Alpha
Quartile

Data as of 04/30/2018.
Source: Morningstar Analyst's Calculations.

the same exposure to that risk as the Agg.
Larger values indicate greater risk, while smaller
values indicate less risk. The model fits
the data fairly well, explaining 90% of the variance
of the median active manager's returns
over the past 10 and 15 years and 96% of the
variance of those returns over the past
five years.
Not surprisingly, active managers in the category
tended to take greater credit risk than the
Agg. Over the 10- and 15-year windows, they
had greater exposure to both investment-grade
and high-yield credit risk, while they reined
in high-yield credit risk over the past five years.
Similarly, active managers tended to take
greater interest-rate risk than the Agg over the
past 10 and 15 years but dialed down that
risk over the past five years, as concerns grew

over the specter of rising rates. Residual market
risk followed the same pattern.
Taken together, these results suggest that active
managers took less risk over the past five
years than they had over the past 10 and 15 years.
That said, fewer managers had a positive
alpha (returns from manager skill) over the past
five years than over those longer periods, even
as the percentage of funds that beat the Agg
was the highest during that time. Underweighting
residual market risk helped active managers'
performance during this period.
This analysis also suggests that the median
actively managed fund in the intermediate-term
bond category didn't generate significant returns
(positive or negative) after controlling for its risks.
Of course, there are many managers who do

2 Bryan, A. & Li, J. 2016. "Performance Persistence Among U.S. Mutual Funds." Morningstar White Paper, January.

Morningstar Augsust/September 2018

To answer that question, I sorted all funds in the
category on their alphas over the trailing
five years through April 2008, grouped them into
quartiles, and measured their alphas over the
subsequent five years. I repeated that exercise for
the trailing five years through April 2013 and
subsequent five-year holding period. The results
are shown in EXHIB IT 5 .
Over these two windows, managers with higher
alphas in the past were more likely to survive
and have positive alphas in the future
(counted as success). The difference in the median
alpha of surviving funds in the top and bottom
quartiles over the holding periods was only modest,
so it's important to interpret these results
with caution. That said, they suggest that investors
have a better chance of success by investing
with managers who have been successful with
a differentiated strategy.
This finding is partially due to differences in fees.
Managers with higher alphas in the past tended
to have lower fees.
Fees Matter

To test the impact of fees more directly, I grouped
all intermediate-term bond funds listed at the end

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2018