Reliable Outperformance Among Bond Fund Managers?

Does past performance predict future results for bond funds? In their April 2007 paper entitled “‘Hot Hands’ in Bond Funds”, Joop Huij and Jeroen Derwall measure persistence in the relative performance of bond mutual funds. Using return data for 3,549 bond funds spanning 1990-2003, they find that:

• Most bond mutual funds underperform a passive benchmark on a risk-adjusted basis.
• Across high-quality, high-yield and mortgage-backed bond funds, the probability that a relative outperformer (underperformer) continues to outperform (underperform) is about 60%. The out-of-sample difference in risk-adjusted returns between the top 10% and bottom 10% of past performers exceeds 3.5% per year, driven largely by strong persistence in underperformance.
• Bond fund investors can beat a passive index strategy by nearly 1.8% a year using a monthly rebalanced portfolio of no-load bond funds that are strong past performers. (See the chart below.)
• While bond index funds are reasonable low-cost vehicles for unsophisticated investors, sophisticated investors can systematically exploit bond fund performance persistence.

The following figure, taken from the paper, compares the cumulative values of one-dollar investments in: (1) a monthly rebalanced portfolio of no-load bond funds selected based on strong past performance (solid blue line); and, (2) a passive benchmark portfolio constructed from a broad investment-grade bond index, a high-yield bond index and a mortgage-backed bond index (magenta dashed line). Funds in the former are weighted according to Modern Portfolio Theory.

In summary, past performance is significantly indicative of future performance among bond mutual funds.

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