Does Active Fixed Income Management Add Value?
FEATURE:  Does Active Fixed Income Management Add Value?
This article reviews the monthly performance of 43 Cana-
dian fixed income funds over a ten-year period to June 30,
2009. The conclusions are that, after fees, a significant ma-
jority of actively managed fixed income funds failed to out-
perform their benchmark index; the outperformance
achieved by a small minority of funds was attributable to
chance; and past performance did not predict future perfor-
mance. Before fees, the long-term returns for fixed income
index funds were roughly equal to the returns of actively
managed fixed income funds. After fees, however, index
funds outperformed actively managed funds since index
fund fees were 60% lower.
by Hubert Lum
©2010 International Foundation of Employee Benefit Plans
Introduction
This article addresses three questions: First, does active
fixed income management add value in excess of a bench-
mark index return? Second, is outperformance due to luck
or skill? Third, does information on past performance help
to predict future performance?
The mostly calamitous investment results of 2008
heightened interest in these questions, which are the sub-
ject of ongoing debate. As shown in Figure 1, the single
positive return result of 2008 was Canadian fixed income,
Canadian Benefits & Compensation Digest  •  October 2010
represented by the DEX Universe Index. Before the next
market upheaval, pension funds may want to revisit their
policy asset mixes and determine whether there is an ade-
quate policy allocation to fixed income. Part of this deter-
mination should include a review of the style of fixed in-
come management—Should it be active or passive?
Description of Data Sources
Morneau Sobeco’s Pooled Fund Survey and eVestment
Alliance, a subsidiary of Morningstar, supplied data for 85
and 166 Canadian fixed income funds, respectively. The
two databases were screened for fixed income funds pos-
sessing the following characteristics: a consecutive ten-
year, monthly performance record to June 30, 2009; the
DEX Universe Bond Index (DEX Index) as the fund’s rele-
vant benchmark; and a pooled fund structure.
The screening produced 38 active funds with an average
market value of $780 million and five passive funds with an
average market value of $2.5 billion.
Most Active Managers Fail to
Beat the Benchmark
Active fixed income managers try to add value by exer-
cising judgment on changes in one or more of the following
areas: the direction of interest rates, the shape of the yield

 Feature Article

Figure 1
Returns of Major Asset Classes in 2008
10.0 6.4%

0.0

-10.0
% Return

-20.0
-22.6%
-30.0 -25.9%
-29.2%
-33.0%
-40.0 S&P/TSX MSCI EAFE $C MSCI World $C S&P 500 $C DEX Universe
FEATURE:  Does Active Fixed Income Management Add Value?

TABLE I
Annualized Returns Before Fees for Periods Ending June 30, 2009
3 Years 5 Years 10 Years
Median of actively managed funds 6.15% 5.77% 6.33%
DEX Index 6.19% 5.90% 6.30%
% of actively managed funds underperforming the DEX 53.20% 58.80% 44.70%
% of actively managed funds outperforming the DEX 46.80% 41.20% 55.30%

curve, the yield spread between market sectors and the
valuation of specific bond securities.
The analysis considered returns before and after fees.
The fees applied to a fund’s return were derived from the
fee schedule specific to an individual fund for an invest-
ment at the $50 million level.
Before fees, the finding was that a slim majority of man-
agers outperformed the DEX Index in the ten-year period
and underperformed the DEX Index in the three-year and
five-year periods. As shown in Table I, there was no pro-
nounced pattern.
However, after fees, the majority of actively managed
funds underperformed the DEX Index in each of the three-
year, five-year and ten-year periods ended June 30, 2009.
The percentage of funds that failed to beat the DEX Index
were 80.7%, 87.1% and 79.4%, respectively. These results
are shown in Table II.
Excess Return Generated by Most Managers
Can Be Attributed to Chance
While a majority of actively managed funds failed to
beat the benchmark, after fees, a minority did beat the
benchmark. In the above example in the ten-year period,
20.6% of active funds outperformed the DEX Index. Here,
the question is: Was the outperformance due to skill or
luck? The distinction is important since, if the positive out-
comes were the result of luck, one would not expect these
funds to outperform in the future.
One way to measure the distinction between luck and
skill is to equate the lucky result with random variation.
The sum of this random variation will be zero. At different
levels of probability, one can measure the amount by which
an active manager beats his or her index and assess if that
excess amount is statistically different from zero.
At a 90% confidence level, the annualized return in ex-
cess of the DEX Index return that qualifies as statistically
distinct from random fluctuation is 0.55%. In other words,
there is only a 10% probability that an annualized return of
benchmark return plus 0.55% is due to chance. For the ten-
year period to June 30, 2009, this equates to a return of
6.85% (0.55% plus 6.30%).
An analysis of the returns of the 20.6% of funds that outper-
formed the DEX over ten years showed the number of funds in
the group that beat the DEX Index by 0.55% was zero. As shown
in Figure 2, the highest return achieved was 6.77%.
At lower confidence levels, 85% and 80%, the results
were similar. The number of funds that achieved returns
statistically distinct from random fluctuation were zero and
one, respectively.

J Canadian Benefits & Compensation Digest  •  October 2010

 TABLE II
Annualized Returns After Fees for Periods Ending June 30, 2009
3 Years 5 Years 10 Years
Median of actively managed funds 5.92% 5.54% 6.10%
DEX Index 6.19% 5.90% 6.30%
% of actively managed funds underperforming the DEX 80.70% 87.10% 79.40%
% of actively managed funds outperforming the DEX 19.30% 12.90% 20.60%

Figure 2
Annualized Returns After Fees for Periods Ending June 30, 2009
9.0

FEATURE:  Does Active Fixed Income Management Add Value?

7.0
Return (%)

5.0

3.0

1.0

3 Years 5 Years 10 Years

Maximum 7.56 6.76 6.77
25th Percentile 6.15 5.78 6.24
Median 5.92 5.54 6.10
75th Percentile 5.30 5.15 5.85
Minimum 3.71 4.17 5.42
DEX Universe Index 6.19 5.90 6.30

The Challenge in Finding the Manager
Who Can Beat His Peers
Most pension funds have at least two return objectives
for their asset classes—one that refers to returns above a
benchmark, such as the DEX Index, and a second objective
that refers to above-median performance in a universe of
similar funds. The earlier portions of this article examined
performance against the DEX Index. The examination now
turns to the second objective.
There are many ways to measure persistently good or
bad performance. The measures have themselves been
evaluated in scholarly literature. One simple, robust test is
the chi-square test, described in the following sections.
Consider the returns for a group of funds for a specific
period—say, one quarter—and divide the returns into
above median and below median. The above-median funds
are identified as “winner” ( W ), and the below-median
funds are labeled as “loser” (L). Divide the group in the
same way into a W group and an L group in the next quar-
ter. Continue in this manner for 40 quarters (ten years) af-
ter the initial quarter.

Canadian Benefits & Compensation Digest  •  October 2010 K

 Feature Article

Figure 3
Chi-Square Test for Performance Persistence
Chi-Square Value: 0.95 Probability Value 33.0%
Change From Period 1 to Period 2
Period 1
Period 2 Winner Loser
Winner WW LW
Loser WL LL
Expected Results if Random
Period 1
Period 2 Winner Loser
Winner 380 380
Loser 380 380
Expected Results % if Random
Period 1
FEATURE:  Does Active Fixed Income Management Add Value?

Period 2 Winner Loser

Winner 50.0% 50.0%
Loser 50.0% 50.0%
Actual Results
Period 1
Period 2 Winner Loser
Winner 399 361
Loser 361 399
Actual Results %
Period 1
Period 2 Winner Loser
Winner 52.5% 47.5%
Loser 47.5% 52.5%

The change in the fund’s status from one quarter to the
next quarter over the ten-year period is one of the following
four combinations: WW, WL, LL and LW. One sums each of
the four combinations for all funds and all periods. The
sums observed are then compared to the sums expected if
the process is random. The hope is that one or more funds
can consistently outperform the peer group. This outcome
would produce a disproportionately high number of WWs.
The information can then be used to try to predict future
above-median managers.
Figure 3 shows that the pattern of change from quarter
to quarter over ten years is not significantly different from a
random pattern. If the pattern is random, the expectation is
to observe 380 as the total in the category WW, which is
simply one-quarter of all observations. The actual total ob-
served in the category WW was 399. The lack of a pattern of
persistent outperformance within the peer group is con-
firmed by a weak chi-square result at 0.95 at a 67% confi-
dence level. The chi-square values at a 90% and 95% confi-
dence level are 2.71 and 3.84, respectively.
The conclusion is that one period’s result is indepen-
dent of the prior period’s result. Outperformance in the
past is not helpful in determining outperformance in the
future.
Risk Reduction Is Negligible
Many plan sponsors employ active fixed income man-
agement for a purpose other than to generate extra return.
They use active management to lower portfolio risk relative
to a passive approach. Consequently, it is useful to examine
the contribution of active fixed income management to the
reduction of portfolio risk.
Consider a portfolio that is split 60% equity and 40%
fixed income where the equity component is represented
by the S&P/TSX Index and the fixed income by the DEX In-
dex. Assume that the long-term historic correlation be-
tween the two asset classes of 0.4 is applicable in the cur-
rent environment. With these assumptions, one can
measure the portfolio volatility in terms of the annualized
standard deviation of monthly returns for the ten-year
period to June 30, 2009.
A portfolio comprising 100% S&P/TSX had a volatility of
15.31%. A portfolio made up of 60% S&P/TSX and 40% DEX

L Canadian Benefits & Compensation Digest  •  October 2010

 Figure 4
Annualized Return Before Fees for Periods Ending June 30, 2009
7.0%
Annualized Return

6.19% 6.11% 6.15% 6.30% 6.29% 6.33%

5.90% 5.86% 5.77%
6.0%

5.0%

4.0%
3 Years 5 Years 10 Years

DEX Universe Index Passive Median Active Median

FEATURE:  Does Active Fixed Income Management Add Value?

Figure 5
Annualized Return After Fees for Periods Ending June 30, 2009

7.0%
Annualized Return

6.19% 6.30% 6.18%

6.01% 5.92% 6.10%
5.90% 5.75%
6.0% 5.54%

5.0%

4.0%
3 Years 5 Years 10 Years
DEX Universe Index Passive Median Active Median

Universe Index had a volatility of 9.86%. Bonds reduced the
volatility by 5.45%. The reduction in volatility was significant.
What happens to volatility when active fixed income
management replaces passive fixed income management?
When combining the portfolio of 60% S&P/TSX with the
median volatility of the above sample of 38 active fixed in-
come managers, the blended portfolio volatility declined to
9.85%. The additional reduction in portfolio volatility, at-
tributable to active management, at 0.01% (9.86% minus
9.85%), was negligible.
Passive Management Outperforms
Active Management
Unlike active managers who exercise judgment to try to
generate excess returns or lower risk, passive fixed income
managers use quantitative models. These models allow the
passive manager to mimic the risk and return of an index
without purchasing the entire index, which in the case of
the DEX Index comprises over 1,000 medium-term fixed in-
come issues.
All passive managers in this study use a similar tech-
nique (called stratified sampling) to produce a representa-
tive sample of the key characteristics of the sectors (federal,
provincial, municipal and corporate) and maturities of the
DEX Index.
A comparison of the returns of the passively managed
sample of funds with the actively managed sample of funds
produced the following findings. Before fees, the median
active and the median passive fund returns were similar
over the three-year, five-year and ten-year periods. Further,
one group did not consistently outperform the other group
over all three time periods measured. Finally, returns were
roughly equivalent to index returns. This is shown in Figure 4.
After fees, the median passive fund return exceeded the
median active fund return in all periods measured. Al-
though neither the active median nor passive median
matched the index return, the passive median was consis-
tently closer. This is shown in Figure 5.
Insofar as the passive group, at five funds, was small,
the number of passive funds exceeding the active median
was identified. In the three-year period and ten-year

Canadian Benefits & Compensation Digest  •  October 2010 M

 Feature Article
period, all five passive funds exceeded the active median.
In the five-year period, four of the five funds exceeded the
active median.
The superior performance of the passive funds is attrib-
utable to their low fees. While the before-fee returns were
similar for active and passive funds, the after-fee returns
favoured passive funds since passive funds cost 60% less
than active funds. At a $50 million investment level, the
median cost of passive funds was 0.10% while the median
cost of active funds was 0.25%.
While the previous discussion has focused on the upside
potential, one could also compare the downside risk of ac-
tive and passive management. As a simple gauge of down-
side risk, consider the spread between the index return and
the worst return of a fund in either the active or passive
fund group.
The analysis shows that over the three-year period, the
worst passive fund underperformed the DEX Index by
0.47% per year while the worst active fund underperformed
FEATURE:  Does Active Fixed Income Management Add Value?
the DEX Index by 2.48% per year. Over a ten-year period,
the worst passive fund underperformed the DEX index by
0.18% per year while the worst active fund underperformed
the DEX Index by 0.88% per year. Not surprisingly, the op-
portunity for significant underperformance was greater
with active management.
Caveats
The findings are accompanied by several caveats. While
many major active and passive fixed income managers are
included in the examination, the samples are small. Fur-
ther, the returns are subject to survivorship, backfill and
self-reporting bias. Survivorship is an issue since the sam-
ples do not account for managers who may have stopped
reporting to the database due to weak returns. Also, the
samples do not account for managers who, after accumu-
lating a strong return record, may have joined the database
and may have added or backfilled strong historic returns to
the database. Self-reporting refers to the fact that returns
are reported by the investment managers, not by an inde-
pendent third party. Hopefully, these biases are similar in
the active and passive groups.
The examination was restricted to fixed income funds
managed against the DEX Index since this is a common
benchmark for pension funds. There may be greater oppor-
tunities for generating excess returns in strategies that in-
clude high-yield bonds, distressed bonds or foreign bonds.
There may also be greater chances to add value in periods
with higher interest rate volatility.
Other caveats include the following: a relatively short,
ten-year time horizon; the potential for end-point bias; and
N Canadian Benefits & Compensation Digest  •  October 2010
the validity of simplifying assumptions such as bell-shaped
returns and stable asset class correlations.
Finally, on a practical basis, it is also acknowledged that
passive management may be unsuitable for small pension
funds, since passive management can have high minimum
account sizes.
Conclusions
The conclusions concerning active fixed income man-
agement are:
� After fees, most active fixed income funds failed to out-
perform their benchmark index.
� Outperformance was attributable to chance.
� Past performance did not predict future performance.
� Active fixed income management did not reduce portfo-
lio risk relative to the benchmark index.
The conclusions concerning passive fixed income man-
agement are:
� On an after-fees basis, passive fixed income manage-
ment outperformed active fixed income management;
long-term median returns for passive fixed income
managers were roughly equal to the median returns of
active fixed income managers but the fees for passive
managers were 60% lower.
� Passive management meant a reduced risk of significant
underperformance.
Plan sponsors should adopt a “show me” attitude. They
should insist that fixed income managers present a compel-
ling case for active management. In the absence of such evi-
dence, a pension plan’s default policy position should be to
obtain low-cost, indexlike returns from passive management
for what is normally the largest asset component of its fund. •
Author’s note: The views expressed in this article are the
author’s alone and do not necessarily reflect the views of
Morneau Sobeco.
Hubert Lum, M.B.A., CFA, is a se-
nior asset management consultant
at Morneau Sobeco in Toronto, On-
tario. He has provided consulting
services to some of the world’s largest
pension funds. His research experi-
ence includes investment and gover-
nance research collaborations with
scholars from the Tuck School of
Business, Dartmouth College, the
Rotman School of Management, the University of To-
ronto, the World Bank and Maastricht University. Lum’s
work and collaborations have been published in Canada,
the United States, Europe and Australia.
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