Another Promise of a Free Lunch

Earlier this month, Mackenzie Investments produced this advertisement for the Mackenzie Sentinel Corporate Bond Fund. The banner headline reads “Think high yield means high risk?” The rest of the ad reads, “Think again. High-yield corporate bonds have produced equity-like returns with less risk.”

Two graphs then compare the performance of the fund with the S&P/TSX Composite Index from November 2000 (the fund’s inception date) through October 31 of this year. During that period, the Mackenzie fund delivered annualized returns of 5.7% with a standard deviation of just 5.8%. The Canadian stock market, by comparison, delivered just 4.5% with much more volatility: a standard deviation of 15.5%.

Those are compelling numbers: high returns with lower volatility is what every investor wants. But it’s always important to scrutinize comparisons like this. There’s nothing incorrect in the data here, per se, but one needs to ask whether the fund really did deliver superior risk-adjusted returns, and whether it is likely to do so in the future.

To begin with, the start and end dates examined here are crucial. If you look at the table under the two graphs, you’ll see that the S&P/TSX Composite returned 8.5% annualized during the 10 years beginning in October 2001, outperforming the Mackenzie fund by 2.8% a year. So by moving the start date by just one year, you get a completely different result. It may be true that “high-yield corporate bonds have delivered equity-like returns,” but only during specific periods when equities dramatically underperformed their historical averages.

Were you rewarded for taking more risk?

The ad also argues that “it takes rigorous company and credit analysis to find bonds with long-term growth and income potential. When you do, it adds up to superior returns and a smoother market ride.” In the case of the Mackenzie fund, it also adds up to an MER of 1.7% a year.

There are only two ways that a bond manager can deliver superior returns than a broad-market index. The first is by adjusting maturities—that is, by selecting a portfolio of bonds with shorter or longer terms than the benchmark. The second is by varying credit quality: by selecting bonds of lower quality, and therefore higher yields. With that in mind, did the Mackenzie Sentinel Corporate Bond Fund add value?

Justin Bender, a CFA and portfolio manager at PWL Capital in Toronto, supplied the following analysis. He compared the Mackenzie fund’s performance to a blended benchmark consisting of two indexes of federal government bonds: 60% DEX Mid Term Federal Bond and 40% DEX Short Term Federal Bond. This 60-40 mix creates a benchmark with an average term to maturity of about 5.7 years, which is identical to that of the Mackenzie fund’s portfolio. In this way, we’ve taken maturity out of the equation so we can focus only on credit quality.

Since high-yield bonds have far more credit risk than government bonds of the same maturity, investors should naturally expect higher returns. Would they have achieved them with the Mackenzie fund? Here are the numbers:

Sources:  PC-Bond, BMO Financial Group, Mackenzie Investments, Dimensional Returns 2.0. Returns as of October 31, 2011.

As you can see, since its inception, the Mackenzie fund has not even outperformed government bonds of similar maturities. Over the last 10 years, it managed a mere 10 basis points of outperformance. Over shorter periods, the results are mixed. This hardly a compelling argument for the fund’s “rigorous company and credit analysis.”

And what about volatility? The Mackenzie fund’s standard deviation of 5.8% does indeed look low when compared with the S&P/TSX Composite. Yet our 60-40 benchmark of government bonds not only achieved higher returns since November 2000, but it did so with a much lower standard deviation of just 3.5%, according to Bender’s analysis.

“Finding equity-like returns with less volatility is something many market weary investors are looking for,” the Mackenzie ad says. No argument there. But the data suggest they need to keep looking.