The Big Idea

An edge in the mutual fund race for excess return

| January 17, 2025

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Actively managed mutual funds finally saw net inflows to fixed income last year after a few years in the desert. But tough competition with fixed income ETFs continues, and that has made excess return, or alpha, in active funds more important than ever. Past performance in active funds and other portfolios has often pointed to the advantages of running conservative or low beta portfolios, and that includes recent performance. Portfolios with low beta in the last six months beat not only active peers but the bigger passive ETFs as well. Note to self: there’s something there.

In the last six months, only two out of 31 actively managed fixed income mutual funds with at least $10 billion in assets beat returns on the Bloomberg Aggregate Bond Market Index after adjusting for risk (Exhibit 1). That is consistent with a long list of studies that show active funds have a tough time beating a market index of any type, fixed income or otherwise. But investors cannot actually buy an index, and that is where things get more interesting. Investors can buy ETFs that try to replicate an index. And the two biggest ETFs indexed to the Bloomberg aggregate, AGG and FBND, trailed the index in the last six months after adjusting for risk. Perhaps more importantly, the ETFs also trailed a number of active funds.

Exhibit 1: Some mutual fund (blue) alpha in the last six months beat ETFs (red)

Note: Data shows alpha or excess return from 13 Jul 2024 to 13 Jan 2025 in ETFs (red) and mutual funds (blue) with at least $10 billion in AUM as of 13 Jan 2025 benchmarked against the Bloomberg Aggregate Bond Market Index. Alpha is the intercept after regressing daily returns from the fund on daily returns on the index.
Source: Bloomberg, Santander US Capital Markets.

The single feature of the larger mutual funds and ETFs most strongly correlated with excess return over the last six months has been the portfolio’s beta—the daily volatility of portfolio returns compared to the index. Portfolios with a beta less than 1.0 are less volatile than the index, and portfolios with a beta greater than 1.0 are more volatile. Lower beta usually reflects lower risk, and that, in turn, could come from several things in a fixed income fund: lower duration, higher credit quality, more diversifying assets and so on. Portfolios with lower beta, or lower volatility, tended to show more excess return in the last six month (Exhibit 2). Most of the mutual funds (blue dots) that beat the ETFs (green dots) had a lower beta than the ETF.

Exhibit 2: Lower fund beta tended to come with better alpha

Note: Data shows alpha or excess return from 13 Jul 2024 to 13 Jan 2025 in ETFs (red) and mutual funds (blue) with at least $10 billion in AUM as of 13 Jan 2025 benchmarked against the Bloomberg Aggregate Bond Market Index. Alpha is the intercept after regressing daily returns from the fund on daily returns on the index.
Source: Bloomberg, Santander US Capital Markets.

The latest combination of lower beta and higher alpha in fixed income mutual funds and ETFs echoes similar results in mutual funds, CLOs, and, more broadly, corporate and Treasury bonds and equity markets. Although a handful of things could explain the pattern, one of the more compelling argues that limits on financial leverage in many portfolios forces capital instead into riskier assets. The crowded competition squeezes excess return in riskier assets and leaves more of it in safer assets.

Mutual funds have had a few uneven years of net flows while ETFs have steadily attracted assets (Exhibit 3A, 3B). Mutual funds lost $394 billion in AUM in 2022, lost another $18 billion in 2023 and then gained $164 billion in 2024. ETFs, on the other hand, added $168 billion in 2022, another $187 billion in 2023 and another $277 billion in 2024.

Exhibit 3A: Steady growth in fixed income ETFs, uneven growth in active funds

Source: Investment Company Institute, Santander US Capital Markets

Exhibit 3B: Mutual funds add to AUM after two years of net outflows

Source: Investment Company Institute, Santander US Capital Markets

The competition between mutual funds and ETFs has a long way to go, and mutual funds still have a much higher share of outstanding debt securities. But ETFs are gaining. Mutual funds will need to keep adding excess return to make the case for new mandates. That will put a high premium on good asset allocation and security selection. But reducing beta also looks like another good path to that end.

* * *

The view in rates

The Fed’s median dot for the end of 2025 shows two cuts, but the market for now is only pricing 39 bp. And beyond 2025, the market if fading the dot path that takes the Fed to the low 3.0%s by the end of 2026. The market clearly does not believe inflation is dead. Breakeven 2-year inflation has gone up 35 bp in January alone. With discussions of tariffs, changes in immigration policy and an active battle underway in Congress over federal spending, the range of potential paths next year for the Fed is getting wider by the day. Rate volatility still does not look fully priced into options markets, especially for longer tenors.

Other key market levels:

  • Fed RRP balances stand at $118 billion as of Friday, down $61 billion in the last week. With RRP at 4.25%, Treasury repo at 4.32% and MBS repo at 4.33%, cash has much better alternatives than RRP.
  • Setting on 3-month term SOFR closed Friday at 429 bp, unchanged again on the week.
  • Further out the curve, the 2-year note traded Friday at 4.27%, down 11 bp in the last week. The 10-year note traded at 4.61%, down 18 bp in the last week.
  • The Treasury yield curve traded Friday with 2s10s at 34 bp, flatter by 4 bp in the last week. The 5s30s traded Friday at 43 bp, steeper by 6 bp over the same period
  • Breakeven 10-year inflation traded Friday at 242 bp, down 3 bp in the last week. The 10-year real rate finished the week at 218 bp, down 14 bp in the last week.

The view in spreads

Implied rate volatility came off a bit in the last week but looks likely to stay high, softening spreads especially in MBS. Volatility will likely depend on the tariff, immigration and fiscal policies implemented by the incoming administration. The market should know more after inauguration day next week.

The Bloomberg US investment grade corporate bond index OAS traded on Friday at 80 bp, unchanged for the second straight week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 136 bp, down 2 bp in the last week. Par 30-year MBS TOAS closed Friday at 43 bp, tighter by 5 bp in the last week.

The view in credit

Fundamentals for consumer and most corporate credit continue to look stable. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. The rate of serious delinquency in residential mortgages and of loans in foreclosure have barely changed over the last year. Leveraged loans are showing signs of stress, with the combination of payment defaults and liability management exercises, or LMEs, often pursued instead of bankruptcy back to 2020 post-Covid peaks. If the Fed only eases slowly this year, fewer leveraged companies will be able to outrun interest rates and signs of stress should increase. LMEs are very opaque transactions, so a material increase could make important parts of the leveraged loan market hard to evaluate.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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