Expert insight
Are investors paying too much for risk exposure?
May 15, 2025
Performance is the compensation that investors make for the risks they take. Vanguard research has shown that credit risk is a greater performance differentiator than other commonly studied risk factors. Costs such as expense ratios present hurdles that active fund managers must clear if they are to outperform their benchmarks and peers.
Expense ratios and the credit risk you take
We employed a regression-based risk factor model to explore the association between fund expense ratios and credit risk. Our findings indicate that higher expense ratios are associated with greater sensitivity to credit risk for both taxable and municipal bond funds.1 This suggests that active fixed income fund managers with higher expense ratios tend to take on more credit risk in the pursuit of outperformance. These managers are essentially “reaching for yield” to overcome their higher costs. As a result, investors keep less of any return premium earned compared to those in lower-cost funds.
The charts below illustrate the positive correlation between bond fund expense ratios and credit risk. The first chart represents taxable funds, while the second represents municipal funds. As expense ratios increase, credit risk moves higher for both taxable and municipal funds.2
Credit risk tends to increase with expense ratio
Notes: Credit risk and expense ratio data are represented as standard deviations from the Morningstar category mean. Negative numbers represent funds with credit risk and expense ratios that are below the category average; positive numbers represent credit risk and expense ratios that are above the category average. Each fund’s x-axis value represents its average expense ratio, calculated as the asset-weighted average of its share classes’ average annual expense ratios for the five years ended December 31, 2024. The y-axis value represents the fund’s sensitivity to credit risk, obtained by regressing individual fund monthly gross returns (in excess of the 1-month Treasury bill rate) over the five-year period on credit, term, and prepayment factor premiums. Individual fund monthly gross returns are computed as the asset-weighted return across share classes. For taxable bond funds, the credit factor is defined as the Bloomberg U.S. Corporate High Yield Index excess return (versus duration-matched Treasuries). For municipal bond funds, the credit factor is defined as the Bloomberg Municipal Bond High Yield Index excess return (versus duration-matched Treasuries). The term factor is defined as the Bloomberg U.S. Treasury Aggregate Index total return minus the 1-month Treasury bill rate. The prepayment factor is defined as the Bloomberg U.S. Mortgage-Backed Securities Index excess return (versus duration-matched Treasuries). Figures exclude results more than four standard deviations from the category average. Regression results show that the relationship is statistically significant for taxable and municipal bonds at the 1% level. We ran the analysis using net returns and found similar results.
Sources: Vanguard calculations based on monthly gross return data for the 842 taxable and 502 municipal active fixed income funds in Morningstar’s universe of U.S.-domiciled active fixed income open-end funds and ETFs, collectively accounting for approximately 90% of the assets under management (AUM) in active taxable bond funds and 100% of the AUM in municipal bond funds as of December 31, 2024. We excluded Morningstar categories for bank loan, inflation-protected bond, global bond, emerging market bond, and preferred stock funds.
Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Interestingly, at any given level of risk sensitivity, there is a wide range of funds and a variety of expense ratios. The funds with higher expense ratios divert more of the return premiums earned from taking risk to the fund managers.
“Curtailing costs, including expense ratios, increases the likelihood of outperformance for active fund investors,” said Andrew Patterson, head of Active Management Research at Vanguard. “Regardless of their risk preference, for a given level of risk, selecting lower-cost funds helps investors keep more of the return premiums that they earn.”
1 For a description of the risk model used in this research, please see Mladina and Germani (2019). Credit risk represents the sensitivity of fund returns to differences in returns on non-investment-grade securities relative to returns on investment-grade securities of similar duration. Credit risk factors are typically constructed using the returns of non-investment-grade taxable bonds. We use a new approach to construct the credit risk factor for municipal bond funds. We use the Bloomberg Municipal Bond High Yield Index excess return (versus duration-matched Treasuries) instead of the Bloomberg U.S. Corporate High Yield Index excess return. The authors would like to thank Vanguard’s Nathan Will and Tanmay Sheth for their helpful comments regarding the benefits of constructing the credit factor with non-investment-grade municipal bond returns.
2 Data has been standardized within Morningstar categories to: 1) allow for comparison of results on the same scale and 2) address cross-category-level differences in sensitivity to risks. Due to the limited number of funds in certain Morningstar categories, we further combined all the state-specific bond strategies into single-state duration-based Morningstar categories based on their benchmark durations when performing standardization. We used a similar approach to combine target maturity municipal bond strategies into national duration-based Morningstar categories.
Notes: All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
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