By Charles H. Webb, CFA
Managing fixed income portfolios against the popular indices is a difficult thing to do. According to PSN, a national database of over 2000 managers, during the past 20 years well over two thirds of bond managers underperformed their indices. Some of the reasons lie with the nature of the indices themselves. Unlike equity index funds that have a manageable finite number of liquid stocks (30, 500, etc) there are, for example, over nine thousand issues in the Barclays Aggregate, a significant percentage of which are illiquid, have gaping bid/ask spreads, or have long ago been put away in portfolios and never see the open market. Securities come and go into the indices with no liquidity problems or transaction costs, and should an issue get downgraded to non-investment grade it magically disappears from the index at month end (e.g. WorldCom in 2002) while the active manager gets stuck with illiquid trash worth pennies on the dollar, and performance suffers. In addition, large groups of bonds maturing within one year vanish from an index, again with no liquidity constraints or transaction costs, unlike the real world of active portfolio management.
Because of the difficulty in outperforming these theoretical benchmarks, some unsuspecting market participants, mistakenly believing bond indexation is like equity indexation, have looked to bond index funds or ETF’s in an effort to achieve the “market” return in fixed income. The following are some of the reasons why this concept is flawed and unlikely to achieve the desired results for the degree of risk taken. As a proxy for indexed fixed income funds and ETFs, the preeminent bond index fund, The Vanguard Total Bond Market Index Fund has been used. It is the oldest, largest, most popular, and least expensive bond index fund in existence, and its policies and operations are representative of the bond indexation industry.
1) Indexed Bond Funds and ETFs are not passive indexes;
They are hardly passive as it is impossible to index fixed income when the indices hold thousands of issues. This mandates the use of statistical sampling and the use of derivatives in an effort to replicate an index’s return. However, the degree of sampling representation is startling, with many bond index funds or ETFs holding less than 2% of the issues in the index. Arithmetically, this means something must be overweighted. For instance, Vanguard fund managers nearly always make use of an option in the prospectus called "corporate substitution," for up to 15% of assets, whereby managers overweight particular types of corporate bonds relative to their index weight.
2) Indexed Bond Funds buy outside the index;
As the Vanguard bond index funds prospectus allows, it not only makes extensive use of statistical sampling from within the Aggregate index, but up to 20% of the holdings fall outside the index.
3) Indexed Bond funds employ active management;
It's astonishing how far beyond the indexes these prospectuses allow their fund managers to go. The truth is that these managers tinker a lot with their portfolios. As the Vanguard bond index fund’s prospectus puts it, "To the extent that the funds invest outside of the index, they may employ active management.” The prospectus goes on to authorize further managerial latitude.
4) Indexed Fixed Income Funds typically underperform the indices;
For example, the above Vanguard proxy has underperformed the stated BCAG benchmark, since inception in 1986, by 29 basis points annualized, and in 5 of the last 7 calendar years. Another prominent bond index fund, The Fidelity Spartan US Bond Index, has underperformed the Aggregate index by 37 bp annualized over the past 10 years. Most astonishing is the fact that these two prominent bond index funds, both among the largest, have had an annual difference in performance by up to 162 basis points over the past 10 years. How can this occur when both are supposedly “indexed” to the same Aggregate bond index? The answer is that true bond indexation only exists in theory and is not applicable in the real world. There is simply no such thing as bond indexation in the sense of equity indexation. With regard to bond ETFs It has been well documented that the problems of daily compounding (recalculation) of indexed ETFs, especially those using leverage, and in rolling derivative contracts in the futures market can cause ETF returns to deviate substantially from the underlying index or commodity. Just as important, the use of truly indexed fixed products (if found) would prevent the possibility of outperformance. Theoretically, they can do only as well as the market. They do not permit investment managers to exploit market inefficiencies because indexation is advertised as “buy and hold”.
5) Indexed Bond Funds fees are not less expensive;
The expense ratio for the Vanguard Fund above, long regarded as one of the cheapest if not the cheapest fund, is up to 20 bp, in line with active separate account fixed management. The above referenced Fidelity US Bond Index Fund is up to 22bp. Bid-ask spreads in fixed income ETFs are not insignificant, soaring whenever bond volatility rises. Long after the most recent financial crisis, the spread on many popular fixed indexed ETFs, such as the Claymore U.S. Capital Markets Bond still showed gaps in bid-ask prices of more than $8 according to NYSE Arca. Nearly 200 ETFs have had bid-ask spreads of over 50 bp. Add to this the effect of higher trading costs in illiquid securities, resulting in the average ETF “charging” 56 bp, up from 40 bp in the 2000’s.
6) Indexed Bond Funds managers can't monitor credit quality or call risk as closely;
Many feel that bond index fund managers are ill-equipped to manage credit quality, that is, to select the highest quality bonds or anticipate which are likely to be upgraded. Also, active managers can potentially better control call risk and are probably better positioned to invest only in bonds that cannot be called, thereby avoiding having to reinvest assets at lower interest rates when higher-yielding bonds are redeemed.
7) Indexed Bond Funds cannot be pledged, dedicated, immunized or loaned;
8) Indexed Bond Funds cannot accommodate specific social investment criteria;
Disallows specific client prohibitions against tobacco, alcohol, gambling, competitors etc.
9) Indexed Bond Funds’ extensive use of derivatives may violate client policy;
Bond Index Funds routinely use up to 20% in derivative securities to manage cash flow or to take advantage of arbitrage opportunities when they arise, such as occurs when Treasury bond futures prices are significantly lower than the cash index.
10) Indexed Bond Funds don’t allow the taking of elective gains and losses;
Bond Index Funds cannot take selective gains or losses on holdings for reporting or tax purposes or for specialized accounting needs such as maximizing return on book, projecting or managing income, etc. for insurance or similar needs companies.
This is not to say that there isn’t a time and place for fixed income indexation, especially for a smaller entity or individual investor who lacks the critical mass to get broad diversification. Attempting to actively manage and diversify a small fixed income portfolio within the inefficient and non-transparent corporate and mortgage backed bond markets, without sacrificing a large portion of one’s capital to retail bond markups and sales fees, is very difficult, even for experienced pros. For those entities large enough to access the economies of scale, active separate account management is preferable, given the surreptitious inherent bets and tracking error that fixed income indexation .