By Charles H. Webb, CFA
In recent years the inability of most active equity managers to outperform their benchmarks has resulted in a significant move towards passive or indexed equity management. This raises the question of whether passive management would be advantageous to fixed income management. For a plethora of reasons the answer to this question is a resounding, “No”. Unlike equity index funds that have a manageable finite number of liquid stocks (30, 500, etc) there are, for example, almost ten 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 seen in the open market. Securities come and go in 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, thereby ravaging performance. 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.
Nevertheless, some market participants, mistakenly believing bond indexation is like equity indexation, have looked to bond index funds or ETF’s in order 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 will be used. It is the oldest, largest, most popular, and least expensive bond index fund in existence, and its policies and operations are representative of passive bond management.
1) Indexed Bond Funds overweight companies with the worst financials:
When indexing stocks, portfolio holdings are weighted based upon market cap, where theoretically superior companies are rewarded with higher share prices and thus a higher portfolio weighting. Conversely, bond indexation overweights inferior companies as weightings are based solely upon how much debt companies have issued, with the largest weightings awarded to the companies with the most leveraged balance sheets.
2) 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 selectively overweight types of corporate bonds.
3) 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.
4) 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 “indexed” 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.
5) Indexed Fixed Income Funds typically underperform the indices:
According to Morningstar, over the past 10 years ending 3-31-17 the median passive bond manager underperformed their indices net of fees by 13 basis points annualized. Another example: the above Vanguard proxy has underperformed the stated BCAG benchmark over the last 15 years by 16 basis points annualized, and in 11 of those last 15 calendar years. Another prominent bond index fund, The Fidelity Spartan US Bond Index, has underperformed the BCAG index by 37 bp annualized over the past 10 years. Most surprising 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. 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. Regarding 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. (Not to mention liquidity crises such as the August 2015 ETF flash crash). 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 and don’t permit the managers to exploit market inefficiencies because indexation is advertised as “buy and hold”.
6) Indexed Fixed Income Funds typically underperform active bond managers:
According to Morningstar, over the past 10 years ending 3-31-17 the median active bond manager outperformed the median passive manager by 49 basis points annualized net of fees.
7) Indexed Bond Funds fees are not significantly less expensive:
Only the expense ratio for the Vanguard Fund above, long regarded as the cheapest fund, at 6 bp, is significantly less than active separate account fixed management. The above referenced Fidelity US Bond Index Fund is up to 22bp, which is competitive with active management. Bid-ask spreads in fixed income ETFs are not insignificant, as they widen whenever bond volatility rises. Long after the most recent financial crisis the spread on many popular fixed indexed ETFs 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 results in the average ETF “charging” 56 bp, up from 40 bp in the 2000’s.
8) Indexed Bond Funds managers can't customize client preferences, or allow for the elective taking of gains and losses:
Passive management does not screen social investment criteria such as specific “sin bonds”. 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. 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, managing profits and losses, etc., for insurance or similar companies. Moreover, indexation eliminates bonds being pledged, dedicated, immunized or loaned.
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, such as when T-bond futures prices are significantly lower than the cash index.
10) Fixed indexation, mutual funds and ETF’s don’t ever mature:
e.g.: An individual 10 yr issue assures 100 cents on the dollar paid upon maturity. Because 10 yr funds / ETF’s never mature there is no assurance of return of your entire principal, and you could easily lose money if interest rates rise over the next 10 years.
This is not to say that there isn’t a time and place for fixed income indexation, primarily for smaller entities or individual investors who lack 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. But for larger institutions, active separate account management is preferable, given the surreptitious inherent bets and tracking error that fixed income indexation entails.