Beware of Bond Indexes
Index funds continue to take market share from actively managed funds, a multi-year trend that shows no signs of abating. Most debate between proponents of active and index approaches centers on equity investments, leading many investors to assume that the arguments in favor of indexation apply equally to both equity and fixed-income investments.
However, fixed-income indexes are fundamentally different than equity indexes, creating additional complexity in determining whether to invest in active, index or hybrid investment approaches.
The most significant difference between equity and fixed-income indexes is that equity indexes can be thought of as rewarding "success." Companies with the highest stock market value have the greatest weight in market-capitalization-weighted indexes. Fixed-income indexes, in contrast, are weighted to favor issuers with the most debt outstanding, a methodology that in many cases isn't an indication of financial success or market popularity.
[See: 9 Ways to Invest in America With Bond Funds.]
Given the limitations of fixed-income indexes, active fixed-income managers have had more success than many of their equity counterparts in beating indexes.
Shortcomings of the Bloomberg Barclays Aggregate Index. The most widely used fixed income index is the Bloomberg Barclays Aggregate Index, which consists of more than 9,000 bonds worth $20 trillion. The iShares Core U.S. Aggregate Bond ETF (ticker: AGG) is the largest bond exchange-traded fund, with assets of more than $50 billion tied to the index. Although the AGG is massive in size, municipal bonds, non-investment grade bonds, and international and emerging markets bonds are among the fixed-income segments outside the index. Consequently, investors looking for comprehensive bond market exposure shouldn't exclusively rely on the AGG.
The composition of the AGG has also changed as a consequence of the global financial crisis, a function of the extraordinary policies adopted by the Federal Reserve in response to the crisis. Today, more than 70 percent of the index is comprised of government-related debt, primarily Treasury, agency and mortgage-backed securities.
The duration of the index, a measure of interest rate sensitivity, is now nearly six years, significantly above pre-crisis levels. Although interest rates may not rise as sharply as many investors fear given an environment of slow growth and aging demographics, at the current level of interest rates even a modest uptick in market yields would produce negative returns for the AGG. AGG-indexed investments, however, remain sources of diversification in the event of a recession, potentially providing some degree of capital appreciation in the event of a bear market in equities.
AGG isn't the only flawed fixed-income index. Many investors diversify their bond portfolios with investments in segments such as high-yield corporate debt, non-U.S. sovereign debt and emerging markets debt. However, high-yield corporate bond indexes and the popular ETFs created to track them have weighting mechanisms tied to bond issuance.
The largest high-yield ETFs have considerable energy exposure, a sector under siege as a consequence of the fracking revolution. For example, the $19 billion in assets iShares iBoxx High Yield Corporate Bond ETF ( HYG) has nearly 13 percent of portfolio assets invested in energy sector bonds. The HYG ETF also has more than 11 percent of its portfolio invested in bonds rated CCC, bonds considered to be the most distressed and at the highest risk of default.
In non-U.S. sovereign debt markets, ETFs such as SPDR Barclays Short Term International Treasury ETF ( BWZ) and iShares International Treasury Bond ETF ( IGOV) had significant exposure to the debt of troubled issuers such as Italy, Portugal, Spain and Greece during the European financial crisis. The counterintuitive nature of bond indexes was apparent, as each country had elevated debt/GDP ratios that could hardly be viewed as evidence of fiscal strength.
Emerging markets debt is an interesting and potential lucrative segment of the bond market, as many emerging markets debt issuers offer attractive yields and solid economic foundations. However, index alternatives may be riskier than actively-managed alternatives.
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Turkey and Argentina are the highest weighted countries in the $11 billion in assets iShares J.P. Morgan USD Emerging Markets Bond ETF ( EMB). Turkey has political and economic challenges and is widely considered one of the more risky issuers in emerging markets. Although Argentina under Mauricio Macri has made tremendous progress unwinding the disastrous economic policies of Cristina Kirchner, it may be premature to assume that Argentina's path will be without difficulty. Despite positive economic steps, Argentina today has a high level of U.S. dollar-denominated debt, leaving the government's balance sheet vulnerable to a decline in the peso and raising the risk of a fiscal crisis over a three-to-five-year horizon.
Smart beta in bonds? Columbia Threadneedle recently launched the Columbia Diversified Fixed Income Allocation ETF ( DIAL), which attempts to offer a "smart beta" approach to bond investing. DIAL is a multi-sector strategy portfolio that includes U.S. Treasurys, mortgage-backed, investment-grade corporate and high-yield corporate bonds, as well as non-U.S. sovereign bonds and emerging markets sovereign debt. In addition to drawing from a broad opportunity set, the Columbia ETF applies a variety of filters to address some of the frequent shortcomings of fixed income indexes.
In the words of Ed Kerschner, the firm's chief portfolio strategist, "allocation by debt outstanding creates a lopsided yield distribution, with a barbell-like overconcentration both in safe haven assets with a limited income profile and in fundamentally risky debt profiles."
Yield filters exclude short-term holdings with limited yield, or negative yielding bonds. Quality and liquidity filters remove tails of the market that may be low quality, create significant downside risk or be difficult to purchase at a reasonable price.
Building a fixed-income portfolio. Many investors use a multi-dimensional approach to constructing a fixed-income portfolio, consisting of both core and satellite investment positions. The core position often is either an actively managed or index fund that tracks the Bloomberg Barclays U.S. Aggregate Index Bond Index, though some investors prefer a shorter term fixed-income index or have a municipal bond strategy as their core.
The core position is supplemented by satellite positions with exposure to segments such as high-yield, international debt and other areas that are absent or under-represented in the AGG. The satellite positions are often more highly correlated with equities, making it advisable to understand the potential downside in an economic recession or bear market for equities.
Also, with credit in particular, an active approach organized around credit research may be preferable to an index-based approach because of the index shortcomings discussed above.
[See: Are Quant ETFs Worth Buying?]
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Advisor's clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable.
Dan Kern is chief investment officer for TFC Financial Management, a wholly independent, fee-only, financial advisory firm based in Boston. TFC's revenues are derived solely from the fees it charges for the services it provides. Prior to joining TFC Financial Management, Dan was president and CIO of Advisor Partners. He is also a former managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds, and was managing director and principal for Montgomery Asset Management. Dan graduated from Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco, and sits on the board of trustees for the Green Century Funds.
