Using index funds in your stock portfolio has historically been a wise choice, but bond indexes have some inherent disadvantages that make them a less obvious choice.
Listen now and learn:
- How bond indexing differs from stock indexing
- The different types of active bond management
- How to choose a fund that’s right for you
Listen Now
Show Notes
Welcome to the long term investor. A few weeks ago in Episode 97, I laid out why bond funds are superior to individual bonds. This week, I’d like to dig a little deeper into bond funds and highlight some of the shortcomings of bond index funds.
I’ve published lots of blog posts and podcast episodes highlighting the failure of active management in stocks.
EP 74: The Failure Of Active Management
EP 72: The Collective Wisdom Of Financial Markets
EP 70: Thinking Of Markets Like Piles Of Sand
Bonds are different than stocks in a few important ways that make investing in bond index funds suboptimal.
Why Bond Indexing Isn’t Optimal
For starters, not all bond investors are total return oriented. In fact, more than half of the $100+ trillion global bond market is controlled by noneconomic investors. Central banks (22%) along with banks and insurance companies (32%) are the noneconomic investors that typically have objectives other than generating alpha.
Central banks, for instance, may buy bonds to weaken their currency or boost inflation and asset prices. Commercial banks and insurance companies may care more about book yield or credit ratings than total return. The result: over half of bond market participants aren’t necessarily concerned with maximizing return. That’s very different than equity markets.
The Bloomberg Barclays Aggregate Bond Index—or “the Agg” as it’s often referred to—has a lot of shortcomings on its own. The Agg is the most common benchmark bond index for funds with names like “Total Bond Market Index Fund.” And if you owned the Agg for your bond portfolio over multiple decades, you’d probably do just fine. But there are two big reasons that using a bond index doesn’t feel intuitive.
First, bond indexes like the Agg are weighted towards issuers with the most debt. Traditional stock indexes—like the S&P 500 or Russell 3000—are market-capitalization weighted like the S&P 500 or Russell 3000. That means the bigger the company, the bigger its position in the index. Successful companies with increasing equity prices see their equity weightings increase as a percentage of the market index. So you could argue that the size of a company’s weighting in the index is an indicator of its success.
But that’s not the case with bonds. The largest components of the Agg (or any bond index) are the issuers with the most debt outstanding. In other words, companies or agencies see their weightings in bond indexes as their debt issuance increases. There’s something about that that just seems off. Having a lot of debt doesn’t necessarily make an issuer a better bond investment, it just means they have a lot of debt.
Second, the Agg is highly concentrated in U.S. government exposure. When you hear that the Agg is composed of over 12,000 bonds worth more than $25 trillion, you probably assume that it’s very diversified.
But in 2022, Treasuries made up 40% of the Agg. And when you factor in debt issued by government agencies and mortgage-backed securities (MBS), the total government exposure is now over 73%.
Plus, the historical correlation of US Treasuries and MBS is 81%, meaning that historically the returns of those sectors have moved in the same direction most of the time. Less correlated sectors either form a much smaller component of the Agg or simply are not represented in the Agg at all.
Is Active Bond Management Better?
Yes and no.
Cost remains incredibly important. There are a growing number of systematically managed fixed-income products that are low-cost and rules-based, two of the primary characteristics that make equity index investing so successful.
The rules driving systematic fixed-income manager decisions typically revolve around the shape of the yield curve, differences in credit spreads, or currency valuations.
But there’s also traditional active management where analysts pick and choose bonds based on their analysis of their expected return. You will typically see higher costs with this style of bond investing, but that’s not always the case….these days you can find active bond fund options with index-like cost structure.
Core bond funds, for example, are often so cheap that it’s easy to assume it’s a passive fund. Oftentimes those funds are taking advantage of rules-based processes while also enjoying the benefits of active bond management.
For example, the composition of bond indexes changes frequently, and passive investors are forced to buy or sell securities at less than favorable pricing when they join or leave an index. Active managers aren’t subjected to this situation and can even potentially profit from it.
Another area of note is that the total bond market itself has much more turnover than the stock market. New issues represent roughly 20% of bond market capitalization annually. With stocks, that number is closer to 1%.
But here’s why that’s important: new issues are typically offered at concessional pricing to drive demand.
Active managers can take advantage, but passive managers are more likely to miss out on these discounts as they tend to buy when new securities join an index (often a few weeks after issuance).
In short, bonds are a bit different than stocks when it comes to indexing.
The two biggest reasons are that over half of bond market investors aren’t concerned with maximizing total return and the rules governing a bond index reward the most indebted entities rather than the most successful ones.
Resources:
- EP 97: Individual Bonds vs Bond Funds
- EP 74: The Failure Of Active Management
- EP 72: The Collective Wisdom Of Financial Markets
- EP 70: Thinking Of Markets Like Piles Of Sand
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About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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