James West, Nasdaq Dorsey Wright, Senior Analyst
“The man who will use his skill and constructive imagination to see how much he can give for a dollar, instead of how little he can give for a dollar, is bound to succeed.” – Henry Ford
As anyone with any proximity to the investment industry can tell you, passive investing has become increasingly popular over the last several years. Whenever you hear a radio or TV personality talk about passive investing, the discussion invariably focuses on the availability of low-cost funds that track widely-known U.S. large cap equity indices. They then typically say something akin to “Less than X% of ‘stock-pickers’ have outperformed the S&P 500 on a net-of-fee basis over the previous 10 years.” On this count they’re often correct. It has been incredibly difficult for active U.S. large cap funds to outperform their indices over the last decade. However, based on this, they typically jump to an unjustified conclusion, telling the audience that low-cost indexing is superior to active management. Full stop.
An analysis that stops here is at best insufficient and at worst disingenuous. As any investment professional knows, asset classes and markets are not created equal – U.S. large cap equity is widely accepted to be the most efficient market, and thus most suitable to being passively managed. Certainly there is value to be added by the advisor in managing risk within this market and taking advantage of sector trends that can drive alpha over time. But for the sake of this discussion we will put that aside and accept that the recent five year period for the S&P 500 Index SPX benchmark (illustrated above) has contributed to the increased appetite for “low-cost indexing,” and that is the environment we face in the here-and-now. Historically, this benchmark doesn’t often outperform 90% of active managers over a five year period, but it has before and it has recently. And so we pivot to the observation that the vast majority of investors also have a significant portion of their assets invested in other asset classes and subclasses. Therefore, any serious discussion along the lines of “active vs. passive” management should extend to those areas as well.
The most basic retirement portfolio model includes two asset classes – equity and fixed income – often in a 60/40 split. Retail investors are told that fixed income is the “safe” portion of their portfolio. And while in some sense this is true – the volatility of (most) fixed income investments is lower than that of equities – this does not mean that a “passive” fixed income investment strategy is a no-brainer. First of all, unlike large cap U.S. equity managers, active fixed income managers have regularly outperformed their benchmark on a net-of-fee basis. Take a look at some rolling five-year rankings of the core fixed income universe and you’ll see the U.S. Aggregate Index regularly finishing below the 50th percentile. Aside from active managers’ ability to generate alpha, there are a few other problems with traditional low-cost indexing within fixed income.
Your Exposure Can Materially Change Without You Doing Anything.
Unlike the major equity indices, which often have fairly stable constituencies from year to year, the composition of bond indices changes much more frequently. Where the S&P 500 Index and the Russell 1000 Index are updated quarterly and annually, respectively, the composition of the Bloomberg Barclays US Aggregate Index changes monthly. The iShares Core U.S. Aggregate Bond ETF (AGG), for instance, had turnover of 242% for the 12-month period ending February 28, 2017; meanwhile the Vanguard S&P 500 ETF (VOO) had turnover of just 4.10% last year.
Why should the average investor care about the more frequent rebalances and higher turnover of fixed income indices? With approximately 20% of the holdings in the Aggregate Bond ETF changing every month, the exposure in the fixed income portion of a portfolio can change fairly quickly and it can happen under the surface, i.e. without an advisor or client “seeing” any trades in the portfolio. While this is often viewed as a primary benefit of the ETF product structure, it may not be as advantageous if you don’t understand what the impact of those changes are over time. Unless the client is looking at the exposure breakdown of the index every month (which they aren’t, and don’t intend to), an investor could find that the exposure in the indexed bond ETF they bought six months ago looks very different than the exposure it brings to the portfolio today.
The table from Wells Fargo below shows how dramatically the composition of a broad-based fixed income product like AGG can change. The US Treasury exposure has increased 15% and the duration has increased 62% within the ETF! Does this strike you or your clients as “passive”?
The “Bums” Problem
The fast-changing nature of fixed income indices we discussed above also contributes to the “bums” problem. As with equity indices, many fixed income indices are essentially market cap weighted. In equity indices, market cap weighting means that the most historically successful companies (at least in terms of increasing their market value) become the most heavily weighted. In a market cap weighted fixed income index, the most heavily weighted entities are those that have issued the most debt. This presents a problem for the buyer of a cap weighted fixed income index, as they will be most heavily exposed to the most debt-laden and not necessarily the most creditworthy of issuers. Apple (AAPL) maintained an enviable credit rating for many years, but only had its first bond issuance in 2013. As such, AAPL couldn’t have been included within Investment Grade Bond Funds or Aggregate Bond Funds before that time.
Furthermore, unlike equity indices which typically include only corporations, issuers within fixed income indices can include corporations, states and municipalities, and sovereign governments. Heavily-indebted sovereigns present a unique challenge, as they can (and at various points have) simply decide to cease payments on their notes, leaving debt-holders with limited recourse.
The “bums” problem can be mitigated through the use of other weighting schema, e.g. equal weighting, but this can introduce new problems, such as more heavily weighting toward thinly-traded, illiquid issues. And so, many bond funds employ some form of market cap weighting, and the impacts of this are quite different than we find within the US equity category.
Fixed Income Indices Can Become More Risky at the Worst Time.
You’re probably aware that we’ve been in an ultra-low interest rate environment for many years and a declining rate environment for far longer still. That trend has recently begun to change, but among the effects of these historically low yields may be that the bond market itself has become more risky.
As discussed within the aforementioned study from Wells Fargo, from 2008 through 2016, the modified duration of the U.S. Aggregate Bond Index increased by 62%; or approximately two and a half years. For the bond aficionados out there, this suggests that a 1% move higher in the yield curve today would cause a corresponding decline in bond valuations of about 2.5% more than a similar rate move back in 2008. This is caused, again, by passive bond portfolios investing in a market that hasn’t itself remained “passive.” Debt issuers, corporations, and municipalities alike, have taken advantage of the low-rate environment by issuing longer-dated debt where possible. If long-dated bonds make up a bigger chunk of the bond market, they often make up a bigger part of your “passively” indexed bond fund.
And there is another, less obvious, reason for the increase in duration – lower coupons. All else equal, a bond with a higher coupon will have a lower duration than an otherwise equivalent bond with a lower coupon. As rates fell following the financial crisis, coupons also decreased, thereby extending the duration of bond indices and increasing interest rate risk.
While it is well understood that the market values of traditional fixed income instruments have an inverse relationship with interest rates (i.e. as interest rates rise, the value of a fixed income portfolio decreases), illustrating the current risk environment within this asset class is often more nuanced. Interest rates remain far below their historic averages, which is one concern, but many investment products have quietly increased in risk as well, which should factor into the “active vs passive” discussion you may be having with clients more regularly today. Our goal is to provide you with as much useful information as possible to support those conversations. The illustration below might be helpful in summarizing the discussion to this point, as it displays a very general rise in duration alongside the converse pattern of declining yields across the US bond market. This lends itself to a discussion of risk vs reward, and why “active” risk management should be a part of any major bond allocation going forward.
Developing a Strategy
The commonly presented “evidence” demonstrating the superiority of low-cost passive investing is often incomplete, and especially so when it comes to bond markets. You may well be able to provide cost savings for your clients through prudent use of passive products in certain areas, but you can also add substantial value for your clients by utilizing strategies that actively manage both market trends and market risk. If you use your skill to determine where you feel you can add value with active strategies and utilize passive products to save your clients money where you feel you can’t, you’ll be doing more to earn your fee than the advisor who isn’t. To paraphrase Henry Ford, you’re displaying how much you can provide for a client’s dollar in return, versus how little you can deliver for that same dollar.