Gavin W. Stephens
Chief Investment Officer
Chief Investment Officer
Investors have shown increasing acceptance of passive investment strategies. Meanwhile, funds that employ active strategies—that is, those with managers who strive to outperform their benchmarks—have lost market share to lower cost, passive mutual funds and exchange-traded funds (ETFs). Offering a diversified basket of securities to replicate broad markets, these passive funds and ETFs have become increasingly common core holdings in investor portfolios. For example, one of the most widely held passive stock funds, the Vanguard 500 Index Fund (VFINX), replicates the U.S. large-cap stock universe as reflected by the S&P 500® Index. The most widely held passive bond ETF, the iShares Core U.S. Aggregate Bond ETF (AGG), seeks to replicate the U.S. bond market as reflected by the Bloomberg Barclay’s U.S. Aggregate Bond Index.
Indeed, since 2015, actively managed funds have experienced net outflows exceeding $500 billion as investors allocated more money to passive funds.1 And while for several years market observers have documented this trend in stock markets, passive bond funds and ETFs have also seen rapid growth. Since 2013, the top 10 passive bond funds and ETFs have seen assets more than double to over $470 billion2 (Display 1).
In general, passive funds offer investors two primary advantages. First, passive funds and ETFs give investors diversified exposure to various markets. Achieving similar diversification through portfolios of individual securities, alternatively, often proves practically unattainable or prohibitively expensive. For example, a beginning investor with a relatively small portfolio can achieve broad exposure to the U.S. stock and bond markets by simply holding the two funds mentioned above (VFINX and AGG). To build a similarly diversified portfolio of individual stocks or bonds—even using sophisticated sampling techniques—this investor would need to buy a sufficient number of stocks to achieve the diversity of the roughly 500 stocks in the S&P 500® Index and the nearly 10,000 bonds in the U.S. Aggregate Bond Index. Most investors’ portfolios are simply not large enough to accommodate enough individual stocks or bonds to create sufficiently diversified portfolios.
In addition to diversification, passive funds offer investors very low operating and transaction costs. Because these funds seek to match the performance of their benchmarks—and not outperform them, as active managers do—passive strategies should require less analytical support, and thus less operating overhead.
However appealing these advantages may be, investing into the bond market via passive funds or ETFs is fraught with under-appreciated risks. And two of these risks should preoccupy any bond investor—namely, credit risk and interest-rate risk. Only actively managed bond portfolios can address these two risks proactively. By doing so, and by taking advantage of opportunities unavailable to index-driven strategies, active bond managers are better equipped to construct portfolios suitable for various market conditions.
The under-appreciated risks of passive bond investing arise from the makeup of the bond market itself and the indexes that replicate it. For example, the iShares U.S. Aggregate Bond ETF (AGG) mentioned above is modeled after the Bloomberg Barclay’s U.S. Aggregate Bond Index which, in turn, is meant to represent the U.S. taxable, investment-grade bond market. To understand the makeup of the AGG ETF therefore requires an understanding of the makeup of the U.S. Aggregate Index and the underlying U.S. bond market that drives the index’s composition. (See Display 2 above). In the case of the U.S. Aggregate Index, the weightings given to each borrower—be it the U.S. Treasury, a government agency, or a major corporation—are intended to reflect that entity’s relative weight as an issuer of debt within the fixed-income market. As that entity issues more debt, it occupies a larger position in the index. As it retires existing debt—without reissuing new debt—its position diminishes. In other words, a borrower’s amount of outstanding debt drives its position in the index.
The growing position of U.S. Treasury debt within the U.S. Aggregate Index illustrates this fact. For example, in 2007, outstanding U.S. Treasury securities amounted to $4.5 trillion, or 15% of all U.S. bonds outstanding. In the following 10 years, the amount of U.S Treasury debt more than tripled to $14.5 trillion or 35% of all U.S. bonds outstanding. In response to the increased position of U.S. Treasury debt within the fixed-income market, the U.S. Aggregate Index increased its weight accordingly to over 35%.3
As another example, consider AT&T, whose bonds combined make AT&T the largest non-financial issuer in the Bloomberg Barclay’s Corporate Bond Index.4
AT&T assumed the top position in the index because over the years it issued more index-eligible bonds than other corporate issuers. Passive funds and ETFs, designed to replicate such an index, would also increase their AT&T weightings as its amount of outstanding debt grew. Active managers, on the other hand, would presumably not establish position weights based on an issuer’s amount of debt outstanding. Rather, active managers would conduct research to make an assessment of that issuer’s general credit worthiness—in addition to informed judgments on the structure and return potential of the bond issue under consideration.
Of the risks that a bond investor faces, none is greater than credit risk—i.e., the risk that an issuer fails to pay interest or principal on its debt. In more typical scenarios, credit risk becomes manifest as an issuer’s financial condition deteriorates causing rating agencies to downgrade the issuer’s bonds. Unfortunately, credit risk within the U.S. bond market has been on the rise. Display 3, for example, shows the percentage of BBB-rated corporate bonds within the U.S. Aggregate Index. These bonds, which carry the lowest of investment-grade credit ratings, have steadily occupied a larger percentage of the U.S. corporate bond market since 2011. Nearly 50% of corporate bonds within the U.S. Aggregate Index now hold these low investment-grade ratings.5
The number of BBB-rated bonds has increased as financially weaker companies, in response to a prolonged period of low interest rates and lenders’ reach for yield, issued more debt than financially stronger companies. As a result, bonds with the lowest investment-grade ratings—and those most susceptible to being downgraded to junk—now make up the largest portion of corporate bonds in the U.S. aggregate bond market and its passively constructed offshoots. And investing in such a passive fund means allocating nearly 50% of your corporate bond exposure to the weakest investment-grade credits.
To illustrate further, consider CVS, the familiar retailer and pharmacy-benefit manager. On December 3, 2017, CVS announced that it would acquire Aetna, a major health insurer, for $69 billion. CVS would fund the acquisition by issuing new debt. Indeed, on March 6, 2018, CVS announced a $40 billion bond issue to fund its Aetna acquisition, the largest corporate bond issue in two years.7 Investors were eager to buy the bonds, and the market easily absorbed the new supply. This new supply of CVS bonds also found its way into the various fixed-income indexes and their corresponding passive funds and ETFs.
As Display 4 shows, CVS’s position within the U.S. Corporate Bond index has indeed adjusted to reflect its growing debt.8 Prior to its $40 billion bond issue, CVS occupied less than 0.50% of the corporate bond index; after its new bond issue, CVS’s weight within the index rose to 1.20%. Funds and ETFs that replicate these indexes would also add to their CVS positions to reflect the company’s growing place within the corporate bond index.
While this practice might be a logical way to build an index, it is not an ideal way to construct a bond portfolio. By adding to its CVS position, the passive fund is adding more weight to an ever-more indebted company with increasing financial risk. As Display 4 shows, this dynamic occurred with CVS: its debt-to-earnings ratio, a common measure of financial risk, rose in tandem with its weight in the index and, by extension, its weight in passive funds and ETFs. With a debt-to-earnings ratio of just over 2.0, its index weight remained below 0.5%. When CVS’s debt-to-earnings ratio ballooned to over 7.5, its weight increased to 1.20%.9 This dynamic occurs again and again for bond indexes and passive ETFs: debtors issue more debt and lenders—or buyers of a seemingly innocuous fund—allocate more of their money to increasingly indebted borrowers, whether they want to or not.
Another risk has been looming within the U.S. Aggregate Bond Index—namely, interest-rate risk or what bond managers call duration. Duration at its most basic level measures the sensitivity of a bond’s price to changes in interest rates. For example, a bond with 7 years in duration might be expected to appreciate 7% with a one percentage-point decrease in interest rates; a one percentage-point increase in interest rates would cause the opposite price action—a 7% decrease in the price of the bond. What’s more, a bond with a longer maturity date and a lower coupon carries more duration than shorter-dated, higher-coupon bonds.
Unfortunately, these lower-coupon, longer-maturity bonds have occupied a larger place within the U.S. Aggregate Index over the past five years. These changes reflect the logical responses of governments and companies to an extended period of low rates and easy credit. With interest rates at historically low levels, corporate and government borrowers locked in long-term financing by issuing long-dated bonds with low coupons. And while this practice may have made great sense from a chief financial officer’s standpoint, it left creditors holding low-coupon, long-dated debt with resulting high levels of interest-rate sensitivity. Indeed, as the U.S. Aggregate Index added these low-coupon, long-dated bonds to its holdings, the overall duration of the index increased by over 10%. (See Display 5.) And only recently have yields on these bonds begun to increase, meaning that throughout most of this period of increasing duration, investors in passive bond funds received minimal compensation for assuming more risk.10
Active managers are not bound to mimic the risks of the U.S. bond market. Rather, using their analytical and trading capabilities, active managers intentionally adjust their levels of credit and interest-rate risk to improve the characteristics of their bond portfolios. These capabilities allow active managers to add value in a wide range of market conditions. This flexibility is especially valuable when market conditions have introduced increasingly high levels of credit and interest-rate risks.
In addition to being bound to the credit and duration risks of U.S. bond market, passive bond funds and ETFs are captive to other constraints of the indexes they mimic. Active managers can add value to investor portfolios because they are not bound to follow such constraints. The following are a few examples, drawn from requirements for inclusion in the U.S. Aggregate Bond Index:11
• Minimum issue size for treasury, government-related, and corporate bonds: $300,000,000. Active managers can add value by including smaller issuers in their portfolios.
• Fixed rate only. Active managers can add value by buying variable rate securities, such as floating-rate notes or hybrid securities (fixed-to-floating rate notes) to benefit from changes in interest rates.
• No inflation-linked bonds. Active managers can add allocations to inflation-linked bonds, such as U.S. Treasury Inflation Protected Securities.
• Maturity must be greater than one year. Active managers can take advantage of opportunities in shorter-maturity bonds, which carry much less interest-rate risk than longer-maturity bonds.
• Ratings – investment grade only. When conditions warrant, active managers can add bonds rated below investment grade to enhance portfolio performance.
These index requirements limit the range of investable bonds in passive funds and allow active managers opportunities to add value to their portfolios by including these securities when conditions are favorable.
Given their advantages over passive funds and ETFs, one would expect active managers to outperform their indexes. Indeed, among the managers of the 100 largest actively managed mutual funds, 83 beat the U.S. Aggregate benchmark on a 5-year annualized basis.12 Moreover, 47 of these same managers produced enough return over the same 5-year period to compensate for additional management fees they charge relative to their passive counterparts.13 Thus, while passively managed funds carry lower expense ratios, most actively managed funds that beat their benchmarks have produced enough value to compensate for the additional fees incurred as a result of their higher research and trading costs. These results are even more pronounced among the 10 largest actively managed funds, which have also outperformed their passive counterparts, net of fees, on a 5-year annualized basis by 0.85%.14
Passively investing into the U.S. bond market is undoubtedly an inexpensive way to establish a diversified bond portfolio. However, choosing passive funds for a bond portfolio exposes investors to risks over which they have little control and limits their ability to adjust their exposures to those risks and improve the quality of their portfolios. Active managers, not captive to the changing characteristics of the bond markets, can proactively adjust levels of credit and interest-rate risk as market conditions change. This capability, in addition to having the flexibility to add out-of-index bonds, provides active managers better tools for managing portfolios through market cycles. For these reasons, active management should remain the preferred approach to bond investing.