Basis Points: A View From the Hills

The “Bums” Problem With Bond Indexing

March 2016

The “Bums” Problem With Bond Indexing

by admin on March 5, 2016

In 1776, Adam Smith penned his opus on the economy. One of the discussions within the work is considered to be one of the earliest references to the law of supply and demand. The law simply states that price is a function of supply and demand. When demand is greater than the supply, the prices increase until a new equilibrium is found. Examples of supply and demand can be found from college tuition to home prices. The concept is as close to universally acceptance.

Price-Equilibrium

It stands to reason that an investor would want to take supply and demand into account when deciding where to invest. This principle seems to exist in all parts of the investment world except for one, bond market indexing.

The “Bums” Problem

Much like their stock market counterparts, bond indexes use market cap weighting to determine the holdings of the index. In the stock universe, a company increases in value and weighting in the index as it grows. Success breeds inclusion. The bond index works quite differently. The larger a debt issue is, the more likely the index is to own it. The more debt a company or country (USA) has, the larger the weight it has in the index.

This curious formula has been dubbed “The Bums Problem”. We tend to think of indexes as broadly diversified investment vehicles that regularly crush their actively managed competition. By and large, bond indices are neither of these. The aggregate bond index holds close to 50% of the portfolio in US Government Debt, with the remaining 50% of the portfolio stretched across the remainder of the bond world.

The average intermediate term bond fund has less than 30% of the portfolio in treasuries. After the financial crisis of 2008, government debt issuance exploded, while corporations issued less debt. The result was that the bond index kept getting more and more dependent on treasuries.

Recently, the corporate world has rushed to issue bonds to take advantage of low yields and to avoid having to repatriate foreign profits. Still the problem remains. Whoever is issuing the most debt is getting rewarded.

Active Alternative

Challenges of the bond indexing formula are readily apparent. Actively managed fixed income options would seem to have the freedom to build more diversified bond portfolios, but has that freedom translated into better results for investors? For the most part, the data suggests that it has. The chart below shows the percentage of actively managed bon offering that beat the index over various investment time frames. Over 55% of all actively managed fixed income funds have bettered the index over the last 15 years. These odds increase dramatically with the size of the fund, with over 80% of the largest fixed income funds beating the index. More recent results are markedly better for the active fixed income managers. As many as 90% of the largest funds have beaten the index over the last 3 and 5 years.

Climate-Change-2

Investors Aren’t Getting the Message

The underperformance of indexing fixed income doesn’t appear to be impacting investor confidence. Of the largest ten core US fixed income funds, only the PIMCO Total Return has more assets than the Vanguard Total Bond Market Index. If inflows remain on their current course, the Vanguard Bond Index will end the year as the largest bond fund in the universe, despite the fact that it has the lowest 5 yr return and is next to last over the 10 yr mark. Investors are clearly not buying on performance. The only explanation is that investors are buying on price, where the index fund does have a clear advantage.

Annualized Return and Exp %
Core US Fixed Income By Size Fund Size USD 5 Yr 10 Yr EXP %
PIMCO Total Return Instl * 95,521,141,788 3.14 5.99 0.46
Vanguard Total Bond Market II Idx
Inv 87,099,839,337 2.76 4.59 0.10
Metropolitan West Total Return Bond M 68,692,100,630 4.28 6.48 0.69
DoubleLine Total Return Bond I 50,408,981,795 5.42 NA 0.47
PIMCO Income A 49,552,547,325 8.05 NA 0.85
Dodge & Cox Income 43,767,114,423 3.66 5.28 0.44
BlackRock Strategic Income Opps Inv A 31,497,557,460 2.88 NA 0.92
JPMorgan Core Bond Select 28,679,331,609 3.06 4.95 0.59
American Funds Bond Fund of Amer A 28,426,514,904 2.91 3.48 0.62
Strategic Advisers® Core Income 28,354,526,241 3.31 NA 0.60
*Pimco Total Return Instl is no longer managed by Bill Gross. He left Pimco in 2015.
SHARE THIS!Share on LinkedInTweet about this on TwitterShare on FacebookGoogle+
Read More »

In 1776, Adam Smith penned his opus on the economy. One of the discussions within the work is considered to be one of the earliest references to the law of supply and demand. The law simply states that price is a function of supply and demand. When demand is greater than the supply, the prices…

Read More »

Previous post:

Next post: