Is bond indexing dead?
(MoneyWatch) Active stock managers underperform the appropriate stock indexes by an overwhelming margin. But not so for bonds, at least in the past few years. Let's examine why.
The Vanguard Total Bond Index Fund (VBTLX) follows the Barclay's Aggregate bond index, which comprises investment grade taxable securities. According to Morningstar, this fund earned 5.53 percent annually over the past five years and has been bested by 80 percent of its peers. Similarly, the iShares Total Aggregate US Bond ETF (AGG) earned 5.24 percent over the same period and has been bested by 57 percent of bond exchange traded funds.
Does this mean that bond markets are less efficient, making it easier for an active manager to add value? A recent paper by Vanguard sought to answer that question. If rated as "alpha," the managers bested the market while taking on no more risk, meaning they added value. Those adjudged as "beta," on the other hand, would have achieved any excess returns from taking on more risk, not from their investment prowess.
For instance, Vanguard found that 44 percent of the bond index is backed directly by the U.S. government. The average comparable bond fund had only 10 percent government-backed bonds. Corporate bonds yield more as compensation for higher default risk. In fact, the amount of corporate risk being taken by active bond funds has dramatically increased over the past 15 years.
So the paper's conclusion was that excess bond returns came from beta -- managers taking on more risk.
A more comparable portfolio against which the average bond fund can be compared was a mix comprised of 80 percent total bond and 20 percent investment-grade corporate bonds. Over the past five, 10, and 15 years, the average active bond fund underperformed this more comparable portfolio. Over the past three years, when active bond managers took the most credit risk, they outperformed by 0.1 percentage points.
Although it is to be expected that bond indexing bested the more expensive active fund managers, the slim margin is surprising. Over the past 15 years, the average active fund only underperformed by 0.3 percent annually. That is less of a disadvantage than in stocks.
Never forget that fixed income investments are your portfolio's shock absorber. In 2008, as the economy was crumbling, the average bond fund lost about 8 percent, according to Morningstar. But the Vanguard bond fund gained 5.1 percent and served quite well to absorb the shock that was shaking the financial markets at the time.
Take your risk with stocks and make sure your fixed income portfolio is safe. Roughly 80 percent of my fixed income is backed by the U.S. government, though most through CDs rather than index funds.