Fixed income myths, part 1: "Indexing doesn't work for fixed income exposures"
21 October 2020 | Portfolio construction
By Jan-Carl Plagge, senior investment strategist, Investment Strategy Group, Vanguard Europe
The view that ‘indexing doesn’t work for fixed income’ is a common misconception founded on an amalgamation of myths. In reality, bond index funds can offer logical and practical access to the fixed income asset class. What’s more, they enable investors to build broadly diversified portfolios at low cost.
A concern frequently expressed by some investors about bond index funds is that they are holders of highly illiquid securities. This notion stems from the assumption that bond index funds are automatic buyers of all an index’s constituents – especially when an index funds represents an entire market, which can include illiquid securities.
In truth, managing a fixed income index fund is much more active than many investors might expect. For example, when it comes to security selection, the managers of bond index funds are afforded some discretion. Many fixed income index funds use a management technique known as sampling, a process of building a portfolio with characteristics that resemble those of the index, without buying every underlying security.
Sampling is more often employed by funds tracking a large index in order to build a more efficient, optimised portfolio. And the management of liquidity risk is an important consideration in this process. That’s because illiquid securities may demand higher transaction costs. Sampling helps bond index managers negotiate these inefficiencies by excluding securities with unattractive bid-ask spreads.
To demonstrate the impact of sampling, we compared the number of holdings in index-linked fixed income funds from Morningstar’s Global Fixed Income sector with those in their corresponding indices to assess how closely they replicated the index composition (see chart below). We found that the coverage of index constituents tends to decrease as the number of constituents in the index increases. For indices with fewer than 500 constituents, the ratio of portfolio holdings to index constituents is close to 1 (98%). For indices with at least 500 constituents, however, the ratio is just 57%.
Ratio of fund to index constituents
Notes: Vanguard calculations based on data from Factset and Bloomberg. Universe consists of index-linked funds (mutual funds and ETFs assigned to Morningstar’s global broad category group’ fixed income’. ‘Each fund is represented by its oldest share class. Fund of funds, feeder funds and virtual share classes are excluded. The underlying fund universe does not contain any limitation in terms of availability for sale or investment region. Only funds for which data for number of holdings in the fund portfolio and for the underlying index was available are included (cut-off-date: 22/09/20). In order to avoid obvious mismatches or data inconsistencies, we excluded all cases where the portfolio included less than 10 constituents or more than 1.1 times the number of holdings reported for the underlying index.
The key point here is that index funds – whether mutual funds or ETFs – are in many cases not forced buyers of all bonds that make up a given market. Sampling is often used to optimise portfolios where index constituents bring unwanted risks such as credit risk or liquidity risk. In this context, it is important to note that many bond indices set minimum size requirements for inclusion to the index, which already acts as an implied liquidity filter.
‘Index trackers buy the most indebted companies’
Another common concern about bond index funds is that they are inherently overweight the most indebted companies. This theory comes from the market cap-weighting allocation approach that underlies many index funds and results in these funds assigning the highest weight to those issuers with the largest amount of debt outstanding. The concern is linked to the misunderstanding that the issuance of ‘debt’ is identical to the level of ‘indebtedness’, measured via the ratio of total debt-to-total shareholder equity (also referred to the leverage ratio).
To demonstrate that we analysed correlations between the leverage ratios and the total debt of companies included in the FTSE All World index. We found correlations to be much lower than many investors may have assumed. In fact, and depending on the chosen cut-off levels that underlie our analysis, they range somewhere from 0.06 to 0.35. In other words, there is a positive although quite weak correlation between the total debt issued by a company and its leverage ratio.
Further, it is important to point out that the market capitalisation of bonds is essentially driven by the price of bonds. Where market participants are not convinced of the viability of an issuer or a particular bond issuance, its price would decline and so would its capitalisation and, consequently, its weight in the index. Hence, issuers with highly capitalised bond issuances are generally the ones where the market has most confidence in their ability to sustain and service their debt.
Lastly, and in the context of index funds with a focus on investment-grade bonds, it is important to note that the quality and viability of the issuer or a particular issuance lies at the very core of bond ratings. The level of indebtedness of companies is therefore just one part of a broader range of measures taken into account. If these measures indicate that a bond no longer qualifies as investment grade, its rating is adjusted and the bond would be removed from the relevant index.
The case for low-cost fixed-income funds
The rationale for index funds is centred on the zero-sum-game concept, which states that for every active position outperforming the market, there needs to be a position identical in size that underperforms the market by an equal amount. This is because all positions taken together, be they active or passive, represent the market and make up its aggregate performance.
With costs factored into the picture, the aggregate performance of investors is less than zero sum – the higher the costs, the greater the drag on performance. Our analysis of various fund types over a 10-year period found that as expense ratios increase, net excess returns tend to decrease unless significantly more risk is taken for the same level of return2. This negative relationship is found for fixed income as well as equity funds.
Our analysis shows that cost matters as much to fixed-income investing as it does to equity investing – if not more, given that expected returns in the bond space are lower than in the equity space. As such, managers may be forced to take more risk to justify their higher fees due to the lack of a compensating return.
So the choice between a low-cost index or active fixed-income fund will come down to the investor’s approach to risk – and it’s not an all or nothing decision.
1 Our analysis excludes all companies with zero debt issuance and negative equity. Since leverage ratios can take on extreme values which may potentially distort our results, we compute correlations not just based on all stocks with positive leverage but also based on subsets by excluding companies with leverage ratios that belong to the top/bottom 1%, 5% and 10% respectively, of ranked leverage ratios. Source: Factset annual data (latest complete period).
2 Vanguard calculations, based on data from Morningstar. Data as at 31 December 2019.
Chris Wrazen, head of bond indexing, Vanguard Europe, explores the myth that managing a fixed income index fund is a straightforward process.
Nusrath Hussain, senior ETF product specialist, and Kunal Mehta, senior investment product specialist, explore the myth that bond index funds can destabilise fixed income market liquidity.
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