Fixed income myths, part 2: "Bond indexing is simple"
22 October 2020 | Portfolio construction
Commentary by Chris Wrazen, head of bond indexing, Vanguard Europe.
In recent years, increasing numbers of investors have adopted fixed income index funds as part of their portfolios. However, the apparent ease with which these funds track their benchmarks has given rise to some misunderstanding among certain investors.
How can they hold all the bonds in an index when many are not available to buy? And aren’t bond index funds simple to manage and just run by algorithms? But as we will see, running a fixed income index fund is not as simple as some investors might think.
Not as straightforward as it seems
Many equity index funds track their benchmarks using a relatively simple replication process. They buy all, or a representative subset, of the index constituents according to their market weights.
But bond indexing is a little different. This is partly because of the magnitude of the bond universe. For example, the Bloomberg Barclays Global Aggregate Index, one of the best known global bond indices, tracks more than 26,000 individual bonds1. Equity indices are typically much smaller – the FTSE Global All Cap Index, for instance, a globally diversified share benchmark, tracks fewer than 9,000 securities2.
The sheer size of the target indices, combined with the over-the-counter (OTC) nature of bond markets and the fact that some bond issues are difficult to purchase, means that fully replicating a fixed income benchmark is usually not practical, nor cost effective.
So how do bond index funds effectively track fixed income indices without buying every bond?
Sampling the index
Most bond index managers tackle this challenge by sampling the index, holding a representative sample of the bonds that make up the universe.
The sample is intended to match the characteristics of the index - such as sectors, currencies, credit quality, capital structure, yield and duration. This allows it to replicate the intended risk of the index as well as to track its returns.
Using this approach, a bond index fund can condense an index made up of tens of thousands of individual securities into a portfolio of a few thousand bonds, all the while accurately tracking the performance and other key features of the benchmark.
But because it’s not just a case of buying every bond in the index, fixed income indexing is far from straightforward. Indeed, managing a bond index portfolio effectively involves a lot of active decisions.
Finding the right balance
As fully replicating a bond index is not cost effective, fixed income index fund managers strive to reach the optimal trade-off between cost and replication. As a result, they seek to minimise tracking error— which is a measure of the consistency of a fund’s excess return versus its benchmark over time—by matching key risk factors.
Finding the optimal trade-off between cost and replication
Notes: Hypothetical representation of trade-off between tracking error and cost of investing. Source: Vanguard
The sampling process lowers portfolio turnover and, as a result, transaction costs; at the same time, it allows the fund to achieve almost the same risk (and returns) as the index, without holding every bond.
This is aided by performing in-depth credit research, which requires experienced teams of specialists to evaluate the creditworthiness and relative value of both corporate and government bond issuers.
It takes a global team of credit research analysts to create an optimised portfolio by selecting the right mix of bonds that, combined, will broadly replicate the essential risk and return features of the benchmark without causing costs to become too high. At Vanguard, our Fixed Income Group contains around 180 professionals, one of the biggest global teams in the industry3.
Adding value with a bond index fund
There are several ways that bond index fund managers can add value for investors, notably by using their scale, expertise and trading relationships to take advantage of opportunities in advance of changes in the underlying index.
Take the new issue market, for example. Issuers often offer concessions to entice investors to buy a new bond, with no transaction costs. The question is, do you buy the bond at the time of issue, taking advantage of any concessions and lower costs? Or do you wait for it to be included in the index at the end of the month, by which point it might have gained (or lost) value?
Similarly, should an index fund proactively buy or sell bonds before they are included or excluded from benchmarks as a result of ratings upgrades and downgrades? The answers will depend on the circumstances of the particular issue or index inclusions or exclusions, and decisions like these are at the discretion of the fund management team. For example, the forced selling that may occur as bonds migrate down from one rating to another can potentially create valuations that deviate from fundamental value, which can present opportunities for both sophisticated index fund managers as well as active funds.
Sampling an index in this way is not an arbitrary process, so managing a bond index fund is in many ways an active process. Credit analysis is a key part of tracking bond indices using a sampling approach, and it can be crucial to have insight from a credit research team to help the bond index fund managers to select the best new issues to buy (and which ones to pass on).
At Vanguard, given that our fixed income index funds employ a stratified sampling approach, our index fund managers take many small, active positions at the bond and issuer level, and they do this in a very intentional way. They pick the most attractive bonds and issuers to represent the small overweights in the indexed portfolio relative to the benchmark, and likewise select the least attractive names to underweight, while maintaining tight tracking and cost efficiency.
Scale and expertise
Achieving the optimal balance between cost and replication takes considerable scale, breadth and expertise. Given the intricacies of bond indexing and the dynamic nature of international bond markets, a dedicated credit research team and global investment platform can be critical.
While tracking error can be influenced by external factors, it can also be minimised through careful intervention by the fund manager.
Costs, too, can be minimised by the fund manager, and fixed income index funds can be an effective way to lower investment costs. When you combine the distribution of excess returns from industry-wide index and active fixed income funds, negative excess returns tend to be more common than positive excess returns4.
Bond index funds offer broadly diversified exposure to global bond markets, capturing the market returns at a lower cost than most actively managed funds. The scale and the philosophy of the index fund manager can also add value to the indexing process.
For those looking to outperform the broad index benchmarks, low cost Active strategies can provide additional opportunities for investors.
1 The Bloomberg Barclays Global Aggregate Float Adjusted and Scaled Index in EUR tracked 26,044 bonds as of 31 July 2020.
2 The FTSE Global All Cap Index in GBP tracked 8,859 stocks as of 31 July 2020.
3 Source: Vanguard. Vanguard’s Fixed Income Group had 179 professionals as at 31 March 2020.
4 Source: Vanguard Research; The case for low-cost index-fund investing, April 2020; Dr. Jan-Carl Plagge, David J. Walker, CFA and Andrew Hon
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Important risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
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Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
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