Passive index investing has significantly grown in popularity. The low-interest-rate and flexible monetary environment we’ve seen until recently is a part of this trend, shifting from active towards passive investing. Asset classes like U.S Large Cap have profited from this, but passive bond strategies haven’t enjoyed the same success. The recent market volatility has prompted many investors to reassess their risk exposure, realizing a need to balance their portfolio with assets like bonds. This article will delve into whether a passive Bond Index Fund like an ETF is a good addition to your portfolio, given that 91% of active managers in the multisector bond category outperformed the primary bond index, as per a study by Fidelity Institutional.
Understanding the Fund Structure
Passive ETF or index fund strategies are designed based on the largest companies in the index, and this works well for U.S Large Cap or an S&P 500 index fund. However, bond index funds are weighted differently. They’re based on the largest issuers of debt – primarily the U.S Government, accounting for about 70 percent of the Barclays Aggregate Bond Index.
This structure means that bond index funds comprise mostly government-issued bonds, and the little corporate debt included is from companies who’ve issued the most debt. These factors can lead to underperformance and can impact returns negatively. Jack Bogle, the pioneer of low-cost index fund investing, even acknowledged that bond indexing needs improvement.
Liquidity Risks of Bond Index Funds
Despite their structural issues, bond index funds offer ease of purchase. However, the flip side of this convenience is a potential liquidity risk. During panic selloffs, the price of bond index funds can fall below the worth of the underlying holdings. The March 2020 Covid sell-off showed how the price of bond ETFs can be dragged down by investor panic, with a -2.42% difference seen in one of the largest bond index funds.
|Largest Bond ETF
|Barclays Aggregate Bond Index
|Year to Date Total Returns as of 3/20/2020
|Month to Date Total Returns as of 3/20/2020
*Source Bloomberg, data compiled by heliosdriven.com
Lack of Credit Analysis
A significant drawback of passive bond index fund structures is the absence of credit analysis. Essentially, no one is ensuring that a company pays interest on their debt. If a company within the bond index fund were at risk of defaulting, a bond index fund manager generally wouldn’t swap it out for another.
Active bond managers, on the other hand, have teams to research company cash flows and balance sheets, to evaluate their debt repayment ability. This enables them to find deals in credit markets and generate higher returns.
Active bond managers can mitigate risks, such as rising interest rates, and use derivatives to hedge against interest rate increases. These strategies can help generate higher returns and reduce volatility compared to their passive bond index peers.
What YOU Should Do
The evolution of bond index funds and their current shortcomings indicate the need for a balance of passive and active strategies. Incorporating alternative assets like private credit or private real estate into your portfolio can create more optimal risk profiles and improve efficiency. We encourage creating a comprehensive plan based on your needs to determine what blend of assets is suitable for you.
For guidance on creating a comprehensive plan, feel free to reach out or schedule a call with us.
MDRN Wealth LLC does not provide specific legal or tax advice. Please consult with professionals in these areas for specific legal and tax recommendations. The information provided herein is general information. It is not intended to be construed as investment, tax, or legal advice. Information in this article is not an offer or solicitation to purchase, sell, or endorse a specific company, security, investment vehicle or strategy. Investing involves risk and the possible chance for loss of principal. Please consider your tolerance for risk before investing. Past performance is never guaranteed and future results can vary. Opinions conveyed by MDRN Wealth LLC cannot be viewed as an indicator of future performance and are subject to change. Results may vary. Use information at your own risk.