Last year wasn’t the best time to hold bonds. Nearly every equity market delivered solid gains in 2021, while the S&P U.S. Aggregate Bond Index fell 1.4%. Nevertheless, flows into fixed income products such as ETFs were firmly positive. The leading asset gatherer was total market-type ETFs, with one in every three dollars newly invested in U.S. fixed income ETFs during 2021 allocated to the “aggregate” category.
This is perhaps unfortunate, as the “aggregate” bond indices largely excluded some of the best-performing segments last year, as Exhibit 1 shows. This anomaly isn’t new, but it is newly causing providers to openly question the traditional thinking of fixed income indexing.
Fixed income investors have long measured the bond market with an aggregate-type index. As the name would imply, the largest portions of the bond market are combined into a single index. In simpler times, this worked: the majority of the bond market consisted of Treasury, government agency, corporate, and collateralized bonds. However, newer segments that are designed to protect investors from inflation (TIPS), interest rate risk (duration hedged and floating rate bonds), and taxes (munis) are excluded. These newer segments, including inflation-linked, high-yield, and global U.S. dollar bonds, have grown in size and scale over the past decades. Nowadays, a typical U.S. aggregate index accounts for only about half of the U.S. bond market, as reported by SIFMA.
Making an analogy to equities, this is akin to excluding stocks because they operate in breakthrough industries that didn’t exist 20 years ago. And, just as avoiding new equity industries can impair performance, last year, the half of the market tracked by aggregate bond indices happened to represent the worst-performing portions of the bond market (see Exhibit 1).
Investment managers, particularly those managing active funds, have moved beyond these core holdings to create “core-plus” accounts. These strategies allow for flexibility to buy non-aggregate securities like inflation-linked and high-yield bonds. Allowing for out-of-index trades opens up the opportunity set but, with the benchmark still anchored to its old rules, a potential mismatch arises in performance evaluation and risk management.
The practice of measuring managers’ performance against core and core-plus categories is recent, yet roughly half of active bond managers are placed in the category. This schism in the largest fixed income category has taken place in the mutual fund world, while the largely passive ETFs have remained anchored to the old index ways. Yet, investment flows into active fixed income ETFs, while small, are double that seen in the equity market (see Exhibit 2). This could be partly due to the flexibility active managers enjoy, as well as the gaps in traditional fixed income benchmarks. Readers of our blog should know better, though. According to our latest SPIVA® U.S. Scorecard, which measures performance of active managers against their benchmarks, the majority of fixed income managers failed to beat their assigned benchmarks in the 3-, 5-, and 10-year horizons.
Despite their long-term underperformance, the past year has been favorable to the large majority of active fixed income managers, at least if their performance is to be compared to traditional aggregate indices.
But traditional aggregate indices may, like their active alternatives, benefit from casting a wider net. As they do, passive bond funds could move to incorporate rules-based, systematic, and transparent return-enhancing bond strategies, such as inflation protection, credit premia capture, and curve strategies (such as carry, roll, and yield enhancement). For that to happen in indices, a new breed of index may be required, and the timing for that solution looks promising.The posts on this blog are opinions, not advice. Please read our Disclaimers.