In political parlance, “gerrymandering” is when the boundaries of an electoral constituency are manipulated to favor a particular result. The practice has long been controversial, prompting intervention from the U.S. Supreme Court. But the High Court has never weighed in on “gerrymandering” in the largest active bond fund segment: the over $1 trillion of assets captured by the Morningstar US Intermediate-Term bond (ITB) category.
The Bloomberg Barclays U.S. Aggregate Bond Index—commonly referred to as the Aggregate Index—is the benchmark against which over 90% of active ITB mutual fund performance is evaluated. Investors have typically used these funds at the core of their portfolios to pursue broad, diversified exposure to the U.S. market. Over time, however, the Aggregate Index has gradually become a less apt mirror of the investment universe of the total investable U.S. bond market.
The Aggregate Index was developed in the 1980s and largely reflects the investment grade bond universe of its era: government bonds, agency mortgage-backed securities (MBS) and investment grade corporate bonds. Just as our fashion choices since the 1980s have expanded beyond parachute pants, Member’s Only jackets and Jordache jeans, the U.S. bond market has markedly evolved with the growth of high yield corporate bonds, dollar-denominated emerging markets (EM) bonds, asset-backed securities, collateralized mortgage-backed securities and more.
The problem is that although the U.S. bond market is materially different than it was in the 1980s, we still talk about it as if it were the same as the Aggregate Index. This conflation in turn clouds how we evaluate the performance of bond mutual funds. What would you think if your large cap stock fund owned 20% of the portfolio in small caps? Or your U.S. stock fund moved 15% of portfolio allocations into Emerging Market (EM) stocks?
You would most likely react in two ways: First, surprise—the portfolio in which you invested does not have the risk/return profile you thought it would. Second, confusion—your ability to judge if the fund manager’s investment acumen is good value for the money would be impaired because of considerable allocations outside the benchmark. In order to try to beat the market, active funds often have to be invested outside that market.
In other words, the right benchmark can help us understand a manager’s investment skill; conversely, a poor fit can obscure skill and make it difficult to objectively evaluate active performance. Neither outcome is desirable, whether we’re considering an active mutual fund or an index vehicle like an exchange traded fund (ETF).
A different lens
Seen through this lens, the Aggregate Index is not an apt benchmark for the ITB category. Managers of these funds often emphasize their expertise in areas such as high yield credit and EM debt. These exposures are often well-represented in actual ITB portfolios, yet the index doesn’t reflect their typical drivers of risk and return, such as credit quality, spreads and sector allocations. These out-of-benchmark allocations give ITB portfolios a wider opportunity set to pursue excess returns, but they also introduce additional risk into the portfolio—neither of which are captured in the reference benchmark.
Let’s see how the average ITB portfolio sizes up against the Aggregate Index versus the Bloomberg Barclays U.S. Universal Index (U.S. Universal Index), an index that includes more comprehensive bond exposures. You’ll notice below that ITB funds look more like the U.S. Universal Index than they do the Aggregate Index. For example, ITB funds have a substantially smaller allocation to government bonds than the Aggregate Index does and a larger weighting to corporate bonds. They also have 12% in assets such as municipal bonds, non-agency MBS, bank loans, and preferred and convertible securities. The Universal Index, meanwhile, has a similar corporate bond profile to ITB funds, including roughly 10% in high yield.
Will the real bond market please stand up?
Here’s why it matters: If funds in the ITB category were benchmarked against the Universal, investors could make more informed manager selections and understand the tradeoff between higher manager fees and a lower-cost ETF implementation. And in fact, fewer ITB fund managers have consistently outperformed the U.S. Universal Index compared with the Aggregate Index (see the chart below).
The U.S. Universal Index has been hard to beat over time
Let’s be clear. There is nothing wrong with the Aggregate Index as an index. The Aggregate Index has helped shape the modern bond markets. It should just be understood for what it is: an investment grade bond index, largely comprising U.S. government and agency debt. It’s when the Aggregate Index is used to judge manager performance in ITB funds, specifically managers that own substantial allocations to high yield or EM debt, that it is akin to gerrymandering. Then, it’s fixing the boundaries, constraining the investment universe against which ITB funds are judged, in order to favor a given result.