A lot of investors have been using equity index funds for years. But many are just getting started with index funds in the bond market, and exchange-traded funds (ETFs) are leading the way. Unfortunately, there are myths and misinformation aplenty surrounding fixed income index funds and ETFs, confusing investors and giving the wrong idea about what they are about and their potential benefits.
My colleague Martin Small in a recent blog post shed some light on why size does not equal risk in the bond market, which is one of the most common misunderstanding of index management. Another prosaic myth: Because bonds are different than stocks, it is more complex and difficult to index efficiently. Therefore, only an active manager is equipped to navigate in such terrain.
Except that is not true. One can effectively manage funds to track bond indexes, even though the bond market does have complexities and idiosyncrasies that don’t exist in the stock market. Case in point: iShares bond ETFs have done so in the past 15 years.
To break down the myth, I am tackling some of its elements and clarifying how index funds are actually managed in fixed income.
1. Bonds are too illiquid to track their indexes effectively.
Not all bonds trade daily, so how can you create an index tracking portfolio? iShares fixed income portfolios managers use a process called stratified sampling to select bonds that are suitable for the fund—and are liquid and trading today. Bonds of an index with similar characteristics can be grouped together and will have similar risk attributes. For example, BBB-rated telecom bonds with 7-10 years to maturity should perform similarly even as interest rates and spreads change. Portfolio managers selecting bonds from this grouping can gain access to the same risk factor without needing to buy all the bonds in the index to get the beta exposure.
At launch, a fund might be highly sampled and only hold the larger, more liquid bonds in its index. Over time, the portfolio managers would likely seek out more seasoned issues when they trade and also invest in newly issued bonds, so the number of bonds in the portfolio will typically grow. Ten year ago, iShares Core U.S. Aggregate Bond ETF (AGG) only had about 150 bonds in its portfolio; now it has 6,500 bonds, or two-thirds of the bonds in its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index. From its inception to 31 December 2017, AGG has returned within 1 basis point of its index, net of fees*.
2. Bond indexes have too much turnover, which cause forced selling for index managers.
It’s true that bond indexes have higher turnover than equity market indexes. Turnover can be thought of as inclusions (bonds coming in) and deletions (bonds coming out) for an index over a period of time. The higher turnover is the result of bonds being issued, rolling out of the maturity window or changes in credit ratings. The logical conclusion seems to be that the portfolio would have high turnover too.
In the real world though, there are ways for fixed Income ETF portfolio managers to reduce turnover and transaction costs relative to the index. In addition to the security sampling mentioned earlier, participation in new bond issues during the origination period and using the in-kind process to remove bonds when they fall out of the index are techniques that allow the fund to track its index tight, net of fees. iShares U.S. Credit Bond ETF (CRED) has demonstrated lower turnover compared to its index in the last five years. Even while incurring turnover, the fund tracked its index within 3 basis points net of fees from its inception to 31 December 2017*.
Index funds can help you gain precise control over the sectors, duration and geographies of your fixed income exposure. The benefits are not limited by asset class. ETFs are generally low cost and tax efficient, and they can serve as the core of your portfolio for both stocks and bonds. Next time you come across conjectures about bond ETFs, it helps to take another look.
*AGG and CRED inception dates are 9/22/03 and 1/5/07 respectively. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting www.iShares.com or www.blackrock.com. For standardized fund performance, click here.