June 11, 2013
Capitalization weighting is the prevailing choice for equity index investors, who can choose from low-cost index funds constructed with theoretically proven methodologies. But capitalization weighting in fixed-income markets enjoys no such theoretical foundation, leaving investors without a clear choice for a diversified core fixed-income holding. A portfolio of bond exchange-traded funds that optimizes the tradeoff between yield and risk gives investors a commendable way to own a broadly diversified core allocation.
John Bogle, the champion of indexing, has expressed concerns about the attributes and performance of the current generation of bond index funds. He focused on the Barclays Aggregate Bond Index (AGG), but his critique is relevant beyond that index. Rob Arnott’s firm, Research Affiliates, has also detailed problems with the current bond indexes. It is intriguing when Bogle and Arnott agree, particularly because they have historically been at odds on the subject of equity indexing.
The problems with capitalization-weighted bond indices
There are a variety of reasons why bond index funds have come under scrutiny. One of the common critiques of bond indices is the practice of capitalization-based weighting, using the outstanding market value of bonds. Companies with more debt have a higher allocation in a corporate bond index. There is no foundation for holding more of a company’s or country’s debt as it borrows more.
Another issue with cap-weighted bond indexes is style drift. The relative weighting of the aggregate bond index to government-backed bonds increased from 35% in 2007 to 47% in mid-2012. The higher allocation to government-backed securities increases interest-rate sensitivity. The effective style drift in AGG was not a one-time event, however. The history of this index shows a constantly varying allocation to different bond classes. A 2011 study of corporate bond indices found that their exposures to both credit risk and interest rate risk exhibit considerable drift through time.
A bond index with changing concentrations to specific fixed income classes is not inherently problematic, but it raises the question as to whether these allocations are broadly representative of the market or a quirk of the weighting methodology.
Another limitation of the aggregate bond index is that it does not include a number of bond classes, such as municipal bonds and high-yield bonds. Those bond sub-classes should not be ignored, since they are two of the few with substantial yields. Investors shouldn’t chase yield, but neither is it rational to exclude certain bond classes because they are high-risk.
There is a very good reason why investors should care whether a bond index consistently captures the entire bond market. A premise of portfolio theory is that for a portfolio to deliver the highest return for a given level of risk, it must be fully diversified. If the aggregate bond index is not fully diversified, investors are missing some fraction of the available return from the bond market. In the parlance of portfolio theory, the Aggregate Bond Index is not on the efficient frontier. This, in turn, means that a better core fixed-income portfolio should allow investors to reap more yield than the aggregate bond index, with no increase in risk. Bogle has suggested that this is the case, but he did not provide quantitative support nor did he propose a solution. Fortunately, as I will demonstrate, we can directly observe yield and risk for bond sub-classes and calculate portfolio yield and risk for combinations of these sub-asset classes, establishing that traditional bond indexes are inefficient at providing yield.
An alternate strategy
Arnott’s firm, Research Associates, has advocated a new approach to designing fixed income indices, but the results to date are inconclusive. Its approach is to weight bonds based on fundamental measures of a country’s or company’s prospective ability to repay debt, rather than upon the amount of outstanding debt. In its research, it found that a fundamentally weighted high-yield bond index had historically out-performed traditional high-yield indexes by an astounding 473 basis points per year. High-yield bonds exhibited the strongest benefit from fundamental weighting in their analysis, and other classes of bonds showed consistent benefits. This result suggests that traditional high-yield indexes are the most flawed as compared to other bond classes and thus present the biggest potential for improvement with a better-designed index.
The implementation of this strategy has not been successful, however. The PowerShares Fundamental High-Yield Bond Fund (PHB) has substantially under-performed Morningstar’s high-yield bond benchmark throughout its 5+ years of history, earning the fund a one-star rating. Some of the other funds using the fundamental bond index methodology have fared better, but the observed under-performance of PHB, for which the back testing showed the best results, is a concern.
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