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Fixed Income: Cheap Beta Can Be Expensive

James Jackson, CFA 10-Jul-2024

Iceberg

Most investors and financial advisors are familiar with the Bloomberg US Aggregate Bond Index—widely referred to as the “Agg.” This broad capitalization-weighted bond market index is often used as the benchmark for the intermediate-term fixed income universe, and both institutions and individual investors often gravitate toward mutual funds and ETFs that track the Agg as their core fixed income position. Some of the largest passive funds indexed to the Agg cost as little as three basis points and are considered an inexpensive way to get exposure to bonds.

 

In theory, this sounds perfectly reasonable. Who wouldn’t love a cheap way to access to the overall bond market (often referred to as beta*)? After all, investors have fully embraced this approach for large-cap domestic stocks (and other market segments, too).

 

However, the bond universe is an enormous, nuanced and complex market. It is much more diverse than the Agg represents and arguably more challenging to track than the market for large-cap equities. We believe that there are potential pitfalls to building one’s core fixed income exposures by simply allocating to a fund passively indexed to the Agg. Setting and forgetting may not be the best approach, and investors may find that embracing the concept of cheap beta for core fixed income might be more costly than anticipated.

 

Lessons Learned

 

One oft-overlooked factor is the way the Agg is constructed. We like to point out that it is an issuance-driven index, and thus its constitution is ever-shifting as it aims to incorporate (a representation of) all the new debt coming to market. As a result, the composition of the Agg becomes naturally tilted toward the largest debtors. This does not seem to be a sound basis when it comes to building a fixed income portfolio. As an investor, do you really want your core fixed income allocation so heavily exposed to those with the ability issue massive amounts of debt? Investors may not really want an overweight allocation to the largest borrowers.  Rather, we think there’s value in employing deep fundamental research and being highly selective in choosing securities when building portfolios.

 

It's also important to remember that a passive approach to fixed income does not necessarily mean less risk. In fact, the make-up of the Agg has materially changed over time, and that has sometimes left investors exposed to more risks (and the wrong type of risks) than they may have understood. Consider two recent examples of changing exposures that negatively impacted investors in passive products that tracked the Agg:

  1. In the lead-up to the Global Financial Crisis that was largely fueled by very low interest rates and runaway optimism in the housing market, the issuance of mortgage-backed securities (MBS) peaked. In fact, in November 2008, MBS represented almost 45% of the Agg at the very time that the mortgage market was beginning to melt down. Loading up on MBS at the height of their popularity was exactly what was happening with the Agg at that time.
  2. Let’s also consider how the duration profile of the Agg has changed over the years. Duration is a measure of a bond’s interest rate sensitivity, with a lower number being less impacted by changes in interest rates. The long-term average duration of the Agg over the past three decades was approximately 4.9. But in the lead-up to the Federal Reserve’s battle against inflation, the duration of the Agg had risen to approximately 6.8 (at year-end December 2021). So at the very time that Federal Reserve was beginning its most aggressive rate-hike cycle ever, any investor in a passive ETF that tracked the Agg was taking on an increasing amount of interest rate risk. That turned out to be the wrong move at the exact wrong time, so it should come as no surprise that the Agg clocked in with its worst ever annual total return in the following year.**

 

Fast forward to today and we’re seeing the composition of the Agg shift again due to its issuance-based nature. With the soaring U.S. deficit, Treasury issuance has spiked. As of the first quarter 2024, Treasuries accounted for more than 40% of the Agg’s constitution. This is a very large position that might not be ideal for investors who are seeking diversified fixed income exposure.

 

Advocating for Active

 

There are other potential limitations of a passive approach as well. The Agg only includes securities representative of approximately half of the U.S. bond market, thus leaving an opportunity for an active manager to allocate to potentially higher-yielding sectors being excluded. For example, the Agg does not hold certain structured products or municipal bonds, which might present attractive risk-reward opportunities.

 

We believe that active fixed income can strategically allocate across asset classes to potentially improve income opportunities in varying market environments. It might also avoid the unintended consequences of passive allocations that change over time based on market dynamics and the types of bonds being issued.

 

There’s no doubt that the largest and most liquid passive bond funds may be cheap and easy to buy. But investors should consider if these funds carry hidden risks that an active manager might avoid. Another consideration is whether a passive core fixed income fund that tracks the Agg is foregoing possible opportunities. Over the past several years we’ve seen several periods of elevated volatility, a dynamic that may endure given today’s uncertainties. Remember, whenever near-term prices dislocate from fundamentals, it also creates an environment for active managers to opportunistically allocate to various sectors and sub-asset classes.

 

Large passive fixed income funds that track the Agg may be cheap, but sometimes you get what you pay for.

 

 


*In finance, beta is a measure of volatility of a security in comparison to the broad market. Any security that has a beta of exactly 1.0 correlates exactly to the price action of the overall market (higher is more volatile, lower is less volatile). As such, beta is also used to convey broad exposure to the market, typically in the context of passive investing that simply tracks the market as opposed to selecting individual securities.

 

**The total return of the Bloomberg US Aggregate Bond Index was approximately negative 13% in 2022, the worst year for the index since inception in 1976.

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