The first half of 2024 is off to a solid start, with all the major equity indices posting solid returns, although these gains were not evenly distributed. Large cap stocks, (represented by the S&P 500) and tech stocks (like those found in the NASDAQ 100), dominated small cap’s (Russell 2000) and international’s (MSCI ACWI ex USA) respectable returns. Even the largest fixed income benchmark, the Bloomberg US Aggregate (“Agg”), managed a small but positive gain. These gains came despite the 10-Year Treasury yield increasing slightly over this period. On the economic front, inflation appears to have cooled for now, with the June CPI coming in at 3% YoY and falling .1% from the prior month.
Academia and market participants alike have long touted the benefits of passive indexing as opposed to hiring an active manager when investing, at least when it comes to large-cap stocks. The lower fees of an equity index fund should, in the long run, more than make up for any skill in stock picks that an active manager may have. Compton Wealth subscribes to this well-tested notion and recommends an indexing approach to equities in most circumstances. It is natural then to assume that this preference for indexing extends to fixed income investing. After all, if replicating the market at the lowest price is the key to long-term equity performance, shouldn’t the same logic apply to fixed income? Why not just load up on an Agg index fund, pay a paltry three basis points per year, and consider your fixed income allocation diversified? Surprisingly, this is not the optimal solution. In this newsletter, we will explore the reasons why index investing is problematic in fixed income.
This results in an index that captures barely half of the market, which is quite different than the commonly used equity indices of the S&P 500 (covering 81% of the U.S. stock market) and the CRSP U.S. Total Market (covering 96% of the U.S. stock market).
First, while the premise of indexing is sound, its implementation is near impossible in the fixed income market if you base your allocation off the Agg. While it has a long track record and is the benchmark for many, J.P. Morgan notes in a 2023 Portfolio Insights paper that “since launching in the mid-1980s, its rules-based construction has grown antiquated and no longer delivers the well-diversified portfolio many believe it to be”. In other words, while the fixed income marketplace has changed profoundly over time, the rules governing this index have not. This results in an index that captures barely half of the market, which is quite different than the commonly used equity indices of the S&P 500 (covering 81% of the U.S. stock market) and the CRSP U.S. Total Market (covering 96% of the U.S. stock market).
This lack of coverage of the fixed income marketplace means that large swaths of publicly traded fixed income instruments are either underrepresented or left out entirely, which negates the whole theoretical framework behind indexing. By tracking such a narrow index, you are taking more of a concentrated bet on a particular market segment than a broad sampling of it. Comparing this situation to the equity markets, would we really call it indexing if the benchmark we tracked excluded all Growth stocks, as an example? Growth stocks comprise 40% of the S&P 500. Excluding 40% of the investable universe does not make sense for stocks, so it should be even more apparent that excluding 48% of the universe for bonds when using the Agg is not in the spirit of indexing.
This under sampling leads to a second problem with using solely the Agg for indexing: concentration. It is float weighted, meaning that the larger the issue of debt, the larger proportion of the index that it comprises. As J.P. Morgan puts it, “the Agg rewards the most indebted borrowers by weighting the index based on how much debt an issuer has outstanding.” As an example of this, U.S. Treasury and Agency debt accounted for 38% of the index in 2000 but now 43% today. It is no coincidence that change occurred during a period of continued large deficits. As J.P. Morgan continued in their note, “Perversely, this means that passive Agg strategies end up with concentrated allocations to the largest borrowers — which isn’t necessarily the camp investors should want to overweight.”
As J.P. Morgan continued in their note, “Perversely, this means that passive Agg strategies end up with concentrated allocations to the largest borrowers — which isn’t necessarily the camp investors should want to overweight.”
This newsletter is not meant to pile on the Bloomberg US Aggregate. It has a long history and does an admirable job capturing the largest issuers of debt in the United States bond market. Because of this, it can show us the trend in how fixed income markets are doing based on the results of the biggest players. However, in terms of generating returns and reducing risk, it is simply too constrained to be an effective tool for indexing like you see with the major equity indices. Therefore, while some allocation to the Agg is reasonable, basing your entire fixed income exposure around it is lacking. Compton Wealth believes that active management has a key role in your fixed income portfolio, and we are continually evaluating our managers and researching alternatives to make sure that your fixed income portfolio is properly allocated.
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