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.
Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This post contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
Buying and selling shares of ETFs will result in brokerage commissions.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.
The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).