The U.S. bond market may be good for a lot of things. Passive investing may not be one of them.

Debates about the relative merits of passive investing too frequently lump equities and fixed income together – as if the assumptions, approaches, strategies and outcomes are the same for both asset classes. But I would argue they aren’t. Especially when you consider that, within the broad fixed income market (represented by the Bloomberg U.S. Aggregate Bond Index):

• precise replication of the index is not possible given the more than 9000 bonds in the index¹
• the index might be considered a poor representation of the full bond opportunity set
• the index has become increasingly risky over the past five years relative to its own history.

The challenges of precise replication of the broad fixed income market

In the typical discussions of the merits of passive investing, a key assumption is that the most authentic way to be market neutral is to closely replicate the target index – e.g. the Russell 1000^® Index, the S&P 500^® Index, etc. But with just over 9,000 individual bond issues on its roster, the Bloomberg U.S. Aggregate Bond Index is likely too large, fragmented and illiquid to make index replication a reality. Add to that the fact those 9,000 bonds regularly change, as old issues mature and new issues are added, and it’s easy to see where the headaches for index replicators lie. In addition, passive investment strategies typically seek to provide a return equal to an index. However, exact replication of index returns is impossible because they don’t include trading costs, fees, or taxes among other considerations. Instead, passive funds may “sample” the index by buying a subset of the underlying securities in an index and trading those securities in order to stay aligned with the index. Obviously, transaction costs, differences in weights and choice of sample can all influence the accuracy of a passive investment. Even if bond index replication were possible with the same precision that equity index replication is, investors may well end up with a portfolio that includes unintended exposures because of some key differences in how typical stock and bond indexes are constructed.

• Many equity indexes (e.g., the S&P 500^® Index) are constructed on a sort of meritocracy basis: the market capitalization of their constituent companies dictates the weight each company represents in the index. As a result, over time, the best performing stocks within the index represent a larger percentage of the index while the poor performers decrease as a fraction of the index.
• What many investors don’t realize, though, is that, unlike equity indexes, bond indexes are weighted by the amount of debt outstanding of the various issuers. In other words, corporations or governments who issue the most debt make up the largest proportion of the index. So essentially, a passive bond index is heavily weighted toward the most indebted issuers. Depending on the credit worthiness of those issuers, that may represent a substantial amount of additional risk.

The Bloomberg U.S. Aggregate Bond Index doesn’t reflect the full investment opportunity set

Despite its 9,000 bonds, 97.5% of the commonly used U.S. bond index Bloomberg U.S. Aggregate Bond Index is composed of only four types of debt: U.S. Government, U.S. Government related, U.S. Agency Mortgage, and high-quality U.S. Corporate debt (as of December 31, 2014). Bloomberg U.S. Aggregate Bond Index – breakdown by debt type Admittedly, these four types of debt account for the largest portion of the overall U.S. bond market. But, they don’t represent the full opportunity set that is available to U.S. bond investors. For example, an investor passively replicating the Bloomberg U.S. Aggregate Bond Index would miss out on the opportunity to invest in riskier non-agency mortgages, high yield corporate bonds, bank loans, floating rate bonds, municipal bonds and TIPs among others. In the current low interest rate environment, these additional sectors offer investors some of the yield potential many have been seeking – although of course some of these sectors may come with increased risks, such as interest rate and default risk.

Beware the current relative riskiness of the Bloomberg U.S. Aggregate Bond Index

Finally, as a result of the prolonged low U.S. interest rate environment, the yield on the Bloomberg U.S. Aggregate Bond Index has decreased while at the same time duration (interest rate sensitivity) has extended as a result of the flat shape of the yield curve. Thus, a passive investment option based on the Bloomberg  U.S. Aggregate Bond Index would likely be more sensitive to interest rate increases and less attractive in terms of yield income than in the past.
Source: Bloomberg Live. Data as of 12/31/14.

In conclusion, when given the choice between active and passive investing strategies for the fixed income portion of a client’s portfolio, it is important to understand the implications of that decision. At Russell, we believe the levers available to active managers relative to passive alternatives in broad market fixed income provide a more sensible bond allocation for long-term investors. As with any investment, fees, risks and return potential should be taken into account before making a decision.