Last year around this time I penned a blog lamenting the fact that the same interest rate forecasts and conversations about the need to either rotate out of fixed income or at least go active within fixed income were happening again, after years of me repeating the mantra with clients that fixed income indexing can work in any interest-rate environment. Below is last year’s blog in its full glory. And while you revisit my musings from a year ago, snack on some timely stats and their implications in light of the noise amongst the global capital markets.
Sources: Yields and index returns from Barclays. Fund category excess returns from all Morningstar funds in each category with at least a 1-year return.
Note: Of course 2015 wasn’t a poor year across the board for active. For example, Vanguard’s flagship bond funds enjoyed a solid year, returning 1.16%, 1.63%, -2.11% and 0.41% respectively for ST Investment Grade (Admiral), IT Investment Grade (Admiral), LT Investment Grade (Admiral) and Total Bond Market Index Fund (Institutional). (Source: Vanguard, as of December 31, 2015. The performance data shown represents past performance, which is not a guarantee of future results. Investment returns and principal values will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. See the table below for 1-, 5-, and 10-year performance data through December 31, 2015. For performance data current to the most recent month-end, visit institutional.vanguard.com/performance.)
What follows is my blog from 2015 in its entirety. Enjoy!
The other weekend I had a fairly animated debate about interest rates with a family member which got me itching to come in to work and blog on indexing (yeah, that’s the definition of weekend excitement for me!). While in the end we agreed to disagree, it was one of those conversations that remind me of the movie “Groundhog Day,” starring Bill Murray. For those who haven’t seen it (do such people exist?), “Groundhog Day” is a comedy about a weatherman who, while covering annual Groundhog Day events in Punxsutawney, Pennsylvania, experiences a time loop that forces him to relive the same day until he changes his outlook on life.
Why “Groundhog Day?” Because I feel like I’ve had the same conversation time and time again over the last 6-plus years. You see, my counterpart was adamant that higher interest rates are right around the corner and that protection from bond risk was of paramount importance. I remained unconvinced and instead espoused the virtues of indexing one’s bond exposure.
So, what does a fear of rising rates have to do with indexing? Well, along with all those expectations for rising interest rates is an implicit (and irrational) fear of indexing. After all, active managers are free to shorten duration, alter credit exposure, and even perhaps move outside of the United States for diversification and better returns. Passive investors, the story goes, are at the mercy of the markets—which means that when rates rise, they’ll lose money. Wow, that stinks!
So, of course, as someone who has coauthored Vanguard’s Case for index-fund investing white paper, I find myself developing a twitch whenever these conversations arise for two reasons: (1) stating that rising rates are bad ignores why and how they are rising; and (2) assuming that because managers can adjust their portfolios appropriately in no way means they will do so with success. Two significant assumptions—both intuitive but extreme generalizations and, therefore, misleading.
I can highlight the risks of these assumptions with a single example: the period March 1, 2003, through June 30, 2006, the longest recent stretch of increasing interest rates. Over that period Treasury bills rose 379 basis points as the Federal Reserve systematically increased its target interest rate. Meanwhile, the 10-year Treasury bond rose 180 basis points as fears of deflation abated and global growth took hold.
Sources: Vanguard using data from Thomson Reuters Datastream, Vanguard, and Morningstar, as of December 31, 2014. The performance data shown represents past performance, which is not a guarantee of future results. Investment returns and principal values will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. See the table below for 1-, 5-, and 10-year performance data through December 31, 2015. For performance data current to the most recent month-end, visit institutional.vanguard.com/performance.
Yet despite this period of sustained rising rates, total return investors in various Vanguard bond index funds actually generated positive total returns. Clearly by indexing, investors did not lose money. Further, the longer the average maturity and duration¹ of the fund, the greater the return! Counterintuitive? Perhaps . . . but with rising rates, as with anything, the devil is in the details. This was a period where inflation expectations were contained, global economic growth was positive, investors were willing to put capital to work, and there were few shocks to the global macroeconomic or geopolitical landscapes. As a result, investors were able to reap the benefits of compounding higher yields over time.
It’s also interesting to note that relative to many actively managed mandates, index funds held their own. To be sure, investors in active mandates also likely realized positive total returns over this period, whether they were in short-, intermediate-, or long-duration funds (for example, Vanguard Short-Term, Intermediate-Term, and Long-Term Investment-Grade Funds returned 9.07%, 10.14%, and 11.73%, respectively, over this period). But a knee-jerk expectation for active to simply be a better option than passive because of rising interest rates proved challenging. In fact, we found that the median active manager in the industry underperformed their benchmark (largely likely due to the impact of high fees).²
While some active funds were able to outperform over this period (both Vanguard Short-Term and Long-Term Investment-Grade Funds outperformed, for example), many active managers did not.
Of course my example is more than 10 years old, and critics might suggest that this time is different (although our own models forecast positive total returns over the next decade despite rising rates along the short to intermediate segments of the yield curve³). However, active managers didn’t fare so well in 2013 either—the most recent episode of rising rates—as 70% of bond funds underperformed with a median excess return of –0.72%, according to Morningstar, on top of the bond market’s loss as represented by Barclays U.S. Aggregate Bond Index of nearly –4% between May 2013 and August 2013. And despite losing money in the year 2013 (–2.02%), the bond market went on to return 5.60% in 2014, in the face of expectations for continued losses among investors (in Q4 2013, for example, investors pulled almost $50 billion out of traditional taxable bond funds, with only $8 billion returning in Q1 2104).
Indeed the markets are just like a real-time example of “Groundhog Day.” We keep hearing the same stories regarding the risk of rising rates and the need to go active. And, our plot is still building as we wait for the next call for rising rates and the “need” to go active. So while we wait, let’s grab the popcorn and remember not only the power of indexing, but the role of risk-controlled, diversified fixed income in a portfolio.
¹Duration is a measure of the sensitivity of bond—and bond mutual fund—prices to interest-rate movements.
²The median expense ratios for actively managed fixed income funds were 0.70%, 0.76%, 0.88% and 0.80% respectively for ST government funds, ST credit funds, IT government funds and IT credit funds respectively as of YE 2013.
³Davis, Joseph, Roger A. Aliaga-Díaz, Andrew Patterson, Harshdeep Ahluwalia, Vanguard’s economic and investment outlook, December 2015, Valley Forge, PA: The Vanguard Group.
|Average annual returns as of December 31, 2015|
|Vanguard fund||Expense ratio*||1 year||5 year||10 year||Since inception|
|Short-Term Bond Index||0.10%||0.92%||1.49%||3.27%||3.13% (11/12/2001)|
|Short-Term Investment-Grade||0.20%||1.03%||2.04%||3.46%||6.26% (2/12/2001)|
|Intermediate-Term Bond Index||0.10%||1.27%||4.39%||5.49%||5.34% (11/12/2001)|
|Intermediate-Term Investment-Grade||0.20%||1.53%||4.45%||5.34%||5.88% (2/12/2001)|
|Long-Term Bond Index||0.20%||-3.47%||6.82%||6.37%||7.34% (3/1/1994)|
|Long-Term Investment-Grade||0.22%||-2.21%||7.32%||6.46%||8.42% (2/12/2001)|
|Total Bond Market Index||0.07%||0.40%||3.13%||4.47%||4.36% (11/12/2001)|
*Expense ratios as of the most recent prospectus.
- All investing is subject to risk, including the possible loss of the money you invest.
- Bond funds are subject to interest-rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
- Diversification does not ensure a profit or protect against a loss.
- Past performance is no guarantee of future returns.