Jason Stipp: I want to talk you a little bit, Ken, about the BarCap Aggregate Index. So, this is the index that the Vanguard Total Bond Market Fund follows.
Our fixed-income research specialist, Eric Jacobson, had mentioned to us recently that there are some areas that the index doesn't track. So, certain high-yield areas, certain residential mortgage-backed securities aren't well represented, non-dollar denominated bonds, so foreign bonds in different currencies, not represented in that index. These are areas that we're seeing some active managers moving into, and they can be big areas of the fixed-income market that aren't represented in this index.
My question for you is, is this still, in this day and age, a good core index for people who want to have broad exposure to the bond market?
Ken Volpert: The Barclays Capital Aggregate Index is ... really measuring the full U.S. investment-grade market, with maturities of over one year. So, there have always been investors that go outside of their benchmark. The Agg Index, with the aggregate index, there has always been investors that have gone high-yield, that have gone into international as out-of-benchmark bets. So, that's nothing new to right now.
So, the whole argument with indexing is that, if you add up the active managers in a particular market, for example, the U.S. investment-grade market, you add them all together you should get the market, and if you can get the market return with much lower cost in a index form then you can by averaging all the active managers with much higher expense ratios, then the index should do well over time and that still definitely holds for the Agg at this point.
Stipp: Do you think within Vanguard, do you think there is a possibility that we could see an index fund that follows a broader index that might include some of these other areas such as foreign bonds and the high-yield areas, so that someone who wants a broader exposure with a core index fund might have an option, for example, but staying within Vanguard?
Volpert: Well, I think what they can do is, if they want to orient towards a higher credit weight, for example, they can blend our Agg with something like our intermediate-term and corporate index. So, they can actually combine themselves the broad index portfolio with some version that gives them a little bit of a tilt or orientation toward a particular market, but they should realize that's an active strategy; that's not the market.
Stipp: Follow-up question somewhat also based on the index. We've seen a lot of active managers taking some pretty significant bets against the index--overweights and underweights, I think especially as it relates to Treasuries, and the fact that Treasuries are yielding very little right now, the prospect for them in some active managers' minds are not very good.
Do you think that active managers might have a period where they are able to outperform the index, given that we're seeing some of these bets taking place and also that there could be some headwinds for Treasuries?
Volpert: There is a tendency for active managers who have--basically who have high expense ratios, they have to take risk, in terms of credit risk, for example, to try to overcome that expenses ratio and then add value incrementally over it. This obviously was something that happened in 2008 and once spreads widened out and there was a lot of concern about recession etc., those managers got hit pretty hard.
So there is a lot of risk that comes with that reaching for yield, going down in quality, reducing your weight to governments and increasing your weight to credit that investors should realize. During the great times when the economy humming along, yes, you're picking up the extra yield, but then when there is trouble in the economy, those spreads could widen, and they should realize that there is that risk that during the downturn in the economy, they could actually lose a lot of money relative to the index.
Stipp: An extension of that question: a lot of active managers also have constraints they can deviate from the index to a certain percentage, but we're also seeing now a step beyond that, the rise of more unconstrained bond funds, managers that can invest just about anywhere with lots of leeway in where they place their bets and the extent to which they place their bets.
I just wanted to get your take as an indexer, how should investors be thinking about all these new options that they have and what is your sense and your take on the rise of the unconstrained bond fund?
Volpert: Well, our view would be that investors--what we've tried to do is, offer investors very good clarity around the risks that they are taking in their market. If they want a corporate fund, they can buy a corporate active fund or they can buy corporate index fund. If they want the full market they can buy the full market. So, it really gives a chance for the investor to kind of express their view and then buy it in a low-cost form.
Active managers have the same tendencies that we have as investors where ... you are at risk of following the crowd or following past performance and still a lot of human judgment and behavioral issues that cause us to make bad choices sometimes as active managers or as investors. And to broaden the range of risks and the range of markets that you can take, I think is potentially a risky strategy for investors. It may work out for a while, but then when there is some huge dislocation in the market, it could result in very large differences in performance than what investors were expecting. So that's something that we're really not interested in offering to investors.
Stipp: I think from a portfolio-planning perspective, trying to keep certain allocations in line with your strategic plan, then you have a fund that could be over here one month and over here one month makes it a lot harder to stick to your strategic asset allocation potentially.
Volpert: Yes, that's right. If you don't know where they're going to be, and they have this wide range of latitude, that's exactly right. You don't know what your actual allocation is until you get the feedback in terms of where they are, and then how do you manage that?