The Curious Case of Vanguard Intermediate-Term Bond Index

On Aug. 11, Morningstar's Christine Benz noticed something quite peculiar--the single best-performing intermediate-bond fund over the trailing month, out of 1,238 funds in the category, was  Vanguard's Intermediate-Term Bond Index (VBIIX).

This wasn't indexing according to The House That Jack Built. The theory behind indexing is that low expenses coupled with an average portfolio gradually leads to above-average results. Each month, the index fund tends to be only very slightly above the norm, just a few basis points. But month after month that modest advantage becomes compounded, so that the index funds over time climb the rankings ladder.

But landing in top thousandth? After one month? What in the name of Bogle had happened? And what can we learn from this oddity?

What happened is unambiguous, and obvious upon reflection: The index fund invests quite differently than do the other funds in the category. Specifically, Vanguard Intermediate-Term Bond Index has one of the longest durations of any fund in the category (34th on the list), and one of the highest allocations to Treasuries (15th). With bond prices rallying sharply amid a flight to quality, in a flashback to 2008, the fund rode the bull. It gained 4.6% for the one-month period through mid-August, more than triple the category's average, and a full 50 basis points ahead of any nonindex fund. (In what likely was the worst stretch of relative performance in Bill Gross' long career, the Vanguard fund beat titan  PIMCO Total Return (PTTAX) by 400 basis points during that time period.)

Most intermediate-term bond funds benchmark their performance relative to the Barclays Aggregate Bond Index. (The fund that tracks that index,  Vanguard Total Bond Market Index (VBMFX), has been among the category leaders, as well.) However, says Morningstar's Eric Jacobson, bond portfolio managers have been unwilling to match that index fund's current portfolio because of "philosophy, instincts or client pressure." By philosophy, bond managers don't feel as tied to indexes as do stock managers. Yes, they also are measured and compensated by performance versus an index, but they are more willing to build portfolios that look very different from the index. Bond managers by instinct have shied away from assuming the index's level of risk as the bond rally has shrunk yields and raised durations, thereby making bond funds more volatile. Finally, clients seek both stability and yield from their bond funds, and neither of those attributes are enhanced by the index fund's Treasury-heavy strategy.

Index-fund wanderings occur more often than you might expect. For various reasons, ranging from the idiosyncratic design of an index, to market architecture (that is, one security, one sector, or one country dominating the market), to fund-manager beliefs, an index fund frequently will not serve as a neutral position for its category. This can also occur because of external market preferences. For example, if foreign governments prefer long-dated Treasuries to shorter securities and to government agencies, then U.S. government funds will likely favor the latter in their portfolios.

The Benchmark Fallacy
This effect leads to what I call the Benchmark Fallacy. If an index fund can differ from its peers so dramatically as to be the top fund in a huge category over a 30-day period, then it can also differ from its peers so dramatically as to corrupt active versus passive comparisons.

Indeed, that is what occurred with international stock funds a generation ago, when they almost universally trailed the Japan-laden MSCI EAFE index during the 1980s, then turned around and almost universally outperformed that same index the following decade.

The Benchmark Fallacy leads to major mistakes in interpreting mutual fund results. In the 1980s, it led to flawed arguments that active investment managers were particularly poor at investing internationally, followed in the 1990s by equally flawed arguments that managers had insights internationally, but were dopey domestically. Similarly, evaluations of the ability of domestic-stock managers have primarily been driven by the relative success of giant-cap stocks, as the S&P 500 tends to own bigger companies than even most large-cap stock managers.

The Benchmark Fallacy extends into other areas besides fund evaluations. For example, in the 1990s, a consultant published a widely cited paper showing that 401(k) plans had dramatically lagged a composite index that was made up 60% of the S&P 500, 40% of the BarCap Aggregate Bond Index. His interpretation that 401(k) investors were hopelessly incompetent was accepted without reservation by the financial media.

This conclusion was an error as a result of the Benchmark Fallacy. The consultant's index was made up of two assets that had recently soared: blue-chip U.S. stocks and high-quality U.S. bonds. Meanwhile, most of the large 401(k) plans that made up the study were diversified per modern portfolio theory and held multiple alternate asset classes--all of which had trailed the two assets that made up the consultant's composite index.

You know the sequel. During the next 10 years, U.S. blue-chip stocks were awful, so poor that even continued good performance by high-quality U.S. bonds could barely get the composite index in the black. Meanwhile, modern portfolio theory paid the rent. Foreign blue chips weren't good either, but small-company, real estate, commodity, and emerging-markets stocks were excellent. For the decade, three fourths of mutual fund categories outgained the consultant's composite index (yes, my calculations account for survivorship bias among funds). The study faded into obscurity; there was no follow-up.

Yes, Jack Bogle did indeed build the correct house--the aggregate numbers support the thesis that, over time, most low-cost indexing strategies will outperform. But that contention cannot be proved by looking at a small data set. Nor can conclusions about the relative merits of different indexing strategies be easily reached. As indicated by Vanguard Intermediate-Term Bond Index, the Benchmark Fallacy complicates the analysis--and invalidates some common beliefs.